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The Asian currency riddle
In the desperation to protect the current imperial order, economics has been reduced to deformed ideology, devoid of rationality and consistency. CONSISTENCY and correctness are not requirements, it appears, when defending the world's only superpower. Nothing illustrates this more than the effort on the part of leading economists, the International Monetary Fund (IMF), developed country governments and the international financial media to hold the exchange rate policy in certain Asian countries, especially China and India, besides Japan, responsible for stalling the "smooth adjustment" of external imbalances in the world system. The biggest names have joined the fray to make the case: Alan Greenspan, chairman of the U.S. Federal Reserve, John Snow, U.S. Treasury Secretary, and Kenneth Rogoff, IMF chief economist.
CHRIS KLEPONIS/BLOOMBERG NEWS
Till recently, many of these countries were being accused of pursuing inward-looking policies, of being too interventionist in their trade, exchange rate and financial sector policies, and, therefore, of being characterised by "overvalued" exchange rates that concealed their balance of payments weaknesses. An "overvalued" rate, by setting the domestic currency equivalent of, say, a dollar at less than what would have been the case in an equilibrium with free trade, is seen as making imports cheaper and exports more expensive. This can be sustained in the short run because trade restrictions do not result in a widening trade and current account deficit. But in the medium term it encourages investments in areas that do not exploit the comparative advantages of the country concerned, leading to an inefficient and internationally uncompetitive economic structure.
What was required, it was argued, was substantial liberalisation of trade, a shift to a more liberalised exchange rate regime, less intervention all-round, and a greater degree of financial sector openness. Partly under pressure from developed county governments and the international institutions representing their interests, many of these countries have since put in place such a regime.
The regime change had its implications. It required governments to borrow less to finance deficit spending, which often led to lower growth, lower inflation and lower import demand. Combined with or independent of higher export growth, these effects showed up in the form of reduced deficits or surpluses on their external trade and current accounts. Since in many cases the `chronic' deflation that the regime change implied was accompanied by large capital inflows after liberalisation, there was a surplus of foreign exchange in the system, which the central bank had to buy up in order to prevent an appreciation in the value the nation's currency. Currency appreciation, by making exports more expensive and imports cheaper, could have devastating effects on exports in the short run and generate new balance of payments difficulties in the medium term. In fact, among the reasons underlying the East Asian crises of the late 1990s was a process of currency appreciation driven by export success on the one hand and liberalised capital inflows on the other.
Faced with this prospect, countries like China and India chose to hold back on the process of economic liberalisation and adopt a more cautious approach, especially with regard to the exchange rate regime and to the liberalisation of rules governing capital flows into and out of the country. China, for example, chose to make a stable exchange rate a prime objective of policy and has frozen its exchange rate vis-à-vis the dollar at renminbi 8.28 to the dollar since 1995. To its credit, it stuck by this policy even during the Asian currency crisis, when the value of currencies of its competitors like Thailand and Korea depreciated sharply. This helped the effort to stabilise the currency collapse in those countries, even if in the immediate short run it affected China's trade adversely. India too had adopted a relatively stable exchange rate regime right through this period, allowing the rupee to move within a relatively narrow band relative to a basket of currencies, and not just the dollar.
However, the overall policy of liberalisation entailed providing relatively free access to foreign exchange for permitted trade and current account transactions and the creation of a market for foreign exchange in which the supply and demand for foreign currencies did influence the value of the local currency relative to the currencies of major trading partners. This made the task of managing the exchange rate difficult. The larger the flow of foreign exchange because of improved current account receipts (including remittances) and larger inflows of capital consequent to limited capital account liberalisation, the greater had to be the demand for foreign exchange if the local currency was to remain stable. But given the context of extremely large flows (China) and/or relatively low demand owing to chronic deflation (India), there was a tendency for supply to exceed demand, even if this did not always reflect a strong trading position. As a result, to stabilise the value of the currency the central banks in these countries were forced to step in, purchase foreign currencies to stabilise the value of the local currency, and build up additional foreign exchange reserves as a consequence.
The net result is that most Asian countries - those that fell victim to the financial crises of the late 1990s, like Thailand and Korea, and those that did not, like China and India - have accumulated large foreign exchange reserves. According to one estimate, Asia as a whole is sitting on a reserve pile of more than $1,600 billion. This was the inevitable consequence of wanting to prevent autonomous capital flows that came in after liberalisation of foreign direct and portfolio investment rules from increasing exchange rate volatility and threatening currency disruption due to a loss of investor confidence. These reserves are indeed a drain on these systems, since they involve substantial costs in the form of interest, dividend and repatriated capital gains but had to be invested in secure and relatively liquid assets which offered low returns. But that cost was the inevitable consequence of opting for the deflation and the capital inflow that resulted from the stabilisation and adjustment strategy so assiduously promoted by the U.S., the G-7, the IMF and the World Bank in developing countries.
For long, this episode of rising reserves in till-recently poor countries appeared almost conspiratorial, because these reserves were being invested in dollar-denominated assets, including government securities in the U.S., and played an important role in financing the burgeoning current account deficit in the U.S. The choice of U.S. assets was, of course, determined by the facts that the dollar still is the world's reserve currency and the U.S. the world's sole superpower, both of which engender confidence in American, dollar-denominated assets. The direct benefit for the U.S. was obvious. With America experiencing growth without the needed competitiveness, that growth was accompanied by a widening of the trade and current account deficits on its balance of payments. Capital inflows into the U.S. helped finance those deficits, without much difficulty. For example, UBS estimates that in the second quarter of 2003, the central banks in Japan and China bought $39 billion and $27 billion dollars respectively. If these are invested in American assets they would finance close to 45 per cent of the estimated $147 billion U.S. current account deficit in that quarter.
The indirect benefits of this arrangement are even greater. For more than a decade now, the U.S. has benefited from a long period of buoyancy, so much so that it has accounted for 60 per cent of cumulative world GDP (gross domestic product) growth since 1995. That buoyancy came not because the U.S. was the world's most competitive nation in economic terms. Rather, till the turn of the last decade growth was accounted for by a private consumption and investment spending boom, spurred by the bubble in U.S. stock and bond markets that substantially increased the value of the savings accumulated by U.S. households. The money market boom was encouraged by the flight of capital from across the world to the safe haven that dollar-denominated assets were seen as providing. Investment of reserves accumulated by the Asian countries was one important component of that capital inflow. With the value of their savings invested in stocks and securities inflated by the boom, consumers found confidence to spend.
To be sure, when the speculative boom came to an end in 2000, triggered in part by revelations of corporate fraud, accounting scandals and conflicts of interest, this spur to growth was substantially moderated. But the low interest rate regime adopted by the U.S. Federal Reserve still encouraged debt-financed consumer spending. Together with the return to deficit-financed spending by the American state, justified by its nebulously defined war on terror, America is once again witnessing buoyant output growth even if this has not improved the employment situation significantly. In fact, 2.6 million manufacturing jobs have been lost in the U.S. since Bush assumed office in 2001.
The only threat to U.S. buoyancy throughout this period was the possible unsustainability of the widening current account deficit in its balance of payments. But the boom was not aborted, because the rest of the world appeared only too willing to finance those deficits, even if at falling interest rates in some periods.
Unfortunately, few other countries benefited directly from this chain of events. They did not because they did not have the military power to create the required confidence in their currencies, even if sheer competitiveness warranted a decline in the dollar. Some countries benefited indirectly: China, for example, because of the boom export to the U.S; the U.K. because, among other things, of a boom in services, including financial services. But overall, to use a phrase popularised by former U.S. Treasury Secretary Lawrence Summers, the world economy was flying on one engine.
Within the imperial order always fearful of a "hard landing", this has created two imperatives. First, in the medium term, the world needs other supportive engines, which must be from within the developed economies. Second, till that time, and even thereafter, U.S. growth must be sustained. The new discovery that Asian currencies, particularly the Chinese renminbi, is undervalued and not overvalued, stems from the second of these two concerns. With the U.S. current account deficit expected to exceed 5 per cent this year, there are few who are convinced that it would find investors who would be confident enough to continue financing that deficit. This is becoming clear from the fact that the share of the deficit financed by central bank investments is rising, as private investors grow more cautious. Thus, if the dollar is not to collapse, the U.S. current account deficit must be curtailed and reversed.
However, this cannot be ensured by curtailing U.S. growth and therefore the growth of U.S. imports. It is necessary to boost exports so that growth can coexist with a reducing trade and current account surplus. This is where China comes in. Even though China cannot boast of a very large trade surplus with the world as a whole, it notched up a record $103 billion trade surplus with the U.S. last year. This is seen as a direct consequence of China's undervalued exchange rate, which has been pegged to the dollar since 1995 despite rising capital flows and reserves. Thus, the story goes, if China revalues its currency vis-à-vis the dollar by anywhere between 15 and 40 per cent, depending on the advocate, China would absorb more imports from and be able to export less to the U.S., correcting the trade imbalance between the two countries.
But that is not all. If China revalues its currency, it is argued, Europe would improve its competitiveness lost as a result of the appreciation of the euro vis-à-vis the dollar and therefore the renminbi, allowing it to register higher export growth. Further, China's revaluation would reduce the need to pressurise Japan to revalue the yen, despite its own surpluses with the U.S. and the high level of its reserves. This deals with the danger that yen revaluation might abort the feeble recovery that Japan is experiencing after a decade of stagnation. These benefits could possibly yield the supportive engines needed to keep the world economy in flight.
In this assault on less developed nations, involving a complete reversal of the argument regarding the currency regime in developing countries, the U.S. and its allies are finding strange supporters. Trade unions and U.S. manufacturing companies located in the U.S. who have experienced job and market losses have joined the chorus, and are threatening to take the Chinese to the dispute settlement body of the World Trade Organisation (WTO) on the grounds that it is manipulating the exchange rate to win unfair gains from trade. And other Asian countries, particularly those experiencing an appreciation of their currencies from the lows they reached after the 1997 financial crisis, are supporting the demand with the hope that they would benefit from the loss of Chinese export competitiveness that a revaluation of the renminbi would involve.
The flaws in these arguments are obvious. A revaluation of the renminbi may reduce China's trade surplus with the U.S., but it is unlikely to trigger either export or output growth in the U.S. Rather, the space vacated by the Chinese in U.S. markets would be occupied by some other trading country such as Vietnam, Korea or the Philippines. Further, those Asian countries that expect to gain from the renminbi's revaluation would soon find that their current account surpluses and reserves are seen as grounds for identifying their currencies as undervalued and provide the basis for a revaluation demand. India, with less than $90 billion of foreign exchange reserves, is already being targeted. Whatever gains would occur from China's revaluation would be short lived.
Further, if China and other countries, like India with rising reserves are deprived of those reserves on these grounds, the capital required to finance the current account and budget deficits accompanying U.S. growth would soon dry up. This would drive up interest rates in the U.S., cut consumption and investment spending, make the current account deficit unsustainable, and ensure the collapse of U.S. growth and the dollar that the revaluation is expected to stall.
In sum, the whole episode indicates that the desperation to protect the current imperial order is yielding a number of scatter-brained proposals. Economics has been reduced to deformed ideology, devoid of consistency and rationality.
Fortunately, the Chinese have thus far stood their ground and refused to yield. Hopefully, other developing countries would also see where their best interests lie.