In mid-July, Alan Greenspan, chairman of the US Federal Reserve, while deposing before a congressional committee, warned the Chinese authorities that they could not continue to peg the renminbi to the US dollar, without adversely affecting the functioning of their monetary system. This touching concern for and gratuitous advice to the Chinese had, however, some background. Greenspan was merely echoing the sentiment expressed by a wide circle of conservative economists that the Chinese must float their currency, allow it to appreciate and, hopefully, help remove what is being seen as the principal bottleneck to the smooth adjustment of the unsustainable US balance of payments deficit.

China was, of course, only the front for a wide range of countries in Asia, who were all seen as using a managed and "undervalued" currencies to boost their exports. Around the same time that Greenspan was making his case before the congressional committee, The Economist published an article on the global economic strains being created by Asian governments clinging to the dollar either by pegging their currencies or intervening in markets to shore them up. That article reported the following: "UBS reckons that all Asian currencies, except Indonesia's are undervalued against the dollar … The most undervalued are the yuan, yen, the Indian rupee and the Taiwan and Singapore dollars; the least undervalued are the ringgit, the Hong Kong dollar and the South Korean won."

The evidence to support this is of course limited. It lies in the fact that while over the year ending September 3rd the euro has appreciated against the dollar by about 9 per cent, many Asian currencies have either been pegged to the dollar, appreciated by a much smaller percentage relative to the dollar or even depreciated vis-à-vis the dollar.
Chart 1 >>

To anyone who has been following the debate on exchange rate regimes and exchange rate levels in developing countries, this perception would appear to be a dramatic reversal of the mainstream, conservative argument that had dominated the development dialogue for the last three to four decades. 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 characterized 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 seen as encouraging 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 liberalization of trade, a shift to a more liberalized 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.

Seen in this light, 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 IMF, developed country governments and the international financial media to hold the exchange rate policy in Asian countries, 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 US Federal Reserve, John Snow, US treasury secretary, and Kenneth Rogoff, IMF chief economist.

The adoption of a liberalized economic regime in which output growth had to be adjusted downwards to prevent current account difficulties and attract foreign capital 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 liberalization, 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 liberalized capital inflows on the other.

Faced with this prospect countries like China and India chose to adopt a more cautious approach to economic liberalization and, especially with regard to the exchange rate regime and to the liberalization of rules governing capital flows into and out of the country. However, even limited liberalization 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 enhanced inflows of capital (consequent to limited capital account liberalization), 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 during the late 1990s due to 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 stabilize the value of the currency the central banks in these countries were forced to step in, purchase foreign currencies to stabilize the value of the local currency, and build up additional foreign exchange reserves as a consequence.

Different countries adopted different objectives with regard to the exchange rate. 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 stabilize 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.

The net result is that most Asian countries – some that fell victim to the late 1990s financial crises, like Korea, and those that did not, like China and India – have accumulated large foreign exchange reserves (Chart 2). According to one estimate, Asia as a whole is sitting on a reserve pile of more than $1600 billion. This was the inevitable consequence of wanting to prevent autonomous capital flows that came in after liberalization 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 stabilization and adjustment strategy so assiduously promoted by the US, the G-7, the IMF and the World Bank in developing countries the world over. Unfortunately, the current account surpluses and the large reserves that this sequence of events resulted in have now become the "tell-tale" signs for arguing that the currencies in these countries are "under-" not "overvalued" and therefore need to be revalued upwards.
Chart 2 >>