Brazilian Finance Minister Guido Mantega aptly captured the current monetary zeitgeist when he spoke of a looming “currency war.” What had seemed a bilateral dispute between the US and China over the yuan’s exchange rate has mutated into a general controversy over capital flows and currencies.
Today, every country seems to want to depreciate its currency. Japan has resumed foreign-exchange intervention, and the US Federal Reserve and the Bank of England are preparing another large-scale purchase of government bonds — a measure called “quantitative easing,” which lowers long-term interest rates and indirectly weakens the currency.
China is fiercely resisting US and European pressure to accelerate the snail-paced appreciation of the yuan against the US dollar. Emerging-market countries are turning to an array of techniques to discourage capital inflows or sterilize their effect on the exchange rate.
Only the eurozone seems to be bucking the trend, as the European Central Bank (ECB) has allowed a rise in the short-term interest rate. However, even the ECB cannot be indifferent to the risks of appreciation, because a strong euro may seriously complicate economic adjustment in countries like Spain, Portugal, Greece and Ireland.
A world in which every country wants a weaker exchange rate is not without precedent. It happened in the 1930s, when one country after another abandoned the gold standard, trying to export its unemployment.
However, everyone cannot have a weak currency at the same time, so, in 1944, responsibility for preventing beggar-thy-neighbor depreciation was assigned to the IMF, whose Articles of Agreement mandate it to “exercise firm surveillance over the exchange rate policies” of member countries.
Given this mission, it would seem that the IMF should help extract concessions from China and the rest of the world should declare a truce. However, this would ignore a fundamental asymmetry between advanced and emerging countries. Both have suffered from the crisis, but not in the same way.
According to the IMF, real output in advanced countries this year will still be below 2007 levels, whereas it will be 16 percent higher in emerging and developing countries. Advanced countries will continue to struggle with the fallout of the 2008 crisis, especially with the deleveraging of indebted households and dire public finances.
The IMF also reckons that the advanced countries must cut spending or increase taxes by 9 percentage points of GDP on average over the current decade, in order to bring the public debt ratio to 60 percent of GDP by 2030. Emerging countries, however, do not need any consolidation to keep their debt ratio at 40 percent of GDP.
Asymmetry of this magnitude requires a significant adjustment of relative prices. The relative price of the goods produced in the advanced countries (their real exchange rate) needs to depreciate vis-a-vis the emerging countries in order to compensate for the expected shortfall in domestic demand.
In fact, this will happen whatever the exchange rate between currencies. The only difference is that, if exchange rates remain fixed, advanced countries will have to go through a protracted period of low inflation (or even deflation), which will make their debt burden even harder to bear, and emerging countries will have to enter an inflationary period as capital flows in, driving up reserves, increasing the money supply and ultimately boosting the price level. For both sides, it is more desirable to let the adjustment take place through changes in nominal exchange rates, which would help contain deflation in the North and inflation in the South.
However, compared with July 2007, at the onset of the crisis, exchange rates between advanced and emerging countries have barely changed. True, some currencies have risen and others have fallen, but on average almost nothing has happened. The adjustment that needs to take place is blocked.
For each central bank, the question is not what happens to, say, emerging countries as a whole, but what happens to its own currency vis-a-vis competitors. So Brazil does not want to appreciate vis-a-vis other Latin American countries, Thailand does not want to appreciate vis-a-vis other Asian countries and no one wants to appreciate vis-a-vis China, which fears that yuan appreciation would lead labor-intensive industries to migrate to Vietnam or Bangladesh. Thus, a change that is in everyone’s interest is hampered by lack of coordination.
Quantitative easing in the advanced countries also raises a question of coordination. Quantitative easing is a legitimate monetary-policy instrument, but the Fed and the Bank of England would probably not embrace it with such enthusiasm were it not for the anticipated exchange rate depreciation. In fact, the ECB’s perceived reluctance to follow suit is likely to add to the expected growth effects of US or British monetary-policy choices, at the expense of the eurozone.
The controversy over China’s exchange rate policy thus is no mere bilateral US-China trade dispute, but rather a global macroeconomic clash between advanced and emerging countries. Moreover, the lack of coordination in both advanced and emerging countries suggests that the solution to currency wars is not to declare a truce, but to recognize the nature of the issue and overcome the problems that stand in the way of agreed common solutions.
This is not to say that the yuan’s exchange rate is a secondary issue. On the contrary, its importance stems from the fact that China holds the key to global adjustment. The recent IMF-World Bank annual meetings indicate that this is gradually being recognized, with emerging countries increasingly critical of China’s inflexibility.
So now is the IMF’s moment. The fund should propose a conceptual framework for the discussions to be held on exchange rate problems by providing an objective assessment of the adjustments that are needed and by facilitating settlement within the multilateral framework. The IMF cannot substitute for governments’ choices, but it can help the search for a solution.
Jean Pisani-Ferry is director of Bruegel, a European think tank.
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