Addressing Global Imbalances

Gone are the days of co-operative economic recovery plans between world leaders to restore global growth rates. Instead, governments have been heavily criticising each other for disturbing the balance in the world economy through currency intervention and controls over capital flow. It is now so bad that Brazil’s finance minister, Guido Mantega, has declared that we may be entering an “international currency war”.

This month’s G-20 summit in Seoul, South Korea, did little to resolve tensions. The most critical battle lies between the two largest economies, America and China. The Chinese government uses a practice known as “competitive devaluation”, where it artificially drives its currency lower in order to boost exports. American officials have branded China’s deliberate undervaluing of its currency as a “damaging dynamic” because it results in unfair prices. At the summit President Obama declared there was “broad agreement” between nations on currency invention; however no concrete resolutions have been announced.

With their own interests in mind, the Chinese government is doing little to change their strategy. Should the Chinese Yuan strengthen too quickly their exported goods will become relatively less price competitive on the world market. Their abundance of low cost manufacturing exports makes them particularly vulnerable given the fierce rivalry of the international price for these goods.

In the absence of government interference the Yuan would be free to naturally appreciate, which could have a negative impact on jobs and economic growth in China, and could also affect global growth. The US claims China’s actions are at a cost to their own growth, jobs and industries. Global leaders have demanded that China float its currency, thereby allowing the Yuan to increase in value, in order to reflect what German Chancellor, Angela Merkel, describes as “economic realities”. Between June and October 2010, China allowed its currency to appreciate by 2% but leaders stress this is not enough. The Big Mac index for instance, a comparison purchasing power parity between countries, suggests that the Yuan is undervalued by as much as 40%.

The other problem for China is that it currently holds the largest stockpile of foreign exchange reserves (2.6 trillion) and about 65% of these are in US dollars. Should China allow its currency to gain in value it would suffer heavy losses on its dollar holdings (because they would receive fewer Yuan when converted back). China could diversify its dependency by investing elsewhere; the only problem is if it sells dollars to buy other currencies it risks depressing the value of the dollar and consequently the value of its reserves.

The reality is that the two largest economies have their own agendas. The US economy is struggling to fully recover from the global financial crisis. The government is desperate to improve growth and reduce unemployment, and it will also do whatever is required to avoid deflation. With reduced government spending due to cuts and lower taxation revenue American policy makers are running out of options. The US will have little choice but to use expansionary monetary policy to devalue its own currency, boost exports and re-inflate the economy.

The US government’s policies are a serious concern for Chinese officials. There is an excessive amount of dollars flowing in and out of emerging markets. This is due to the large number of dollars the Federal Reserve has printed over the past ten years. Printing more dollars will make matters worse as devaluing the currency causes distortions in international investment.

Global investors will respond to the declining dollar by looking for short-term higher yields, especially in emerging markets. Higher investment in these developing economies will result in their exchange rates soaring, impairing their external competitiveness and possibly forming significant short-term asset bubbles. The fluctuations could also lead to the imposition of capital controls. Brazil recently doubled a tax on foreign purchases of its domestic debt and Thailand has just announced a new 15% withholding tax for foreign investors in its bonds.

Currency issues concern not only American and European policy makers but Chinese investors. Without international co-operation, the global economy faces possible stagnating growth rates and deadlocks in the movement of capital. British Prime Minister David Cameron warned that without global agreements we risk the return of a 1930s wave of “protectionism, trade barriers and currency wars”.

China’s growing economic status makes it unlikely that it will immediately bow to U.S demands. They will probably set their own pace for currency reform. But if nothing is done, global imbalances will only get worse. If the developed world is to persuade China to revalue the Yuan, they must convince its leaders of the critical role the country plays in maintaining short and long-term international trade and investment flows. Governments must realise there is no domestic solution: addressing a currency war requires multi-lateral efforts.

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