The leaders of the G-20 nations will meet next month in Seoul to attempt to defuse tensions over competitive devaluation by governments — the currency war of the tabloid headlines — that their central bankers and finance ministers were unable to resolve at last weekend’s annual meetings of the International Monetary Fund and the World Bank. At this point the prognosis is not good. The consensus and cooperation that was there at the start of the global financial crisis continues to evaporate.
Host South Korea, as Japan’s finance minister has mischievously pointed out, is one of the countries that “regularly” intervenes in foreign exchange markets, but it is China’s foreign exchange-rate policy that will be the elephant in the room, as it was at the IMF meeting. The pace of the yuan’s appreciation against the U.S. dollar since China again loosened its peg with the greenback in June (2.4%) has been insufficient for the critics who accuse China of keeping the yuan cheap to protect its exporters.
If China’s most recently posted trade surplus of $120.6 billion dollars in the first nine months of 2010, 10.5% lower than in the same period a year earlier, hasn’t assuaged China’s critics, then the largest quarterly increase in the country’s foreign exchange reserves in the third quarter, $194 billion, thanks to the persistently large trade surplus and capital inflows, is only likely to inflame them, providing further evidence that the yuan is undervalued.
The new factor is the beggaring of neighbours. U.S. Treasury Secretary Timothy Geithner says that that the yuan’s undervaluation is forcing other developing countries that supply China to attempt to halt the appreciation of their currencies, too. What Geithner did not say was that it halting his country’s attempts to devalue its way to export growth, too. For those with even longer memories than ours, the calamitous competitive devaluations of the Great Depression come into prospect.
Beijing has been candid about the damage it believes a rapid upward revaluation of the yen would to do its exporters, citing that as its reason for moving cautiously. It continues to remind anyone who will care to listen, though its words mostly fall on deaf ears in the rich countries, that there are other sources of the current global imbalances, such as huge fiscal deficits and unconventional monetary policy in the developed economies.
We are likely to be hearing more of that refrain. In the U.S., the Federal Reserve is expected to embark soon on another wave of flooding the U.S. economy with money, the so-called second round of quantitative easing (“QE2”). The Fed’s strategy for stimulating a recovery that is stubbornly sluggish, if not unexpectedly so given the de-leveraging the U.S. economy has undergone, is to inflate the economy and depreciate the dollar by a combination of running negative real rates (nominal rates are already as close to zero as makes no difference) and quantitative easing.
This is not with our risk. So much world trade is denominated in dollars, as the only global reserve currency, that price inflation of commodities like oil is inevitable. That may not worry Americans so much (yet; but wait for $200 crude), as fighting off deflation is their immediate concern, but it sure worries emerging economies that are not natural-resources exporters, such as China, where inflation is the more pressing concern.
The double hit that quantitative easing in developed economies lands on emerging economies is that it will increase their inward capital flows, potentially inflating asset bubbles, making more probable further intervention in foreign exchange markets to forestall that. The Institute for International Finance forecasts net capital inflows into emerging economies of more than $800 billion in 2010 and 2011.
Governments usually respond to such potentially disruptive capital inflows with some mix of the three policy tools they have available to them: intervention in foreign-exchange markets; the imposition of taxes and controls on the capital flows directly; or doing nothing–letting their currency appreciate and take the hit to their export competitiveness. Neither is a particularly palatable choice, particularly for export-driven emerging economies. We are likely to see all three in some form if the “currency wars” continue.
The long-term solution is well-known, high-spending, high-deficit developed economies need to get their fiscal houses in order while the real exchange rates of the surplus economies need to appreciate and domestic demand expanded to offset the effect on exports. Getting there is the difficult part.
Not only has the journey barely begun, the kids are already bickering in the back seat. Instead of the sort of co-operation among governments that marked the early days of the global financial crisis to coordinate an orderly adjustment of exchange rates and external accounts (pace the IMF pulling an unlikely rabbit out of the hat before the G-20 summit), each is starting to go its own way. The U.S. is resorting to the instant creation of money, as it uniquely can as it has the world’s only reserve currency (oh, that we could all increase our bank accounts at the touch of a button as the Fed can). China is resisting in the way it knows best, controls, in this case on its exchange rate by having its central bank tightly manage the bands in which the yuan can move.
At the same time, China’s leaders, who have a historic fear of inflation and who know well what it can do for ill to the country’s rulers, believe that the way to make the underlying adjustments to real exchange rates that everyone agrees is necessary long-term is through falling domestic prices in the U.S. That would be similar to the sort of deflationary austerity on the U.S. that is being wished on Greece. That may not be politically acceptable in the U.S. any more than inflation would be politically acceptable in China. But inflating away the world’s global imbalances vs deflating them away are fundamentally opposite policies. The standoff between the two is worsened because deflation in the U.S. would be as bad for China as inflation in China would be for the U.S.
Both threaten to send the global economy into reverse. That all makes a G-20 agreement on exchange rates ever more necessary as a dampener on rising protectionist spirits in the developed economies and the rising nationalism in China among those who see the economy as primarily a matter of national security. When elephants fight, as the Swahili saying goes, the grass gets trampled. Unfortunately, that doesn’t make an agreement in Seoul any more likely. The best that can be hoped for is that the grass will be left in good enough condition to spring back up again.