THE REPORT Friday, October 29, 2010

THE
CURRENCY
PUZZLE
For some time now, global powers have
been engaged in a currency war, which can
simply be summed up as: mine is weaker than
yours. The implicit calculation is that a cheaper
currency would spur exports, making up for the de-
mand shortfall that has afflicted the Western economies
in particular after the financial meltdown. However, the reality
is far less linear. At the centre of this battle are China, which
has emerged as the second largest economy in the world, and the US, still
the numero uno of the global economic order. Outliers such as India have
a lesser stake in this battle, but are nevertheless being drawn into what is
a very contentious debate. A temporary truce was managed at the meet-
ing of the finance ministers of the Group of 20 countries at Gyeongju,
South Korea. But nobody is willing to bet on whether the truce will hold.
To help readers understand the underlying issues, many of which are
very complex and nuanced, Mint and Project Syndicate present the expert
perspectives of 12 specialists.
2 THE CURRENCY PUZZLE
FRIDAY, OCTOBER 29, 2010
By Martin Feldstein
..................................
Cambridge
Martin Feldstein, a professor of
economics at Harvard
University, was chairman of
former US president Ronald
Reagan’s Council of Economic
Advisors, and is a former
president of the National
Bureau for Economic Research.
Comments are welcome at
feedback@livemint.com
The columns that appear in this
issue were commissioned to be
delivered by 19 October.
By Christine Lagarde
.....................................
Paris
Christine Lagarde is France’s
minister for the economy,
industry and employment.
Comments are welcome at
feedback@livemint.com
Illustrations by Jayachandran
and Shyamal Banerjee/Mint
THE FUTURE OF
THE DOLLAR
American economic policy aims
for a dollar that is strong at home
and competitive abroad. A strong dol-
lar at home means a dollar that retains
its purchasing power, thanks to a low rate
of inflation. A competitive dollar abroad
means that other countries should not implement
policies that artificially depress the value of their
currencies in order to promote exports and deter imports.
The goal of a strong dollar at home has guided the US Fed-
eral Reserve (Fed) at least since Paul Volcker crushed inflation in
the early 1980s. Although the US does not have a formal inflation
target, financial markets understand that the Fed aims for an infla-
tion rate close to 2%. And, while the law mandates the Fed to ensure
sustainable growth as well as low inflation, monetary officials recog-
nize that sustainable growth requires price stability.
For decades, US treasury officials have insisted that “a strong dol-
lar is good for America”. But that slogan has never been a guide to
official US action in international markets.
The treasury does not intervene in currency markets to bolster the
dollar, and the Fed does not raise interest rates for that purpose. In-
stead, the US stresses to foreign governments that an effective global
trading system requires not only the removal of formal trade barri-
ers, but also the absence of policies aimed at causing currency val-
ues that promote large trade surpluses.
In recent years, countries around the world have accumulated
very large volumes of foreign exchange, topped by China with more
than $2 trillion, but including hundreds of billions of dollars held by
Korea, Taiwan, Singapore, India and the oil-producing countries.
Most of these funds are now invested in dollar securities. The US
dollar is, and will remain, these countries’ major investment curren-
cy, reflecting the depth of the US capital market and the relatively
favourable outlook for US government policies.
These large foreign exchange reserves are no longer held to buffer
EUROPE AND
THE EURO
For anyone living in the 16 euro
zone member states, the euro’s
enduring success is both a technical
and an emotional issue; both hearts
and minds are involved. I consider it axi-
omatic that the euro is vital to Europe and,
indeed, to the world economy.
First of all, it should be recalled that the European
idea began as a project for ensuring peace and democracy
among Europe’s peoples. When the new currency was intro-
duced in 1999—and even more so when European citizens had their
first opportunity to use it in January 2002—it was experienced as the
most tangible, decisive proof that European integration was a reali-
ty. As the slogan goes: euro in your wallet, Europe in your pocket.
Twenty years after the European parliament was elected by uni-
versal suffrage in 1979, the introduction of the euro marked a logical
extension of the European dream.
It should also be recalled, however, that when Slovenia entered
the euro zone in 2007, many people suggested that the country was
somehow joining “Old Europe”. But Cyprus, Malta and Slovakia
have since followed suit in making the euro their currency. From
Dublin on the shore of the Irish Sea to Bratislava in the foothills of
the Carpathians, the same coins and banknotes are legal tender, and
they are constantly pushing back the European Union’s (EU)
boundaries. Tomorrow will bring additional members, such as
Estonia, which is slated to join the euro zone on 1 January.
Europe’s “founding fathers” were right that “Europe will not be
made all at once”, and neither will the euro. Our common currency
should rather be viewed as an inspiring symbol—the symbol of a Eu-
rope that is vibrant, attractive and, above all, cohesive.
Just how cohesive Europe can be is something that we know from
the experience of the past few months. The history of the euro, not
surprisingly, has turned out to represent a further stage in the ongo-
ing saga of a European economy that has been in a state of perpetual
construction since the Treaty of Rome.
The financial support provided to Greece; the new European Fi-
nancial Stability Facility, which we created to extend guarantees to
euro zone member states in need; and our efforts to achieve more
effective financial regulation are among the latest illustrations of
European cohesion in practice.
mint
temporary trade imbalances. While some of the funds serve that
purpose and must be held in the most liquid form, most of these
large holdings are investment funds that will be managed to balance
risk and return. That means that, over time, these governments will
seek to diversify their portfolios, moving away from the current
dominance of dollar investments.
The euro is now the primary alternative to the dollar. While the
turmoil in Europe and the uncertain future of the euro have caused
a pause in the shift from dollars to euros, the rebalancing in favour
of euros will resume at some point in the future. Countries with
large reserves are now overweight dollars, and their effort to balance
risks will cause the value of the euro to rise again relative to the dol-
lar. Several other currencies now have minor shares in those portfo-
lios, and will continue to do so in the future.
The major risk to the sustained role of the dollar is the large and
growing US national debt. After varying between 25% and 50% of
gross domestic product (GDP) for the past half-century, the recent
budget deficits have caused the debt to reach 62% of GDP. The offi-
cial non-partisan Congressional Budget Office predicts that the poli-
cies that now seem most likely could push the debt to 100% of GDP
by the end of the decade.
Foreign investors might, therefore, fear that future US administra-
tions will be tempted to reduce the real value of that debt by allow-
ing a higher inflation rate. But that is unlikely, given the Fed’s gen-
eral anti-inflationary consensus and the very short average maturi-
ty—roughly four years—of the national debt. Higher inflation would
cause the interest rate on new debt to rise in a way that prevents the
erosion of the real value of the total debt.
But foreign investors, who hold nearly half of the US government’s
debt now—and are likely to hold an even larger share in the fu-
ture—could still have reason to worry that the US might someday try
to reduce the value of its debt in a way that adversely affects them but
not Americans, or that affects all debt holders but relieves the for-
eign-debt burden on American taxpayers. This need not mean out-
right default; a plan to repay principal and interest with low-interest
securities rather than cash—or to withhold income tax on interest
earned from government bonds, crediting those taxes against the ob-
ligations of American taxpayers—would achieve the same result.
While such policies are extremely unlikely, a fear of such possibil-
ities could cause foreign investors to shun the dollar. The current
policies and those proposed in the government’s recent budget
would cause the national debt to rise rapidly, but those policies are
not inevitable. The best protection of the dollar’s future role—and of
the health of the US economy—will be policies that reduce the
growth of the national debt.
©2010/PROJECT SYNDICATE
Admittedly, the various crises affecting the euro zone have
highlighted—sometimes starkly so—the need to reform our
institutions and the way they operate. It has been argued
that Europe’s institutions move forward only in times of
crisis. Perhaps the same is true of the single currency,
which will derive strength and validation from the chal-
lenges that it overcomes.
In the last few months, as it just barely emerged from
the deepest economic and financial crisis in close to a cen-
tury, the euro zone experienced the worst jolts in its history,
although in terms of public finance, the euro zone as a whole
has fared better than the US or Japan. Once the extent of
Greece’s financial crisis and the difficulties encountered by
other member states became known, the euro zone econo-
mies found themselves on the brink of disaster.
But the EU reacted swiftly and forcefully, with a support
programme for Greece and a financial guarantee plan for
the entire euro zone. In this state of emergency, a genuine
European economic government, most compellingly ad-
vocated by German Chancellor Angela Merkel and
French President Nicolas Sarkozy, began to take shape.
Following the European Council meeting in June,
France and Germany jointly outlined a number of pos-
sible reforms. Three key points emerged, concerning
the need to:
l Strengthen the Stability and Growth Pact, notably
through enhanced European coordination during a
“European semester”
l Maintain our efforts to expand the scope of eco-
nomic surveillance to include government deficits and
public as well as private sector debt, if necessary by im-
posing “political penalties”
l Establish a credible crisis-resolution framework
without encroaching on the budgetary prerogatives of
member states
Other possible approaches are under consideration as
well. But what they all share is the recognition that the
time has clearly come to stabilize and institutionalize a
European economic government. That process is already
well under way. The European Commission has made
proposals, and the working group chaired by European
president Herman Van Rompuy, in which I represent
France, will be submitting its own in the fall.
We all expect that the euro, which proved to be such an
asset during the crisis, will be just as effective in getting our
economies back on the path to vigorous, sustainable
growth. Indeed, according to Eurostat (the EU’s statistical
office), by the second quarter of 2010, the euro zone was
growing faster than the US, while the euro remains the sec-
ond most widely used trading currency.
The euro, like the EU itself, is an exciting adventure that
must continue—and we intend to make sure that it does.
©2010/PROJECT SYNDICATE
mint
A WORLD OF MULTIPLE
RESERVE CURRENCIES
By Barry Eichengreen cy—say, the dollar—as other import ers and exporters avoids
...................................... confusing one’s customers. For central banks , holding reserves in
Berkeley, California the same currency as other central banks means holding the
Barry Eichengreen is a professor
of economics and political
science at the University of
California, Berkeley.
Comments are welcome at
feedback@livemint.com
By Howard Davies
................................
London
Howard Davies, a former
deputy governor of the Bank of
England, is director of the
London School of Economics.
His latest book, co-authored
with David Green, is Banking
on the Future: The Fall and
Rise of Central Banking.
Comments are welcome at
feedback@livemint.com
THE CURRENCY PUZZLE 3
The competition for reserve cur-
rency status is conventionally por-
trayed as a winner-take-all game.
There is room, in this view, for just
one full-fledged international currency.
The only question is which national curren-
cy will capture the role.
Market logic, it is argued, dictates this result. For
importers and exporters, quoting prices in the same curren-
most liquid asset. With everyone else buying, selling and
holding dollars, it pays to do the same, since markets in dollar-
denominated assets will be the deepest.
While it is always possible that there could come a tipping point at
which everyone migrates from one currency to another, the network-
based nature of the international monetary system, it is said, leaves room
for only one true international unit.
But this premise is wrong, for three reasons. First, the notion that im-
porters, exporters and bond underwriters will want to use the same unit
as other importers, exporters and bond underwriters holds less weight in
a world where everyone has a mobile phone that can compare currency
values in real time. Once upon a time, comparing prices in dollars and
euros might have been beyond the capacity of all but the most sophisti-
cated traders and investors. Nowadays, “Currency Converter” is one of
the Apple app store’s top 10 downloads.
Second, the sheer size of today’s global economy means that there is
now room for deep and liquid markets in more than one currency.
Finally, the view that there can be just one international and reserve
currency at any point in time is inconsistent with history. Before 1914,
there were three international currencies: the British pound, the French
A STERLING
QUESTION
On 16 September 1992, a date that
lives in infamy in the UK as “Black
Wednesday”, the Bank of England
abandoned efforts to keep the pound
within its permitted band in the European
exchange rate mechanism. Supporting the
pound at the required exchange rate had proved
prohibitively expensive for the bank and the gov-
ernment. By contrast, it proved highly remunerative for
George Soros.
Since then, the Bank of England has eschewed all forms of interven-
tion in the foreign exchange markets. And the episode served to rein-
force an international consensus that monetary policy should focus on
domestic price stability while letting exchange rates float freely.
After Black Wednesday, it became conventional wisdom that it was
impossible to fix both the exchange rate and domestic monetary condi-
tions at the same time. According to this view, in a market economy with
a convertible currency and free capital flows, the rate cannot be manipu-
lated without consequent adjustments to other dimensions. Seeking to
influence exchange rates using capital controls or direct intervention in
currency markets were doomed to failure in anything other than the
shortest term. This consensus has been maintained through a long peri-
od in which exchange rates between the major Western currencies have
been allowed to find their own level. But it did not extend to Asia.
The Asian financial crisis of 1997-1998 convinced governments and
central banks that countries that maintained exchange controls were
able to weather the storm better than countries that embraced liberaliza-
tion. It was accepted that maintaining controls required a high level of
reserves. So, in much of Asia, we have seen fixed exchange rates for the
last decade or more, the maintenance of some controls on capital flows,
and a massive increase in reserves. The authorities have tolerated a
somewhat greater volatility in domestic inflation rates as a consequence.
There are now signs that the consensus reigning in Western central
banks for the last two decades is being challenged. Some economists
have begun to argue central banks need not be so wary of intervening.
For example, Paul De Grauwe of the University of Leuven has pro-
posed that the European Central Bank intervene when exchange rate de-
FRIDAY, OCTOBER 29, 2010
franc and the German mark. The dollar and the pound then shared inter-
national primacy in the 1920s and 1930s. Today, currencies other than
the dollar account for 40% of identified international reserves.
The implication is that the dollar, the euro and the renminbi will share
the roles of invoicing currency, settlement currency and reserve currency
in coming years.
To be sure, all three currencies have their critics. Willingness to hold
the dollar may be undercut by concern with America’s twin fiscal and
external deficits. Uncertainty about whether the European Union will
hold together could limit the use of the euro. And, although China is
aggressively promoting international use of the renminbi in trade set-
tlements, it has a long way to go before its currency is attractive as a ve-
hicle for foreign investment and holding reserves.
But the very fact that there are questions about all three currencies
means that none of them will obviously dominate. There will be an in-
ternational market for all three.
Some worry about the stability of this world of multiple international
currencies. They shouldn’t: a more decentralized international mone-
tary system is precisely what is needed to prevent a replay of the finan-
cial crisis.
Countries seeking additional reserves will not be forced to accumu-
late only—or even mainly—dollars. No one country will be able to run
current account deficits and use foreign finance to indulge in financial
excesses as freely as the US did in recent years. This will make the
world a safer place financially.
Will exchange rates between the major currencies be dangerously
unstable? Will those responsible for managing central bank reserves,
seeking to maximize returns, shift erratically between those curren-
cies?
The fear underlying such questions rests on a misunderstanding of
the behaviour of central banks’ reserve managers. Reserve managers
do not have the high-powered financial incentives of hedge fund man-
agers to seek to maximize returns. They do not have to exceed their
previous high-water mark in order to draw a paycheque. They have so-
cial responsibilities, and they know it.
This means that they have less incentive to herd—to buy or sell a
currency just because everyone else is buying or selling it. They can
adopt a longer time horizon, because, unlike private fund managers,
they do not have to satisfy impatient investors.
Compared with private investors, then, central bank reserve manag-
ers are more likely to act as stabilizing speculators. The result will be to
make the exchange rates between the three international currencies
more stable, not less.
The world economy of the 21st century is becoming more multipo-
lar. There is no reason why the same should not be true of its interna-
tional monetary system. In the end, that will be a good thing.
©2010/PROJECT SYNDICATE
velopments are out of touch with reality, in order to send a signal to the
markets. He points to the high volatility of the dollar-euro rate over the
last decade, and its adverse consequences for Europe.
Politicians, too, are concerned. French President Nicolas Sarkozy has
regularly complained about the damaging consequences of excess cur-
rency volatility, and has called for exchange rates and international mon-
etary conditions to be at the top of the Group of 20 (G-20) agenda when
France assumes the group’s presidency this November. Sarkozy’s rheto-
ric suggests that he hankers after new international agreements on ex-
change rates, and, indeed, perhaps a new global reserve currency.
There have been actions, too, as well as words. Beginning in March
2009, the Swiss National Bank became the first Western central bank in
years to seek to influence its currency’s exchange rate through interven-
tion. The Swiss were concerned about the franc’s rise, especially against
the euro, and intervened heavily in an attempt to hold it down.
It is always difficult, even after the event, to decide how effective an in-
tervention strategy has been. But the Swiss reported losses of 14 billion
francs in the first half of 2010, without succeeding in stemming exchange
rate appreciation. This episode, which other central banks watched with
great interest, tended to reinforce the views of those who are sceptical of
monetary authorities’ ability to manage exchange rates.
So where does this leave us? No doubt the debate will continue. The
underlying problem remains that, while both central banks and finance
ministries are unhappy about the excessive volatility of real and nomi-
nal exchange rates, they do not understand very well what causes it.
They may think that, in the long run, parities will reflect developments
in relative unit labour costs. But the long run can be long indeed, and
the influence of speculative capital flows can be substantial and sus-
tained.
Intervention sceptics, therefore, remain the strong majority. While
they recognize Asia’s experience has been rather different, they tend to
attribute that to dissimilar capital markets. They acknowledge that in
some circumstances intervention, or at least the readiness to intervene,
may be effective, but only if a number of associated conditions are met.
In particular, a country planning to intervene must demonstrate it
has an intimidating stockpile of foreign exchange reserves, and the
readiness to use it. There must also be a strong political commitment to
intervention, and an explicit willingness to accept the consequences for
domestic monetary conditions, which may involve an inflation rate that
is higher or lower than desired, perhaps for some time. And it is likely
that there will be a need for exchange controls, certainly on short-term
capital flows, whether permanently or from time to time.
These conditions do not typically apply in Western countries. The
Swiss have large reserves, but are so interlinked with global capital mar-
kets that exchange controls are not a realistic option. Most other West-
ern countries, certainly the US and the UK, are in no position to invest
heavily to maintain a particular exchange rate. The London markets
have waited 18 long years already for the Bank of England to appear on
their screens, and I suspect their wait will continue for some time yet.
©2010/PROJECT SYNDICATE
4 THE CURRENCY PUZZLE mint
FRIDAY, OCTOBER 29, 2010

AFRICA’S MISPLACED
MONETARY AMBITIONS
Sub-Saharan African is in the grip
of currency union mania. Region-
al groups of countries in eastern,
southern and western Africa are all
giving priority to the idea of creating a
monetary union. But haven’t we heard this
all before in Africa?
Indeed, today’s enthusiasm for currency unions
ignores the poor track record of previous attempts on the
continent to establish them through peaceful means. A com-
mon currency requires unified and centrally agreed monetary and
fiscal policies. But this necessitates political integration, which, as
the troubles of the euro this year have demonstrated, is a hard sell
By Sanou Mbaye among nation-states.
............................. Before the euro’s arrival on the international financial scene in
Dakar 1999, the only examples of countries with common currencies were
neo-colonial francophone Africa and 19th century precedents such
as the Latin American and Scandinavian monetary unions. The cre-
Sanou Mbaye is a former ation of the CFA franc, which gives France control of 65% of the CFA
member of the senior countries’ foreign exchange reserves, combined currency convert-
management team of the ibility with a grossly overvalued parity—pegged first to the French
African Development Bank and franc and now to the euro—as well as trade barriers. This led only to
the author of L’Afrique au structural deficits, vast capital flight, and, in 1994, a 100% devalua-
Secours de l’Afrique (Africa to tion.
the Rescue of Africa). Yet, despite the difficulties that have bedevilled the CFA (and the
euro of late)—indeed, despite the absence of viable regional cus-
Comments are welcome at toms unions (except in the East African Community), let alone a sin-
feedback@livemint.com gle market—Africans retain a strong allegiance to the idea of a cur-
rency union.
That allegiance is misplaced. At this stage of their economic de-
velopment, with its focus on commodity exports, the priority for Af-
rica’s countries should be long-term economic integration, not cur-
rency unions. Here, the model to follow is not the euro, but Latin
America’s Southern Common Market (Mercosur) and the Associa-
tion of Southeast Asian Nations (Asean). Both regional groupings
have, by lowering trade barriers, delivered a real catalyst to eco-
nomic growth.
Mercosur’s member countries have adopted a strategy that priori-
tizes the creation of a free trade area. They steered clear of estab-
lishing a heavy budget-fuelled bureaucracy, leaving respective min-
istries to handle administering the accord. In 2008, Mercosur intra-
regional exports reached $41.6 billion, up by 28.4% from 2007. The
external trade of Paraguay, Argentina and Brazil within the area
amounted, respectively, to 65%, 33% and 15% of their total exports.
The other major advantage of such regional groupings has been
their ability to attract foreign direct investment (FDI). Since the ear-
ly 1990s, Mercosur has managed to mobilize 5.9% of world FDI in-
flows. In 2008, it attracted a record $56 billion in FDI, an increase of
31.5% from 2007. Moreover, cross-investment between Mercosur
member countries has led to greater economic integration. Argen-
tina is now Brazil’s second largest trading partner, behind the US,
while Brazil is Argentina’s largest trading partner, ahead of the US.
The seven member countries of Asean decided to implement eco-
nomic “road maps” defining integration priorities, a testimony to
their determination to achieve a single economic community. A cur-
rency union, however, is not high on the agenda. In 2009, Asean re-
gional trade represented 24.6% of its members’ total exports and
24.3% of total imports.
By contrast, trade among African countries accounts for only
about 10-12% of the continent’s exports and imports. But, partly be-
cause several African countries have escaped the hangover from the
global credit crisis, more investors are focusing on business oppor-
tunities there. By 2050, the combined gross domestic product of the
largest 11 African economies should reach more than $13 trillion,
surpassing Brazil and Russia (but not China or India).
For some analysts, the emergence of countries such as Brazil as
economic powerhouses stems partly from successful demutuali-
zation of their stock exchanges. Twenty-three bourses are current-
ly operating in Africa, and their combined market capitalization
has soared from $245 billion in 2002 to $1 trillion (2% of the
world total) at the end of 2009—as high as the 15th largest stock
exchange in the world. With a volume of $800 billion, the Jo-
hannesburg Stock Exchange alone accounts for 80% of the to-
tal and ranks 19th worldwide. Nigeria plans to demutualize
its stock exchange in order to establish it among the prime
destinations for frontier investors.
Africa stands to benefit from a massive economic turn-
around, provided that the right environment for sustainable
growth and rising productivity is created. This requires con-
sistent macroeconomic policies focused on economic integra-
tion, food self-sufficiency, low inflation and reduced debt. It
also requires political stability, eradication of corruption, en-
hanced rule of law, improvement of basic levels of education
and greater use of mobile telephones and the Internet.
What it does not require is a currency union. When it comes to
exchange rates, the members of Africa’s economic groupings
would be better off linking their currencies in regional monetary
systems to prevent large fluctuations relative to one another.
©2010/PROJECT SYNDICATE

THE CARRY TRADE invested, it would be possible to get a lower return than simply keeping
the money in a Japanese bank account. Indeed, economic theory sug-
gests that the interest rate differential should be offset on average by
depreciation of the currency with the higher interest rate, the differen-

CARRIES ON tial thus reflecting the compensation required by investors to hold

By Hans-Joerg Rudloff &
Paul Robinson
...........................................
London
Hans-Joerg Rudloff is chairman
of the board of Barclays Capital
and a member of the boards of
directors of Novartis AG and
OJSC Rosneft. Paul Robinson is
a director and chief sterling
strategist at Barclays Capital.
Comments are welcome at
feedback@livemint.com
The Bank for International Settle-
ments recently reported that $4
trillion a day is traded in global for-
eign exchange (forex) markets, up
from $3.3 trillion in 2007. But, while the size
of the forex business always grabs head-
lines, the way that currencies are traded also mat-
ters—and this has evolved mightily over the years.
Any introductory finance textbook will tell you that inves-
tors care about the returns of their overall portfolio, not just
its individual assets. Investors prize assets that are relatively uncor-
related, or even better, negatively correlated with the returns of the
market as a whole. Owning such assets tends to stabilize overall re-
turns.
That is fine in theory, but where do such assets come from? Some
stock prices are normally relatively uncorrelated with the market.
But stock prices tend to move much more closely together at times
of market dislocation. So the relationship is liable to go wrong at the
worst possible time: when a hedge would be most useful, the asset
you were relying on becomes a risk.
Many financial derivatives were developed for exactly this rea-
son—to allow both financial and non-financial companies to hedge
their overall returns. But not all investors are able to trade deriva-
tives.
Partly for these reasons, using currencies to hedge overall portfolios,
or to have exposures that are related to other asset markets, has be-
come increasingly popular. Forex markets have two important advan-
tages in this respect. First, forex is all about relative prices—if the dollar
appreciates, some other currency must depreciate. So it offers natural
hedges.
Second, forex markets are very liquid. Even during the worst of the
recent financial crisis, when many markets almost stopped functioning,
the forex market carried on relatively normally.
Some of the more important examples of how currencies have be-
come hedges involve the yen. Japanese interest rates have been close to
zero for many years—significantly lower than those in most other econ-
omies, especially in the pre-crisis period. Low Japanese rates led to a
“search for yield” by Japanese investors who increasingly invested their
savings in foreign currencies, where they received higher interest rates:
the famous “forex carry trade”.
This was not without risk. What matters to Japanese investors is the
overall return in yen terms, not simply the difference in interest rates. If
the yen were to appreciate against the currency where the money was
money in relatively risky currencies.
But the carry trade has tended to produce positive returns. And in the
period prior to the financial crisis, the yen depreciated against most
currencies, as well as having lower interest rates, so borrowing in yen
and investing in high-interest-rate currencies such as the Australian
dollar or the Turkish lira was very profitable. This led to increased flows
into the carry trade, which for a while increased its success, because
higher inflows tended to exacerbate the weakness of the low-interest-
rate currencies.
The carry trade during this period was primarily aimed at maximiz-
ing returns rather than managing risks. But it did lead to two develop-
ments in risk management.
First, whereas in equity markets, few advocate investing in just one
company’s shares rather than a diversified portfolio, that is essentially
what happened in forex markets, where the traditional way of investing
in the carry trade was to use a single exchange rate. So products were
developed that allowed investors to borrow easily in several currencies
at once and invest in a portfolio of high-interest-rate currencies. This
protected investors from a general sell-off of the carry trade and less-
ened their exposure to idiosyncratic risks.
The second development was that the carry trade appeared to per-
form strongly when other risky assets also did well, and vice versa.
More specifically, exchange rates such as the Australian dollar-yen be-
came strongly correlated with global equity markets. This meant that
an investor who was pessimistic about equities, but who might face
constraints in hedging that risk by using derivatives or selling equities
short, could reduce his exposure to equity markets by reversing the car-
ry trade—borrowing in Australian dollars and investing in Japanese
yen, for example.
Of course, a good hedge lasts only as long as such correlations per-
sist. But, while many financial relationships broke down once the fi-
nancial crisis started, this one actually became more pronounced, and
has become a popular strategy.
The relationship between the Chinese economy and the Australian
dollar is another interesting example. Chinese growth has been stellar,
but many investors find it difficult to put their money directly in the
economy. Australia has been a particularly large beneficiary of Chinese
growth, which is relatively commodity-intensive. This has tended to in-
crease metals prices, fuelling Australia’s large export surplus in metals.
That means that buying the Australian dollar is seen as a proxy for in-
vesting in China. Because it is traded in developed and liquid markets
that have no capital account restrictions, many investors have bought
or sold it according to their view of China’s economic prospects.
Investment strategies such as this must be entered into with caution:
simply assuming that a past correlation will persist is never a good idea.
But currency values are driven by macroeconomic developments, and
therefore forex does offer natural hedging opportunities in liquid and
transparent markets. So if the correlation makes sense given the funda-
mentals, it seems sensible to bet on its persistence. And it does seem
likely that such strategies will continue.
©2010/PROJECT SYNDICATE
mint
By Vijay Joshi
..................................
Oxford
Vijay Joshi is a Fellow of St
John’s College, Oxford, and an
Emeritus Fellow of Merton
College, Oxford.
Comments are welcome at
feedback@livemint.com
By Mario I. Blejer
...............................
Buenos Aires
Mario I. Blejer is a
former governor of the
Central Bank of Argentina.
Comments are welcome at
feedback@livemint.com
THE CURRENCY PUZZLE 5
A STATE OF
CONFLICT
The currency conflicts that we
have witnessed in recent weeks
and months highlight the fact that
current global exchange rate arrange-
ments are not fit for purpose.
The basic issue concerns what is known in
international economics as the (N-1) theorem.
This states that if there are N currencies, there can
be, at most, (N-1) independent exchange rates. Suppose
there are only two countries, each with its own currency.
Then it is easy to see that the number of independent exchange
rates can be zero or one but not two. The first case corresponds to a
float: neither country has an exchange rate target. In the second
case, one of the countries sets the exchange rate and the other is
passive. The third and impossible case is where each country wants
to set the exchange rate at a different target level. In this case, there
is conflict. The (N-1) theorem simply extends this reasoning to N
countries and much of the history of exchange rate regimes con-
cerns how the (N-1) problem is resolved. An obvious case in point is
the breakdown of the post-war Bretton Woods system in 1971. De
facto, this system was a dollar standard. Each country fixed its ex-
change rate to the dollar and could change the rate if it chose to do
so. The US was the passive Nth country. The system broke down
when the US wanted to alter its exchange rate. This meant the other
countries giving up their exchange rate targets, which they were re-
luctant to do. In the ensuing struggle the US succeeded, as it was
bound to, but only by breaking up the system.
The (N-1) theorem can be applied to any group of countries. Its
relevance is sharpened if we apply it to the group of large, key coun-
tries such as the US, the euro zone, China and Japan. A small coun-
try’s choice of exchange rate regime does not matter to other coun-
tries. Not so with a key country. Its exchange rate arrangements and
policies affect many other countries. So if the key countries have
conflicting or inappropriate exchange rate targets, this matters for
global stability. The contemporary relevance of this proposition is
evident. The US is suffering from a shortage of aggregate demand
and is likely to engineer a further monetary expansion, which will de-
preciate the dollar. China is reluctant to see its exchange rate appre-
ciate because that would hurt its export industries, so it is likely to in-
tervene in the foreign exchange market to prevent the appreciation.
But this means the euro and the yen will appreciate a lot more
than they would otherwise. That is the last thing Europe and Japan
need right now since they too are in a recession. Many emerging and
THE LATIN
EXPERIMENT
Ever since World War II, the
countries of Latin America have
served as something of a currency lab-
oratory. Across the region, countless
exchange rate regimes have been tried—
some succeeding, others failing abysmally.
In all cases, however, exchange rate policies have
played a central role in determining these coun-
tries’ overall macroeconomic results. And today, after two
turbulent decades, they seem to be converging towards a
more unified and sustainable framework.
The 1980s was a harrowing decade for most Latin American coun-
tries. The second oil shock and high international interest rates,
coupled with a lack of foreign investment, led to significant internal
and external imbalances and high levels of foreign debt. In all the
major countries, this resulted in defaults, significant and continu-
ous exchange rate adjustments, and, by the end of the decade, a se-
vere inflation/devaluation spiral, bordering, in some cases, on
hyperinflation.
These traumatic events set the stage for Latin America’s two-dec-
ade-long currency roller coaster. That experience was marked by
the attempt to use a fixed exchange rate regime as the main policy
instrument to control inflation; that attempt’s colossal failure; and
the shift, over the last decade, to more flexible regimes, freeing the
exchange rate from playing a central role in controlling inflation,
but not necessarily allowing a pure float in world currency markets.
At the beginning of the 1990s, with inflation rampant, the three
largest Latin American countries decided to use the exchange rate
as the centrepiece of their stabilization strategies. Given that inter-
national capital flows had restarted, they did not fear immediate ex-
ternal constraints.
Argentina adopted the hardest peg, introducing a quasi-currency
board and fixing the exchange rate by law. Mexico and Brazil also
put in place fixed exchange rates as part of broader reform policies.
The result of these experiments reminds one of the rueful saying:
The operation was a success, but the patient died. Inflation did, in-
deed, come down; but the real exchange rate rapidly became over-
valued. This, together with external shocks and severe recessions,
made fixed exchange rate regimes untenable, first in Mexico, later in
FRIDAY, OCTOBER 29, 2010
developing countries also fear that capital inflows generated by
looser monetary policy in the US will appreciate their currencies
and cause an unwelcome decline in their international competitive-
ness, all the more so if China refuses to let its exchange rate take
some of the strain. Not surprisingly, several countries in Asia and
Latin America have already taken steps to restrict capital move-
ments. Plainly, the probability of a disorderly outcome of competi-
tive devaluations, trade protection and capital controls has in-
creased significantly.
Why has the world ended up in this quandary? The reason is that
since the collapse of Bretton Woods, we do not have anything that
can be called an exchange rate “system”. An effort to devise one was
made in the 1970s but was given up. The amendment of the IMF Ar-
ticles that was agreed in 1978 established the principle of freedom of
choice in exchange rate arrangements. (The amendment also for-
bade “exchange rate manipulation” but the term was never clearly
defined and the provision became a dead letter.) This ushered in a
free-for-all based on the idea that each country should adopt any
exchange rate regime that best suits its goals and circumstances. As
we saw above, from the global standpoint, this is a crazy idea, espe-
cially when pursued by the key countries. And it will become crazier
as the number of key countries (India, Brazil, etc.) increases in the
coming decades. To prevent global monetary chaos, key countries
must agree on a common exchange rate system. Only small and mi-
nor countries can be allowed the luxury of unconstrained freedom
of choice.
Agreement on a system for key currencies, and on how to get there,
will not be easy and will take time. A necessary first step is agreement
on the final objective. What should be the eventual shape of an ex-
change-rate system for key currencies? All alternatives have their dis-
advantages. A fixed exchange-rate regime would imply a loss of mon-
etary autonomy. It would imply adjusting to asymmetric shocks by in-
ternal wage and price changes. That would be inefficient as well as in-
tolerable. (The current strains in the euro zone exemplify the costs of
such a regime.) For the key countries, this would be a political non-
starter. Another alternative is to adopt clean floating. But this too is
unlikely to be acceptable, because governments regard the exchange
rate as too important a price to be left entirely to the mercy of market
forces. Unmanaged floating can sometimes lead to exchange rate be-
haviour that is manifestly insane, for example, the US dollar bubble in
the mid-1980s. Many intermediate regimes can also be ruled out as
unworkable. For example, a return to Bretton Woods-style adjustable
pegs would be incompatible with today’s high capital mobility.
In my opinion, there is only one option that has the potential to be
desirable as well as eventually acceptable. Key countries should
agree to float but with one major proviso. This is that they periodi-
cally agree on reference exchange rates that are appropriate for in-
ternational adjustment, intervention being allowed only if it is un-
dertaken to influence market exchange rates in the direction of ref-
erence rates. Such a scheme would require regular dialogue be-
tween the key countries, along with some macroeconomic policy
cooperation and some willingness to abide by the rules. These are
not easy requirements to satisfy, and many details would have to be
sorted out. But the impetus for agreement could come from the real-
ization that the status quo is clearly a recipe for disaster.
Brazil, and then, spectacularly, in Argentina.
During the same period, other Latin American countries, particu-
larly Colombia and Chile, adopted an alternative strategy. Their in-
flation was lower, and they oriented their policies towards main-
taining a competitive exchange rate through the adoption of a so-
called “crawling band”, whereby the currency is allowed to fluctuate
within a band around a central parity.
Both countries managed to reduce inflation gradually while main-
taining economic growth. Their greater currency flexibility, however,
did not prevent the recessionary impact of the Asian and Russian cri-
ses of 1997-98, and Colombia did experience a financial crisis in 1999.
The collapse of Latin America’s currency pegs in the financial cri-
ses of the 1990s contributed to a shift in the world’s currency para-
digm. Coming from different experiences, most countries converged
on the adoption of a floating exchange rate, many in the context of
inflation targeting.
But what most characterizes Latin America’s experience is that,
despite publicly preaching the virtues of a floating rate, the authori-
ties actively intervene in currency markets, this time in different and
creative ways. Thus, the exchange rate regime in Latin America to-
day is one of actively managed floating.
During the first part of the decade, intervention was motivated by
a desire to avoid devaluation, and therefore to support the inflation-
targeting objectives. However, in later periods the objective was to
avoid real exchange rate appreciation, and, at the same time, to ac-
cumulate international reserves and strengthen credibility.
One important lesson from Latin America’s journey concerns the
futility of relying on the exchange rate regime as the main stabilization
instrument. Inflation is too stubborn to be tackled without a coordi-
nated set of fiscal and monetary policies. Anchoring the exchange rate
is likely to result in disproportionate real appreciation, loss of compet-
itiveness, external and financial crises, and disastrous recessions.
A second lesson is the importance of flexibility. In the 1990s, when
hard pegs were in vogue, it was believed that flexibility reduced
credibility. Yet, in the end, credibility collapsed because of the lack
of flexibility. Now, in a low-inflation environment, flexibility is prop-
erly regarded as an important tool to avoid misalignments and to
shield economies from external shocks.
But flexibility is not a synonym for “pure” floating. In a highly inte-
grated world of highly volatile prices and volumes, flexibility also im-
plies the capacity to intervene and actively manage the exchange rate.
Indeed, a third lesson is that neither hard pegs nor unfettered floating
facilitates the preservation of a competitive real exchange rate, which
is crucial to promoting and sustaining economic development.
Managing a floating rate has also allowed Latin American coun-
tries to accumulate a significant level of international reserves. De-
spite advice to the contrary, this has been highly stabilizing. There is
little doubt that substantial foreign reserves, together with the flexi-
bility to float and intervene, have mitigated the impact of the recent
crisis on Latin America, and contributed to its emergence as one of
the best-performing regions in an era of deep uncertainty elsewhere.
©2010/PROJECT SYNDICATE
6 THE CURRENCY PUZZLE
FRIDAY, OCTOBER 29, 2010
DOLLAR DIPLOMACY AND
JAPAN’S LOST DECADES
By Takatoshi Ito
............................
Tokyo
Takatoshi Ito, a former
deputy vice-minister of finance
for international affairs in
Japan, is a professor of
economics at the University of
Tokyo.
Comments are welcome at
feedback@livemint.com
mint
A spectre is haunting China’s exchange rate re-
gime: the long-running dispute between the US
and Japan throughout the 1980s and early 1990s over
the value of the yen. That dispute ended only when Ja-
pan’s economy entered its “lost decades”, which has made the
Chinese determined not to repeat the experience.
Of course, history—particularly financial history—never repeats itself
exactly. But the arguments being heard about the renminbi today certain-
ly give rise, at least for Japanese, to a strong sense of déjà vu.
Now, as then, the US Congress is the focal point of American anger. Today, it is prepa-
ring retaliatory legislation against China in response to pressure from many in the US who argue
that an artificially weak renminbi is contributing to global imbalances, in particular to the US’
massive bilateral trade deficit. They are also frustrated that the US treasury has not “named and
shamed” China by designating it a currency manipulator.
But, based on Japan’s experience, the Chinese do seem to have good reasons to be wary of US
pressure to revalue the renminbi. Indeed, the economists Ronald McKinnon and Kenichi Ohno
have singled out US pressure for yen appreciation as a key source of the Japanese economy’s long-
term deflation and stagnation—the so-called “lost decade” of economic malaise that is now well
into its second.
The US and China have engaged simultaneously in dispute and dialogue for several
years—again reminiscent of what Japan went through with the US in the 1980s and 1990s. Just as
China has its “Strategic Dialogue” with the US, so Japan had the “Structural Impediments Initia-
tive” (1989-1990) and “Framework Talks” (1993-1995).
And for China now, as for Japan then, the undercurrent for these discussions is US frustration
with bilateral current account deficits. Both structural factors and the exchange rate are discussed.
But the weight given to the exchange rate is higher today in the US-China dispute, because, where-
as Japan had a “managed float” exchange rate regime in the 1980s and 1990s, the Chinese exercise
much tighter control over the renminbi.
Chinese officials agonize over the US pressure. If they yield to it, the Chinese economy, they ar-
gue, may fall into the same deflationary trap that ensnared Japan after the yen’s appreciation in
the 1980s—under US pressure—inflated a catastrophic asset-price bubble. But if they continue to
resist, China may face hot trade disputes with the US, which could be even messier.
Like Japan in the 1980s, China must defend itself from US claims that the renminbi’s weakness
is the source of the imbalances between the two countries. Currency appreciation, Japan argued
then and China argues now, is unlikely to result in a significant current account adjustment,
which requires addressing not only China’s high savings rate, but also low savings in the US.
How the situation will develop in the near future can be gleaned from the recent past. China in-
stituted a flexible exchange rate from July 2005 to the summer of 2008, and the renminbi gradually
appreciated against the dollar—cumulatively by more than 20%. Whereas the peg to the dollar was
resumed during the global financial crisis, in June China announced a return to flexibility. The
renminbi fluctuated without a clear trend until mid-September, when it appreciated sharply, ap-
parently in response to increased US pressure stemming from the impending Congressional vote.
In one respect, then, the dispute appears set to follow a path similar to the US-Japan case. It will
be prolonged and occasionally very tense, but eventually result in appreciation of the renminbi.
But there is a crucial distinction to be made between the two cases: Japan needs the US to ensure
its security, while China does not. Moreover, the size of China’s economy will surpass that of the
US in about 15 years. So time is on China’s side.
But there is a more fundamental issue: the Chinese authorities, in arguing that it was a mistake
to allow the yen to appreciate, may be misinterpreting what happened in Japan—and thus overes-
timating the risk posed by currency appreciation.
For Chinese officials who believe that yen appreciation was the source of Japan’s chronic eco-
nomic malaise, the Plaza Accord of September 1985—a concerted effort by the US, the UK, France,
West Germany, and Japan to depreciate the dollar—is Exhibit A. The yen soared from 240 to $1 in
September 1985 to 200 to $1 the following December.
The real dilemma for Japan arrived in March 1986, when the yen neared its then record high,
178 to $1. Japan responded by intervening in the opposite direction—dropping interest rates, sell-
ing yen, and buying dollars. That proved decisive. Keeping interest rates low discouraged capital
inflows and encouraged asset-price inflation.
The ensuing bubble in Japanese housing and equity prices inflated and burst not because Japan
succumbed to US pressure to allow the yen to appreciate, but because Japan, in the end, resisted
that pressure. So, if China is to draw the correct lesson from the Japanese experience, it must know
what really happened in Japan back then.
What China should be carefully watching is whether there is are signs of overheating in the do-
mestic economy, and whether asset prices are rising sharply. Allowing the renminbi to appreciate
would be a good way to prevent both.
©2010/PROJECT SYNDICATE
mint
By Yu Yongding
............................
Beijing
Yu Yongding, president of the
China Society of World
Economics, is a former member
of the monetary policy
committee of the People’s Bank
of China, and a former director
of the Institute of World
Economics and Politics at the
Chinese Academy of Social
Sciences.
Comments are welcome at
feedback@livemint.com
By Jahangir Aziz
............................
Mumbai
Jahangir Aziz is India chief
economist at
JPMorgan Chase.
These are the author’s
personal views.
Comments are welcome at
feedback@livemint.com
THE CURRENCY PUZZLE 7
CHINA
DILEMMA
In June, the People’s Bank of Chi-
na (PBC), China’s central bank,
announced an end to the renminbi’s
23-month-old peg to the dollar and a
return to the pre-crisis exchange rate re-
gime adopted in July 2005. So far, however,
the renminbi’s appreciation against the dollar has
been slow. Will the pace of appreciation accelerate
enough to satisfy American demands? If it does, will global
imbalances disappear sooner?
It is hard to argue that the renminbi is not undervalued, given
China’s large and persistent current account and capital account
surpluses. But, despite ending the dollar peg, faster appreciation of
the renminbi seems unlikely for the foreseeable future.
China’s official position is that, to avoid the negative impact of a
stronger renminbi on China’s exports and hence employment, ap-
preciation must proceed in an autonomous, gradual and controlla-
ble manner. The current exchange rate regime, which links the ren-
minbi to a basket of currencies, was designed to give the PBC leeway
to control the pace of renminbi appreciation, while creating two-
way fluctuations in the exchange rate against the US dollar in order
to discourage speculators from making one-way bets on the ren-
minbi.
Renminbi appreciation should have started earlier and at a faster
pace, when China’s trade surplus was much smaller and its growth
was much less dependent on exports. Delay has made current ac-
count rebalancing via renminbi appreciation costly. And now China
faces a dilemma.
As a result of the global financial crisis, China’s export growth in
2009 dropped by 34% compared with 2008. In the first seven months
of 2010, China’s trade surplus was $84 billion, down 21.2% from Jan-
uary-July 2009. This large, steady fall in the country’s trade surplus
makes the Chinese government hesitant to allow the renminbi to
appreciate significantly, for fear of the lagged impact on the trade
balance.
But the PBC is also reluctant to buy dollars constantly. The PBC
knows that rapid deterioration in America’s fiscal position and con-
tinual worsening in its external balance may create an irresistible
temptation for the US to inflate away its debt burden. The more the
PBC intervenes, the larger the national welfare losses that China
may suffer in the future.
FOR A FEW
DOLLARS LESS
It’s déjà vu all over again. Emerg-
ing market economies are once
again flooded with capital inflows,
struggling to resist currency apprecia-
tion, and threatened with asset price surg-
es. And in some emerging market econo-
mies, such as Brazil and India, things are further
complicated by inflationary pressures. Most major
emerging markets, barring India, have responded with large-
scale interventions in foreign exchange markets and intensif i-
cation of capital controls.
That something like this would happen has been on the cards since
earlier this year. Emerging markets have led the current recovery, and
the growth differential with developed economies is likely to widen. If
any of the developed market funds intend to recoup their losses in
the crisis, increasing exposure to emerging market assets has to hap-
pen. What held them back were concerns of another October 2008
style liquidity and redemption squeeze hitting them. The probability
of such a situation arising in the near term has now been significantly
lowered: first by the ECBs liquidity support for peripheral European
debt, and then, more recently, by the US Federal Reserve announcing
a second round of quantitative easing; these assurances opened the
flood gates of capital inflows into emerging markets since September.
While the currency appreciation and asset price surge are prob-
lematic, the concern that the inflows could reverse may be over-
blown. Whenever inflows come in such large magnitude, there is
bound to be some froth and some speculative flows. Some coun-
tries, such as Brazil and Korea, may be under more severe specula-
tive inflows than others, but, by and large, much of these flows are
driven by portfolio rebalancing in developed markets rather than
currency speculation or just interest rate differentials.
This raises two issues. First, the rebalancing will continue and
with that the inflows. Second—and this is the real problem—while
the rebalancing exercise from the developed market perspective is a
small portfolio shift, it will create tidal waves in emerging econo-
mies given their much smaller market size. This situation unfortu-
nately isn’t going to change soon. So as long as the rebalancing goes
FRIDAY, OCTOBER 29, 2010
The Chinese government must therefore strike a balance between
protecting China’s export sector and preserving its national welfare.
The dilemma that officials face is that the impact of a fall in exports
as a result of renminbi appreciation will be felt acutely and immedi-
ately, whereas the large welfare losses due to the evaporation of the
value of China’s foreign exchange reserves will be borne by society
as a whole—but not immediately.
Moreover, the increase in China’s overall price level—and wage
levels in particular—has caused the renminbi to strengthen steadily
in real terms, reducing (to a certain extent) the need for nominal ren-
minbi appreciation. True, commerce ministry officials recently de-
clared their wish to see a further fall of China’s trade surplus in 2010.
But renminbi appreciation is not the preferred instrument for achiev-
ing this goal. Thus, nothing dramatic will happen to the renminbi ex-
change rate in the near term—unless something dramatic happens.
At the same time, the effect of currency appreciation on the trade
balance should not be exaggerated. The renminbi appreciated by
18.6% in real effective terms, and by 16% in dollar terms, from June
2005 to August 2008. Yet, from 2006 to 2008, China’s annual exports
grew 23.4%, outpacing import growth of 19.7%.
Exchange rates are just one of many factors that affect trade bal-
ances. For China’s, the income effect of global demand is signifi-
cantly larger than the price effect of the exchange rate. The fall in
China’s trade surplus since late 2008 is attributable mainly to the
global slowdown and the stimulus package introduced by the Chi-
nese government, rather than to changes in the renminbi’s ex-
change rate.
But if the renminbi is allowed to float, isn’t a balanced trade ac-
count likely? Probably not. With a fast-rising renminbi, net capital
outflows will increase, which is what Japan experienced after the
Plaza Accord of 1985 pushed the yen upward. As a result, balance-of-
payments equilibrium would be reached at a certain exchange rate
level, but a current account surplus (albeit smaller) would still exist.
America should not pin too much hope on a weakening dollar to
correct its trade imbalances. For the US, the fundamental cause of
imbalances is not a strong dollar, but America’s over-consumption
and over-borrowing. A strengthening dollar would worsen the US
trade balance, but a weakening dollar could cause panic in capital
markets, which might push up risk premia on dollar-denominated
assets, including US government securities, in turn leading to an
economic slowdown and a further weakening of the dollar.
Of course, renminbi appreciation may displace Chinese goods
sold in the US. But if the US fails to narrow its savings gap, its cur-
rent account deficit will not disappear, regardless of where the dol-
lar goes. Whether America can achieve decent growth while keeping
its current account deficit in check depends on whether it can rein-
vigorate its ability to innovate and create, thereby restoring compet-
itiveness and creating demand at the same time.
For both China and the US, the renminbi-dollar exchange rate is
important for achieving growth and a more balanced current ac-
count. But that dual objective requires structural change in the Chi-
nese and US economies.
©2010/PROJECT SYNDICATE
on, the tidal wave will keep pounding emerging markets.
Tweaking capital controls is not going to slow the pace of inflows
as recent experience shows. These flows aren’t seeking short-term
interest differential or appreciation gains. They are driven by portfo-
lio rebalancing and unless there are liquidity or redemption pres-
sures in developed markets, these flows will continue. Any substan-
tial quantitative easing by the Fed will only reinforce that redemp-
tion pressures are unlikely to re-emerge any time soon, thereby
speeding up the rebalancing.
The other policy response, namely large-scale intervention to pre-
vent the currency from appreciating, is far less benign. Capital con-
trols at worst will be ineffective. Interventions on the other hand run
the real risk of raising the expectations of future appreciation, there-
by inviting speculative flows, adding to the already large rebalanc-
ing related flows. And it is this nightmare that emerging markets
need to avoid. Letting the exchange rate be the shock absorber,
while painful to the real economy, has been an effective way to pre-
vent speculative attacks. Can’t recall the last time a floating curren-
cy was targeted by speculators.
Clearly, sudden and large appreciations are disruptive and can
potentially harm the real economy. And this has been the argument
used to justify large-scale interventions. But the problem is that
these countries have not really let the exchange rate appreciate in
any material manner when inflows were milder. Consequently,
when inflows surge, the size of potential currency adjustment looks
scary and is intervened away. In this regard, the Reserve Bank of In-
dia’s exchange rate policy over the last 18 months has been very
sensible by letting the exchange rate absorb modest capital volatili-
ty, setting aside interventions to combat more volatile flows.
But there is a much bigger problem: the dreaded global imbalanc-
es. With an ageing population, high fiscal deficit, and thus low sav-
ings, developed markets will be short of savings for a long time. And
emerging markets will have to run current account surpluses and
supply their excess savings to fund the developed markets’ saving
shortage. Thus global imbalances are likely to remain. The issue is
whether these imbalances remain modest or blow up, threatening
another disruptive adjustment in asset and foreign exchange mar-
kets. While umpteen combinations of policy options have been sug-
gested in the last five years, ultimately all the potential solutions re-
quire growth sacrifice on both sides. Developed markets need to
consolidate their fiscal deficits much more quickly, which will re-
duce demand in their economies and, with that, growth. Emerging
markets need to let their exchange rate appreciate more markedly,
which will also lower some growth in their economies. These are not
new options. The problem lies in coordinating such policy moves.
And at the heart of it lies an old problem in economics: the inability
to credibly commit to policies that are temporally inconsistent. The
exchange rate adjustment is needed upfront, the fiscal consolida-
tion, by its very nature, is a medium-term promise. And someone
will need to step up and break this impasse.
8 THE CURRENCY PUZZLE
FRIDAY, OCTOBER 29, 2010
By Ashok K. Lahiri
................................
Manila
Ashok K. Lahiri is an executive
director, Asian Development
Bank (ADB), Manila. The views
expressed here are personal and
do not reflect those of ADB.
Comments are welcome at
feedback@livemint.com
mint
STOOPING TO
CONQUER
Currency markets are in the doldrums. Since
April 2010, the yen has appreciated by about 12%
against the dollar. For the first time in six years, Japan
unilaterally intervened in the exchange market in Sep-
tember drawing adverse reactions from the US and Europe.
In China, after the June decision of allowing more rate flexi-
bility, the renminbi has nominally appreciated against the dollar by about
2% as of early October. Active foreign exchange purchases held the ren-
minbi down, while reserves surged by $194 billion in the third quarter to a record $2.65
trillion. Fred Bergsten, director of the Peterson Institute, thinks the renminbi is under-
valued by between “[at least] 25 and 40%”. The rapid yen appreciation coincided with the deploy-
ment of a part of Chinese reserves in yen. Some allege that interventions to hold the renminbi
down is distorting the global currency system by forcing other emerging economies to intervene
and undermining recovery.
India, Indonesia, Malaysia and Thailand have experienced the strongest real effective exchange
rate appreciations so far in 2010, and their currencies were close to 10-year highs in August. In
Brazil, in spite of interventions that have pushed foreign reserves up 18% this year to a record over
$280 billion, the real has gained 38% since the end of 2008. Goldman Sachs says that the real is the
most over-valued currency in the world.
Brazilian finance minister Guido Mantega last month declared that the world was in the midst
of a “currency war”. Some suggest that the large and growing Chinese reserves hangs like “a target
around the neck of China’s exchange rate regime”. War or no war, there is palpable war-like un-
certainty. Will the uncertainty reduce by November with the Federal Open Market Committee
(FOMC) meeting and the Group of Twenty nations’ (G-20) summit?
On 2-3 November, the FOMC—the key committee of the US Federal Reserve System—will de-
cide whether monetary policy in the US should be further eased or tightened or kept unchanged.
Some quantitative easing is expected, but some residual uncertainty remains whether it will be in-
cremental of say roughly $100 billion per month or, follow a “shock and awe” approach of a large
upfront commitment of $500 billion to $1 trillion.
The two-day meeting of G-20 finance ministers and central bankers, which ended last Saturday
in Gyeongju, South Korea, promised to refrain from a currency war, double the International
Monetary Fund (IMF) quota and to give fast-growing countries a greater say at the IMF. The agree-
ment to “move toward more market-determined exchange rate systems that reflect underlying
economic fundamentals” fell short of the US proposal to limit the surplus or deficit on the current
account to less than 4% of the gross domestic product (GDP) by 2015. It is unlikely that the G-20
summit on 11-12 November will go far beyond this general agreement.
Devaluation for prosperity? We seem to have come a long way. Recall the intense and wide-
spread political reaction to the 1966 devaluation of the Indian rupee. The opprobrium attached to
the IMF in developing countries came partly from its advocacy of devaluation in the face of bal-
ance of payments problems.
The wheel has turned a full circle with a proliferation of countries trying to manage their ex-
change rate down through intervention and the IMF advocating “greater exchange rate flexibility”,
a coded phrase for allowing appreciation. A weaker exchange rate makes a country’s exports
cheaper, and boosts a key source of growth.
The standard recipe for a country afflicted by balance of payments problems is the pursuit of de-
flationary policies. But with the dollar universally accepted for international transactions, the US
does not have a financing problem for its balance of payments deficit. Thus, it is not forced to de-
flate and wants the rest of the world to inflate—including through expansionary policies and cur-
rency appreciation—to solve the US problems, while the rest of the world wants the US to deflate
and attain external balance.
The financial crisis triggered by global macroeconomic imbalances from the second half of 2007
is not quite over. The recession in the US from December 2007 technically got over in June 2009.
Revival’s green shoots, which Federal Reserve chairman Ben Bernanke saw as early as March
2009, have not grown robustly. Unemployment in September 2010 was still as high as 9.2%.
World output, which declined by 0.6% in 2009, is projected by the IMF to increase by 4.8% in
2010. But this growth is uneven and is being propelled mainly by emerging economies, particular-
ly in Asia. The advanced economies, by growing at only 2.7% in 2010 after declining by 3.2% in
2009, will still be worse off than in 2008. Emerging Asia was the growth leader with China growing
by 9.1 % in 2009 and expected to grow by 10.5% in 2010. The corresponding figures for India were
5.7 % and 9.7 %, respectively.
The fundamental cause of the recent financial crisis lay in policies that resulted in overcon-
sumption in the US and underconsumption in China. There have been some improvements as re-
flected in the expected decline in 2010 (relative to 2004-08 average, as a proportion of GDP) in the
US current account deficit and Chinese current account surplus to 3.2% (from 5.4%) and 4.7%
(from 8%), respectively. But a lot more needs to be done before declaring victory. Even after ad-
justments, in 2010, the savings rate in the US at only 12.4 % is about a quarter of that in China!
In the meantime, countries are likely to try preventing their currencies from appreciating either
by following loose fiscal and monetary policies (like the US) or by intervening in the foreign ex-
change markets (like China). Will the currency war lead to a old-style trade war? Will the US, for
example, impose restrictions on imports from China, through the proposed Currency Exchange
Rate Oversight Reform Act 2010? It may be difficult to have a WTO-consistent trade remedy for an
undervalued currency of a competitor.
Some recent years have seen sizeable investment flows from low-growth, low-return rich na-
tions to faster-growing emerging economies. The scent of future appreciation together with low
interest rates in advanced economies will accelerate these flows and exacerbate the upward pres-
sure on exchange rate of emerging economies. To contain capital inflows, Brazil imposed a finan-
cial transactions tax on foreign investments in fixed-income securities of 2% a year ago and re-
cently increased the tax to 6%. Such capital account measures are likely to proliferate. Further-
more, some developed countries may ban countries such as China with large reserves investing in
their government securities by allowing sales to official institutions only from countries in which
they themselves are allowed to buy and hold public debt, and thereby increase the cost of holding
reserves. Whether and when it will happen and what the reaction will be is difficult to tell. After
all, the US-China relation is a delicate one. Just as US as a debtor is too big to fail for China the
creditor, China as a creditor is too big to annoy for the US.