"We’re in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness.”
This complaint by Guido Mantega, Brazil’s finance minister, is entirely understandable. In an era of deficient demand, issuers of reserve currencies adopt monetary expansion and non-issuers respond with currency intervention. Those, like Brazil, who are not among the former and prefer not to copy the latter, find their currencies soaring. They fear the results.
This is not the first time for such currency conflicts. In September 1985, now 25 years ago, the governments of France, West Germany, Japan, the US and the UK met at the Plaza Hotel in New York and agreed to push for depreciation of the US dollar.
Earlier still, in August 1971, the US president Richard Nixon imposed the “Nixon shock”, levying a 10 percent import surcharge and ending dollar convertibility into gold. Both events reflected the US desire to depreciate the dollar. It has the same desire today.
But this time is different: the focus of attention is not a compliant ally, such as Japan, but the world’s next superpower: China. When such elephants fight, bystanders are likely to be trampled.
Here there are three facts, relevant to today’s currency wars.
First, as a result of the crisis, the developed world is suffering from chronically deficient demand. In none of the six biggest high-income economies – the US, Japan, Germany, France, the UK and Italy – was gross domestic product in the second quarter of this year back to where it was in the first quarter of 2008.
These economies are now operating at up to 10 percent below their past trends. One indication of the excess supply is the decline in core inflation to close to 1 percent in the US and the eurozone: deflation beckons. These countries hope for export-led growth. This is true both of those with trade deficits (such as the US) and of those with surpluses (such as Germany and Japan). In aggregate, however, this can only happen if emerging economies shift towards current account deficit.
Second, private sectors are working in just this direction. In its April forecasts (soon to be updated), the Washington-based Institute for International Finance suggested that this year the net flow of external private finance into the emerging countries would be $746 billion. This would be partially offset by a net private outflow from these countries of $566 billion.
Nevertheless, with a current account surplus of $320 billion as well, and modest official capital inflows, the external balance of the emerging world, without official intervention, would be a surplus of $535 billion. But, without the intervention, that could not happen: the current account must balance the net capital flow. The adjustment would go via a higher exchange rate. In the end, the emerging world would run a current account deficit financed by a net inflow of private capital from the high-income countries. Indeed, that is precisely what one would expect to happen.
Third, this natural adjustment continues to be thwarted by the build-up of foreign currency reserves. These sums represent an official capital outflow. Between January 1999 and July 2008, the world’s official reserves rose from $1,615bn to $7,534 billion – a staggering increase of $5,918 billion. This increase was, one might argue, a form of self-insurance after earlier crises.
Indeed, reserves were used up during this crisis: they shrank by $472 billion between July 2008 and February 2009. No doubt, this helped countries without reserve currencies cushion the impact. But this use of reserves was a mere 6 percent of the pre-crisis level. Moreover, between February 2009 and May 2010, reserves rose by another $1,324 billion, to reach close to $8,385 billion. Mercantilism lives!
China is overwhelmingly the dominant intervener, accounting for 40 percent of the accumulation since February 2009. By June 2010, its reserves had reached $2,450 billion, 30 percent of the world total and a staggering 50 percent of its own GDP. This accumulation must be viewed as a huge export subsidy. Never in human history can the government of one superpower have lent so much to that of another.
Some argue – Komal Sri-Kumar of the Trust Company of the West, in Tuesday’s Financial Times, for example – that such management of the exchange rate is not manipulative, contrary to views in the US Congress, since adjustment can occur via “changes in domestic costs and prices”. This argument would be more convincing if China had not worked hard and successfully to suppress the natural monetary and so inflationary consequences of its intervention.
In the meantime, the inevitable adjustment towards current account deficits in the emerging world is being shifted on to countries that are both attractive to capital inflows and unwilling or unable to intervene in the currency markets on the needed scale. Poor Brazil! Could we even be seeing the starting gun for the next emerging market financial crisis?
John Connally, Nixon’s secretary of the Treasury, famously told the Europeans that the dollar “is our currency, but your problem”. The Chinese respond in kind. In the absence of currency adjustments, we are seeing a form of monetary warfare: in effect, the US is seeking to inflate China, and China to deflate the US. Both sides are convinced they are right; neither is succeeding; and the rest of the world suffers.
It is not hard to see China’s point of view: it is desperate to avoid what it views as the dire fate of Japan after the Plaza accord. With export competitiveness damaged by its soaring currency and pressured by the US to reduce its current account surplus, Japan chose not the needed structural reforms, but a huge monetary expansion, instead. The consequent bubble helped deliver the “lost decade” of the 1990s. Once a world-beater, Japan fell into the doldrums. For China, self-evidently, any such outcome would be a catastrophe.
At the same time, it is difficult to envisage a robust configuration of the world economy without large net capital flows from the high-income countries to the rest. Yet it is also hard to imagine that happening, on a sustainable basis, if the world’s biggest and most successful emerging economy is also its largest net exporter of capital.
What is needed is a route to these needed global adjustments. That will demand not just a will to co-operate that now seems sorely lacking, but greater imagination about both domestic and international reforms. I would like to be optimistic. But I am not: a world of beggar-my-neighbour policy is most unlikely to end well.