Asian Currencies: New Global Scapegoats
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.
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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.
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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 US and
played an important role in financing the burgeoning
current account deficit in the US (Chart 3). The choice
of US assets was, of course, determined by the facts
that the dollar still is the world's reserve currency
and the US the world's sole superpower, both of which
engender confidence in American, dollar-denominated
assets. The direct benefit for the US 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
US 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 of dollars respectively.
If these are invested in American assets they would
finance close to 45 per cent of the estimated $147
billion US current account deficit in that quarter.
They indeed were. Central banks, mostly from Asia,
are estimated to have financed more than half of the
US current account deficit in the second quarter.
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The indirect benefits of this arrangement are even
greater. For more than a decade now, the US has benefited
from a long period of buoyancy, so much so that it
has accounted for 60 per cent of cumulative world
GDP growth since 1995. That buoyancy came not because
the US 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 US stock and bond markets (Chart 4) that substantially
increased the value of the savings accumulated by
US 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.
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To be sure, when the speculative boom came to 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 Fed still
encouraged debt-financed consumer spending. Together
with the return to deficit-financed spending by the
American state (Chart 5), 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 US
since Bush assumed office in 2001.
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The only threat to US 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 export boom to the US; the UK because, among
other things, of a boom in services, including financial
services. But overall, to use a phrase popularized
by former US 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, US growth
must be sustained. The new discovery that Asian currencies,
particularly the Chinese renminbi, is under- and not
overvalued, stems from the second of these two concerns.
With the US 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 US current account
deficit must be curtailed and reversed.
However, this cannot be ensured by curtailing US growth
and therefore the growth of US imports. It is necessary
to boost exports, so that growth can coexist with
a reducing trade and current account surplus. This
is where China and the fact that it notched up a record
$103 billion trade surplus with the US last year comes
in. Ignoring the fact that simultaneously China had
recorded a trade deficit of $75 billion with the rest
of the world, the surplus with the US 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 US,
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 pressurize Japan
to revalue the yen, despite its own surpluses with
the US 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 the less-developed nations, involving
a complete reversal of the argument regarding the
currency regime in developing countries, the US and
its allies are finding strange supporters. Trade unions
and manufacturing companies located in the US who
have experienced job and market losses have joined
the chorus through organizations such as "The
Coalition for a Sound Dollar". They are even
threatening to take the Chinese to the dispute settlement
body of the WTO on the grounds that it is manipulating
the exchange rate to win unfair gains from trade.
There effort is ostensibly aimed at invoking a provision
in the World Trade Organisation that bars countries
from influencing exchange rates to "frustrate
the intent" of WTO trade agreements. In practice,
the clamour is all intended to get the US government,
in a pre-election year, to increasing pressure on
China to float its currency.
However, not all of American business supports this
effort. Calman Cohen of the Emergency Committee for
American Trade, which represents many large US companies
doing business in China, is reported to have said
that while the renminbi may well be undervalued, it
was not the main cause of the industrial problems
facing the US. His principal and well-founded fear
is that action against China would adversely affect
US companies that as part of their competitive strategy
are sourcing their products from countries like China.
Not surprisingly, Rob Westerhof, chief executive of
Philips Electronics North America and former chief
executive of Philips Electronics East Asia, argues:
"A free float or sudden revaluation would be
bad for China and bad for business. Instead, Beijing
should maintain the peg for now and aim for a gradual
revaluation of about 15 per cent over the next five
years. Free- floating the renminbi can be considered
only when China has a well established financial system.
That will take at least another 10 years." He
made it clear that "business prefers a stable
renminbi-dollar exchange rate. A sudden revaluation
of the renminbi would disrupt results for the many
multinational companies (Philips included) that supply
American and European retail chains with goods made
in China. Currently, hedging against exchange rate
fluctuations of a free-floating, unpredictable renminbi
would be very costly for those companies."
Unfortunately, some Asian countries, particularly
those that have been 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. Interestingly, Japan
too is part of this group, even though it is itself
intervening in currency markets to prevent the yen
from appreciating too much against the dollar.
Thus at the end of September, the dollar recovered
sharply against the yen as a result of Bank of Japan
intervention, conducted through the New York Federal
Reserve. This help reverse a prior downward lurch
of the dollar vis-à-vis the yen. According
to information released recently by the Japanese Finance
Ministry, the government and central bank have spent
a total of $ 40 billion between August 28 and September
26, taking the total amount spent on supporting the
yen in the first nine months of 2003 to well above
$100 billion. This willingness to intervene openly
is partly explained by the fact that the G-7 has accepted
that any excessive appreciation of the yen could abort
a recovery which has come after a long while and which
is seen as crucial for overall global growth. This
support for action against yen appreciation goes against
the G-7's own recent statement that cam out in favour
of exchange rate flexibility in the world, which it
is now clear was aimed at developing Asia in general
and China in particular.
Despite its own actions, the Japanese government has
been willing to go along with the demand that the
Chinese and other developing Asian countries should
revalue their currency by opting for a float. Once
again the fact that the developed countries believe
that developing countries should do as the G-7 says
and not as it does has been brought home.
The flaws in these arguments are obvious. A revaluation
of the renminbi may reduce China's trade surplus with
the US, but it is unlikely to trigger either export
or output growth in the US. Rather, the space vacated
by the Chinese in US 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 shortlived.
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
US growth would soon dry up. This would drive up interest
rates in the US, cut consumption and investment spending,
make the current account deficit unsustainable, and
ensure the collapse of US 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.