With money-printing presses working overtime in the U.S. and in the euro area, one would expect the currencies of major developing economies in East Asia to be much stronger against the dollar and the euro than has been the case throughout the ongoing financial crisis.
But the opposite has happened. Over the past 12 months, for example, only the Thai baht rose 6 percent against the dollar. Other currencies, like the Chinese yuan, Singapore dollar and Malaysian ringgit recorded relatively minor gains between 0.6 percent and 1.6 percent, while the Korean won, Indian rupee and the Indonesian rupiah fell between 1 percent and 8 percent with respect to the U.S. currency.
The reason for this apparently puzzling weakness is very simple: All these countries use an active exchange rate management to protect and enhance their export-driven growth strategies.
What are these exchange rate management policies?
They consist of the key instruments of monetary policy and its extensions in the form of currency market interventions and controls of capital flows.
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To avoid confusions sometimes encountered in European discussions, it should be noted that there are no exchange rate policies and monetary policies as separate tools of economic management. There is only monetary policy, because exchange rates are relative prices (so many units of currency X per unit of currency Y) resulting from demand-supply relationships of a given currency.
Loose Money Policies
With this important clarification out of the way, it is obvious that expansionary monetary policies are the key source of weakness for currencies in major developing East Asian economies.That is clearly shown by very low - and even negative - real short-term interest rates, ranging from 1.4 percent in South Korea to -4.3 percent in Singapore.
No wonder, then, that none of these countries' currencies, with the exception of the Thai baht, showed any strength against the two wobbly international reserve currencies.
And to make sure their currencies stayed low to support export sales, these countries even kept propping up the dollar by buying $150 billion of U.S. Treasury debt over the past 12 months. These are, in fact, currency market interventions.
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Predictably, China was by far the largest U.S. creditor, adding nearly $100 billion of American debt instruments to its foreign currency reserves. But before anyone springs for the conclusion that China is a captive buyer of Washington's IOUs, one should note that these purchases were less than half of what China added to its reserves over the past 12 months.
And here is an interesting question:What else did China buy at a time when most of the world was dumping euro assets?
But if China was spending only a fraction of its reserves increase to buy U.S. Treasury securities, some other Asian countries were spending much more than their net additions to foreign currency holdings to prop up the dollar and manage virtual dollar pegs. Capital controls are also used to resist upward pressures on their currencies.
One can understand these countries'desire to take maximum advantage of the good things created by the large dollar and euro liquidity: by operating expansionary monetary policies, the U.S. and the euro area (nearly 40 percent of the world economy) are supporting demand for Asian exports. That is the positive income effect on what Asia has to sell.
The less positive part is equally clear: the excess supply of dollar and euro assets is putting upward pressure on Asian currencies. That raises the price of exports – often the key component of aggregate demand - and makes them less competitive on world markets.
Don't Count on Reserves
Obviously, the major developing East Asian economies want to have the full benefit of the positive income effect,while minimizing the negative price effect by keeping the currency values down. But, in the process of doing that, they are running the risk of stoking inflation – including imported inflation, a big problem in small and open economies - as they try to deflect capital inflows with very loose monetary policies when their growing – and accelerating - economies apparently need a tighter monetary stance (i.e., higher interest rates) and stronger currencies.
The problem here is a policy misalignment. If these countries want to protect exports as the main driver of demand, output and employment, they would have to offset easy credit conditions and weak currencies with tighter fiscal policies to maintain a balanced and noninflationary growth.
Dangers of cheap and widely available credit in growing economies are quite well known. Not only does that raise cost and price pressures, but it also creates financial excesses. And, when the tide turns, as it always does, the accumulated liabilities can quickly become bad assets, degrading banks' balance sheets and causing serious systemic risks.
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A large, and continuing, credit expansion in major developing Asian countries is one of major concerns stated in the run-up to this week's International Monetary Fund spring meeting in Washington, D.C. Governments in that region would do well to heed thecall for timely policy adjustments.
They would be making a big mistake by thinking that their relatively large foreign currency reserves, and regional reserve pools, will protect them against adverse market movements and reversing capital flows. Hundreds of billions of dollars in reserves are a drop in abucket in a global currency market with a daily turnover of $4-$5 trillion.
As a former German central bank president,and a veteran of Europe's chronic financial market upheavals in pre-euro days,used to say "currency interventions are just throwing cheap money at speculators …" and "… reserves will melt like butter on the sun …" if fundamental policies are misaligned.
Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.