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Saturday, 9 October 2010

Currency wars at a time of deficient demand


LAST week, Brazil’s finance minister said: “We’re in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness.”

This says it all. The International Monetary Fund has since warned of widespread currency interventions which could derail the fragile recovery. Many nations are engaged in policies to weaken their currencies. Further competitive devaluation will inflame global tensions.

At a time of continuing deficient demand, this is not the time for the world’s major currencies to face off in what can only be described as an “ugly contest”.

By the third quarter of this year (Q3), attention had shifted from the deep woes engaging the eurozone to re-emerging economic and fiscal fissures in the United States.

This sudden re-orientation of focus helped the euro reverse most of its springtime collapse, and saw the US dollar lose more lustre.

Then there is the ever-strong yen. Japan is faced with a deep economic malaise and is anxious to ease exporters’ burden. It is not surprising that Q3 highlighted the standoff over which of the three most actively traded currencies has the lousiest outlook.

The euro hit a new low against the US dollar (1.1917) on June 7 and for the first half of 2010, it was 15% from where it started the year.

But the euro rose 11.5% in Q3. Against the yen, the US dollar fell to a 15-year low (83.10 yen) in mid-September. That prompted the unleashing of a US$20bil blitz of yen selling, driving it off its high.

The yen has since returned to its pre-intervention rate. The end result: the US dollar not only slid against the euro and the yen, but also fared worse against most emerging market currencies.

When measured against a basket of major currencies, the US dollar sank to its lowest level since January. By Oct 5, the ICE Dollar Index was below 78, against 88 in June.

The grass gets crumpled

This is not the first time we see a currency conflict. In August 1971, the “Nixon shock” ended US dollar convertibility to gold. In September 1985, the Plaza Accord devalued the US dollar, notably against the yen. This time around, the target is the Chinese yuan.

The East has a saying – when tigers fight or make love, the grass gets crumpled. The United States has pressed hard on China to revalue faster; the European Union (EU) and Australia have since raised the volume of their rhetoric on China. Meanwhile, others have been intervening to hold their currencies down.

Australia warned Europe against reviving protectionism masquerading as environmentalism. The situation can only get worse. Already, the Institute of International Finance (IIF), representing 420 leading financial institutions, just revised upwards its latest forecast for net inflows of capital into emerging markets, showing a sharp increase to US$825bil for 2010. All in search of higher yields, thereby risking instability.

Of course, the United States and EU blames all this on China. But many emerging economies blame ultra-low interest rates in rich countries (reflecting aggressive quantitative easing, or QE) for diverting vast amounts of cheap funds to their domestic markets, creating a policy dilemma for most.

Their economies are growing nicely in the face of rising inflation. This limits the use of interest rates to curb these funds inflow.

On Oct 4, Brazil doubled a tax on foreigners’ purchases of local bonds. Australia and Indonesia kept their benchmark rates unchanged to ward off further inflows. The Philippines is expected to hold their rates. India and Thailand are considering new steps of protection.

The big problem remains. Globally, ad hoc currency interventions don’t work. At its heart is the US dollar, trapped in a downward spiral as expectations of further monetary easing by the Federal Reserve Bank (Fed) drags it lower.

The global architecture is broken. But how best to move away from a system where the US dollar plays the role of a major reserve currency and the United States sets global interest rates?

It looks like the entire Asian sovereign community is suddenly buying euro and yen – so much so the Japanese on Oct 6 lowered the target for its key overnight rate to 0.0% and 0.1%.

John Connally (Nixon’s Treasury Secretary) says it best when he famously told Europeans that the “US dollar is our currency, but your problem.”

In the absence of currency adjustments, the Chinese response appears to be, in the words of Financial Times’ Martin Wolf: “In effect, the United States is seeking to inflate China and China, to deflate the United States.” It’s a stalemate. The grass continues to get crumpled.

There is now, according to the IIF, “an environment of unilateralism and bilateralism laced with isolation and parochialism.” Somewhat exaggerated, but in essence, correct as I see it.

The yuan scapegoat

Reality check: The developed world suffers from chronic deficient demand. The IMF just cut its growth forecast. The six biggest high-income nations’ gross domestic product (GDP) in Q2 is nowhere near what it was in Q1 of 2008.

They are operating up to 10% below potential. In the United States and eurozone, core inflation is only 1%. Deflation beckons.

Those with trade deficits and surpluses alike all love to have export-led growth. In a zero-sum world, this can only happen if emerging nations shift to run huge current deficits. That’s not about to happen.

Also, the vast accumulation of foreign reserves complicates any meaningful adjustment. Between January 1999 and May 2010, reserves went up by US$6.8 trillion to reach US$8.4 trillion. China accounted for 30% of the world total, or equivalent to 50% of its own GDP. That’s the big picture.

Until the early 1970s, currency rates were fixed under the Bretton Woods monetary system. It fell apart with the US-inspired inflation of the 1970s. So the world moved to floating rates.

But most nations still chose to peg to the US dollar. With the euro, most of Europe moved to fixed exchange rates. Pegging offered the benefits of exchange rate stability, eliminating a source of uncertainty for investment and trade to flourish.

One catch though: pegged nations give up monetary independence. In the US dollar-bloc, they yield to the Fed and in the euro-bloc, the European Central Bank (ECB).

This is what China did when its yuan was pegged to the US dollar. In exchange for the benefits of exchange rate stability, it subcontracted much of its monetary discretion to the Fed.

For more than a decade, this served the world economy well; Americans raised their living standards and millions of Chinese enjoyed prosperity.

For years, the United States had pressed the yuan to revalue in the name of reducing the US trade deficit. What’s not so obvious is that much of this deficit is intra-company trade, that is, US firms outsourcing production to China to stay globally competitive.

Beijing bent for a while in the middle of last decade and adopted a crawling peg, allowing the yuan to revalue by 18% with little impact on US trade deficit. China re-pegged amid the financial panic in 2008. American clamour to revalue revived and the yuan relented and moved to greater “flexibility” last June. Recently, the yuan reached its strongest since 1993 – up 2% to 6.69 per US dollar but fell 10% against the euro. That’s far too slow for the United States and Europeans.

The US trade deficit with China surged to US$268bil in 2008, up from US$202bil in 2005. Currency is but one factor influencing where firms manufacture.

Furthermore, the United States no longer make many of the goods China exports. So a shift in business out of China would more likely mean relocation to other low-cost Asian nations, rather than rebuild US capacity.

The yuan has appreciated 55% against the dollar since 1994, when Beijing begun to overhaul its forex system. That bilateral imbalance is structural. As I see it, the only way the United States can fight off Chinese competitive challenges is to innovate and boost productivity at home.

Both the United States and EU now urge China to allow “an orderly, significant and broad-based appreciation” of the yuan. I think China is right to resist these calls, not least because a large revaluation is likely to damage China’s growth and basic restructuring plans.

China’s continuing expansionary “train” is pulling along growth in East Asia nicely, and to a lesser extent, that of the developed world as well.

“The world has already become partially de-coupled” says Nobel laureate Joseph Stigliz. China has learned from past experience, including that of Japan, which bowed to similar US pressures in the 1980s and 1990s, revaluing the yen from 360 per US dollar to a high 80 in 1995.

According to Stanford’s Prof R. McKinnon, one result was domestic deflation and its lost decades in growth. Meanwhile, Japan continues to run a trade surplus as imports fell with slower growth and cross-border prices adjusted. China helped lead the world out of recession and the world needs that to continue.

What’s China to do?

The media wants us to believe the biggest sinner in this game of beggar-thy-neighbour is China. But, in their own way, the United States, Britain and EU are engaged in much the same thing.

Massive QE has effectively created negative interest rates and debauched their currencies to boot with floods of liquidity. QE proved a highly effective way to devalue the dollar.

Indeed, it is a much more powerful form of persuasion than the threat of tariffs. The very prospect of more QE can rattle China and most of Asia to submission.

But the global imbalances that created the crisis have yet to be addressed by centring criticism on China. Reform of the international monetary architecture is needed to resolve the problem, with a global “clearing” organisation acting independently among nations to manage “surpluses” and “deficits”. This institution is intended to keep the world in balance. This won’t happen.

Maybe, the approach is wrong. I think the real problem is not the yuan’s exchange rate but its inconvertibility and capital controls. As a result, the yuan’s development has been stunted since private markets can’t recycle the flow of dollars arising from continuing large surpluses.

China’s huge reserves represent a significant misallocation of global resources. Instead of letting these reserves find their optimum private investment use, China uses them to buy US Treasuries and bonds.

Once made convertible, capital and trade flows will adjust through private markets rather than the Peoples’ Bank. That’s how Germany recycles its surpluses. In this way, a one-time modest revaluation accompanied by convertibility can assist in the global adjustment process, while avoiding the perils of Japan-like deflation.

Whether China is ready for convertibility of its yuan is a key question. All I can say is that stage-by-stage convertibility increases domestic pressures for China to further liberalise to develop its financial system, which in turn, helps in global rebalancing.

What’s important is for China and the other surplus nations (Germany and Japan) to understand that their policies are not helping the United States to rebalance.

Similarly, the United States and EU need to understand that the surplus nations simply can’t adjust fast enough to suit them.

Resolution requires realistic “grown-up” behaviour on the part of core parties in this dispute to agree to global rebalancing with care and with determination.

For a start, I see merit in the IIF’s call for a new coordinated currency pact by the core parties to hammer out with haste, an understanding to help rebalance the global economy.

It needs a more sophisticated version of the Plaza Accord to include “stronger commitments to medium-term fiscal stringency in the United States and structural reform in Europe.” The world deserves more, not less.

Former banker Dr Lin is a Harvard-educated economist and a British Chartered Scientist who now spends time teaching and promoting the public interest. Feedback is most welcome at