China's refusal to allow its currency to respond to market forces has attracted unwanted and widespread criticism. Of course, China is not the only sinner.
For their part, generations of Japan's corporate and political leadership have revealed a preternatural fear of a rising international value of the yen. At the same time, South Korea's financial and monetary authorities have been very active.
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With the won at its highest level against the dollar in almost seven years, the Bank of Korea stepped up its intervention on the foreign exchange markets. Citing "excessive" appreciation, it bought up to US$2 billion.
Whereas the Korean currency gained almost 10 percent against the dollar this year, the yen and the New Taiwan dollar and Singaporean dollar are also up substantially. Given attempts to keep the won undervalued to support the price competitiveness of exporters in overseas markets, it is unsurprising that the adjustment has been so large. Only recently, the government has withdrawn from currency markets after criticism that heavy dollar buying pushed up costs of imported oil and other raw materials.
Indeed, virtually every country following an export-led growth strategy follows the same path. An artificially-low currency is seen as aiding local exporters in maintaining their global price competitiveness and allowing foreign currency reserves to rise.
Ironically, the increasing foreign exchange reserves become part of the problem that lead to costs that almost certainly outweigh the presumed benefits. In particular, most of the remedial steps lead to creating public-sector debt instruments that lead to substantial interest payments.
It turns out that export-led growth and currency intervention are logically inconsistent from an economy-wide perspective. In defending a local currency from appreciating, import prices of capital goods and raw materials are kept higher while local facility investments are sluggish. However, the artificially-low foreign exchange values kept import prices of consumer products and capital goods. This adds to upward price pressures on the domestic economy that lower the real income of workers.
A hidden loss from defending a targeted exchange rate is measured by differences between interest paid on the bonds and what was generated with the foreign currency bought by the government.
Government actions to keep a local currency weak against major currencies cause more foreign currencies to flow into the domestic banking system. In response, central banks issue bonds to absorb excessive liquidity from the financial system and thus relieve upward price pressure on the economy.
As it is, export-oriented economic policies contribute to the decision for governments to intervene in foreign currency markets that tend to push up domestic consumer prices. At the same time, forays into foreign exchange markets usually lead to increased volatility in currency markets since speculators sniff out profit opportunities created by the interventions.
It might be helpful to trace the impact of monetary policy on foreign exchange markets to see what steps are taken to avoid appreciation of a currency. If the central bank or finance ministry wishes to hold down the international value of the domestic currency, foreign currencies are purchased. This will increase the supply of the domestic currency in money markets combined with increased demand for the foreign currency that causes the value of the former to fall relative to the value of the latter.
Yet the overall impact depends upon the source of the funds used to intervene in foreign exchange markets. When drawn from existing currency supplies, liquidity will be reduced in the financial system. In response, central banks tend to seek to maintain sufficient liquidity by purchasing government bonds.
The increased demand for exports leads producers to seek loans from commercial banks that can lend at lower interest rates due to the loose monetary policy. Initially, exporters experience increased profits. But eventually domestic prices begin to rise under pressures of the bidding war to control access to inputs.
When prices of domestic goods and services rise there will be a decline in profits earned from exports as well as domestic sales. These rising prices end the illusion that growth can be created from thin air by loose monetary policy and export-led growth.
Attempts to manipulate foreign exchange valuations are not only fruitless, they are damaging. History is replete with examples where markets overwhelmed government attempts to impose a change or fight against pressures that determine the relative values of currencies.
Over the past year, the yen has risen relentlessly against the US dollar despite massive interventions from Tokyo. Meanwhile, Japan's record reserves suggest that its capacity to export was not hurt by a strengthening currency.
And Beijing's position inspires howls from protectionists to block its exports while its own macroeconomic situation is destabilized, most evidently by high and rising prices. Now South Korea is beginning to catch a whiff of the stale odor of stagflation.
Christopher Lingle is visiting professor of economics at Universidad Francisco Marroquon in Guatemala.
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