Playing the Currency Blame Game

The slanging match over currency and monetary policies at the annual Fund-Bank meetings, held over the second weekend of October, points to the disarray in global economic governance.  While the US sought to mobilise IMF support for an effort to realign exchange rates and ensure an appreciation of the renminbi in the wake of China’s reserve accumulation, the Chinese accused the US of destabilising emerging economies by allowing ultra-loose monetary policy to flood the emerging world with money.  The result was that there was little agreement on what needs to be done to drag the world out of stagnation.

Evidence mounts that the much-touted recovery from the Great Recession of 2008 is yet to gather steam, and unemployment in the developed world remains at intolerable levels.  On the other hand, there is still no consensus on how to deal with the problem.  Governments in the developed countries are clearly overcome by “stimulus fatigue”.  Having used up a substantial part of the head room they had for deficit spending to bail out the financial sector, and having accumulated much debt in the process, there is scepticism about continuing with a fiscal stimulus.  So, increasingly, the push for recovery is moving in two directions.  One is the resort to “quantitative easing”, or the injection of liquidity into the system through lending by central banks, especially the US Federal Reserve, at near zero interest rates.  The other is to increase pressure on emerging market economies, especially China, to allow their exchange rates to appreciate, in the hope that it would expand US exports to and reduce its imports from those markets and facilitate a recovery.

The simultaneous advocacy of these two options is a sure recipe for conflict.  It is widely accepted that the injection of cheap money into the developed economies is resulting in financial firms borrowing cheap at home to invest in emerging markets for profit, with little contribution to domestic recovery in the developed world.  Emerging markets, on the other hand, are witnessing a capital inflow surge that is not merely triggering speculative booms in stock and real estate markets, but also exerting upward pressure on their currencies.  To expect them, therefore, to allow their currencies to appreciate further would be preposterous.  In fact, despite efforts to use some capital controls to limit inflows as well as resort to open market purchases of foreign currencies by the central bank to absorb surplus foreign exchange in domestic markets, countries like Brazil have not been able to prevent appreciation of their currencies.

China, however, is a potential target for the currency baiters because of the trade and current account surpluses it runs and the reserves it has accumulated.  This provides the basis for declaring that the country is manipulating its currency in mercantilist fashion to sustain growth at the expense of the rest of the world, especially the US and Europe.  Most recently, the US House of Representatives has passed, with a 348-to-79 majority, a bill that allows the country to impose countervailing duties on imports from China.  Those duties are to be calibrated using estimates of the extent of “undervaluation” of the renminbi, to signal that, in the US’ view, China is manipulating its currency for export gain and generating global current account imbalances in the process.  This round of China bashing has been justified by referring to the evidence that, while China unpegged the renminbi from the dollar in June this year, the currency has appreciated only marginally.  Thus, the accusation is not that China is resorting to devaluation, but that it has not “permitted” adequate appreciation despite its trade and current account surpluses, especially vis-à-vis the United States.

What is surprising is that the House has resorted to this move despite evidence that in the past, and even today, intervention in various forms to prevent currency appreciation or even ensure depreciation of currencies has been the norm.  The United States, which protests much today, had exercised its global economic and political power to ensure the depreciation of the dollar vis-à-vis other leading currencies, especially the Japanese yen, through the Plaza Accord of 1985.  A year and a half later, it engineered the Louvre Accord to prevent further decline of the dollar.  Currency manipulation is an old G8 practice.  Most recently, the Bank of Japan intervened in its currency market to purchase 20 billion dollars in return for Japanese yen, allowing it to stabilize an appreciating currency and ensure its depreciation from 83 yen to the dollar to around 85 yen to the dollar.  Since the Japanese economy is still in deflationary mode, the injection of liquidity into the system to manage the currency does not stoke fears of inflation.

Japan’s decision to intervene does weaken the legitimacy of the attack on the renminbi implicit in the US bill and of the pressure being mounted by the G20 on China to ensure further appreciation of the renminbi.  However, while Japan’s move has indeed been criticized by many of its trading partners, dissent is muted because of the recognition that Japan has suffered for long from a recession that was triggered in part by developments flowing from the appreciation of the yen consequent to the Plaza Accord.

Given its governance structure, it is not surprising that the IMF has joined this chorus.  In its view, the sharp divergences in growth or uneven development in the global economy calls for a process of “external rebalancing, with an increase in net exports in deficit countries and a decrease in net exports in surplus countries, notably emerging Asia.”  This, in turn, is seen as requiring a realignment of currencies involving “greater exchange rate flexibility”, with an appreciation of the Chinese renminbi, for example, and a relative depreciation of the dollar and the euro.

There are a number of issues this argument glosses over.  To start with, uneven development is an essential characteristic of capitalism, and in the past, for centuries, today’s developed countries were the winners in a process that polarised the world into the developed and the underdeveloped.  Underlying that polarisation was the consolidation of a division of labour wherein the developed were the producers of productivity-enhancing manufactured goods and the underdeveloped were left to live off the technologically less dynamic primary products that were losing out in world trade.  What we have been observing in a gradual and limited manner over the last three decades is a partial reversal of this process, with a few emerging markets having turned winners in the trajectory involving uneven development.

Secondly, as economist Prabhat Patnaik has argued, this shift in favour of emerging markets has been the outcome of the nature of recent processes of globalisation in which capital and technology have flowed easily across borders, while labour movement has been far less flexible and increasingly more limited.  Since past processes of development have ensured that some of the more populous countries of the world (including China) were left with underutilised labour reserves, this differential in ease of cross-border movement led to the flow of capital in search of the cheap labour reserves in those parts of the developing world.  This has not only changed the pattern of uneven development, but since highly productive modern technology now combines with the cheap surplus labour in these countries, it results in a rise in the surpluses or profits garnered from production and therefore to inadequate- or under-consumption that depresses overall global output and employment growth.  It must be noted that among the beneficiaries of this distorted process are also firms from the developed countries that seek to locate production facilities in these low-cost, labour surplus economies and produce for world markets including the markets of their countries of origin.  Yet their role rarely receives the attention it deserves in discussions of global imbalance.

US Trade Imbalance and Total Trade Growth Rate with Including and Excluding FAS (Foreign Affiliate Sales)
US Trade Imbalance and Total Trade Growth Rate with Including and Excluding FAS (Foreign Affiliate Sales)
Source: Yan Chen, Chunding Li, John Whalley, “Foreign Affiliate Sales and the Measurement of Trade in Goods and Services” (VOX, 8 October 2010).

Finally, given these drivers of contemporary uneven development, adjusting any one currency, such as the renminbi, is unlikely to redress the global imbalances.  It would at most merely shift the balance of payments surpluses to other countries with labour reserves that would now become the new hubs for world market production.

Despite all this, since countries that are the target of capital inflows are finding it difficult to prevent the appreciation of their currencies, the US and Europe are receiving explicit or implicit support for the China-bashing.  Central banks from many other countries have been and are intervening in currency markets to hold down the value of their currencies, but have not been all too successful.  This is true, for example, of South Korea, India, Malaysia, Taiwan, the Philippines and Singapore.  Their moves have received global attention ever since Guido Mantega, Brazil’s finance minister, declared that a currency war had broken out in the global economy.  “We’re in the midst of an international currency war, a general weakening of currency.  This threatens us because it takes away our competitiveness,” Mr Mantega reportedly said.  In doing so he was being disingenuous because Brazil’s immediate problem is not the weakening of the currencies of its competitors but the strengthening of the Brazilian real, which has been identified as one of the world’s most overvalued currencies.

In fact “overvaluation” that affects export competitiveness adversely seems to be the factor accounting for currency market interventions by central banks in most countries.  The explanation for such “overvaluation” is the surge in foreign capital flow to these countries in the period between 2003 and the Great Recession and once again over the last one year.  Intervention to address the excessive strength of individual currencies is costly since the reserves accumulated by buying foreign currency have to be invested in liquid financial assets that offer very low yields, while the foreign investors bringing in the dollars that lead to appreciation of the local currency earn substantially high returns.  Moreover, for countries that do not have the “advantage” of low inflation and low interest rates, the problem can be never-ending.  Thus, in India, for example, increases in interest rates aimed at combating inflation are resulting in further inflows and a substantial strengthening of the rupee.

The implications are clear.  The resort to monetary easing in the developed counties, with another round of such easing expected in the US after figures pointing to the loss of 95,000 jobs in September were released, is triggering a boom in the “carry-trade”.  Financial investors borrow cheap in dollars and put their money in emerging markets to earn high returns.  In the event, emerging market countries unwilling to impose controls on capital inflows experience a capital surge and invite an appreciation of their currencies.  Since such appreciation undermines their export competitiveness, they are forced to intervene in currency markets to limit or reverse such appreciation.  To justify this costly way of dealing with the problem created by fluid capital flows, they point their fingers at other countries which are preventing currency appreciation.  China comes in useful here, not just because it severely limits appreciation, but because it is a successful exporter and records current account surpluses.  Thus, joining the American clamour against China becomes a way of deflecting attention from the fact that the failure to export enough stems from an inadequacy of domestic policies rather than the aggressive currency moves of others.  This “currency war” blame game makes the prospect of progress on formulating a coordinated recovery plan in the G20 summit at Seoul next month extremely dim.

C.P. Chandrasekhar is Professor at the Centre for Economic Studies and Planning at Jawaharlal Nehru University.  This article was first published by MacroScan on 20 October 2010; it is reproduced here for non-profit educational purposes.

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