Brookings: Topics - Exchange Rates

Time to Call a Truce in the Currency Wars

Michael W. Klein — Fri, 01 Mar 2013 00:00:00 -0500

Yes, the yen has weakened and the pound has gotten pounded, but worries about an all-out currency war may be overblown.

There's a perception that some countries' economies are being harmed by currency movements that have been undertaken to gain an unfair advantage.

That may be a bit misguided.

In the United States, the threat of a fiscal contraction due to sequestration has prompted the Federal Reserve to take actions that could weaken the dollar.

Signals suggest that the new head of the central bank in Japan will pursue a more expansionary policy in an effort to stimulate that country's long-moribund economy.

These actions are taken for purely domestic reasons, but they could have consequences for currencies.

In anticipation of frictions that could arise, there was an agreement by the G-20 nations at the recent Moscow summit to refrain from so-called competitive devaluations.

But, since then, governments such as South Korea and New Zealand have signaled a desire to pursue explicit policies to weaken currencies, or even to impose capital controls.

Read the rest of the opinion at cnn.com »

Authors

Michael W. Klein

Publication: CNN

Image Source: © Toru Hanai / Reuters

Global Imbalances and Petrodollars

Rabah Arezki and Fuad Hasanov — Sat, 22 Dec 2012 11:04:00 -0500

Editor's Note: The article was originally published on the Wiley Online Library . A subscription required to access the full article »

ABSTRACT

Oil exporters have run large current account surpluses. We explore oil exporters’ role in the global imbalances debate. Current account dynamics are estimated for oil-exporting countries and the rest of the world. We find that fiscal policy has a much stronger effect on the current account of oil exporters than on current accounts of other countries. The current account adjustment of oil-exporting countries is also faster. Fiscal policy of oil exporters can have a significant and speedy impact on global imbalances. The impact via the adjustment of exchange rates might not be effective.

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Authors

Rabah Arezki
Fuad Hasanov

Publication: Wiley Online Library

Image Source: © Yusuf Ahmad / Reuters

The Future of the CEMAC CFA Franc

Julius Agbor — Tue, 11 Dec 2012 11:55:00 -0500

EXECUTIVE SUMMARY

A total of 80 currency boards have come into existence at some point since the mid-19th century, but to date only about 15 of them still exist, among which is the CFA franc monetary zone. The future sustainability of the CFA franc zone, to which the CEMAC CFA franc belongs, is increasingly questioned in the light of increasing asymmetries in exposure to external shocks, differential speeds of adjustment of the real exchange rate following shocks, differential impacts in economic fundamentals, and low levels of intra-regional trade and financial flows between CEMAC and WAEMU. For the CEMAC bloc of countries in particular, the future sustainability of the fixed exchange regime depends crucially on continued oil exports, which currently represent about 90 percent of export revenues and 40 percent of GDP. Should oil reserves deplete in the near future or oil prices decline significantly, a substantial source of foreign reserves would be lost, thereby exposing the regime to collapse. Even without resource depletion, continued volatility in global financial markets is increasing the risks of collapse of the fixed exchange regime as oil and commodity price swings ignite currency speculation as well as render reserves much more volatile. Against this backdrop, the present study examines the stakes facing the CEMAC CFA franc, discusses the exit options from the currency board and makes recommendations towards a sustainable monetary policy framework for CEMAC countries going forward. The analysis points to the imperative of pursuing a full monetary union with a single CEMAC franc pegged to the U.S. dollar and further suggests that, like the experience of the eurozone, the CEMAC monetary arrangement can be best implemented only by complying with the principle of political union.

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Authors

Julius Agbor

Image Source: © Thierry Gouegnon / Reuters

Reform by Stealth is Reason for Optimism about China

Eswar Prasad — Mon, 06 Aug 2012 10:14:00 -0400

China pessimists are claiming vindication as growth slows in the world’s second-largest economy. Optimists point out that Beijing has fiscal room to respond but there are risks to any short-term policy measures. A surge in bank-financed investment, for example, could boost growth but it is also likely to increase the stock of non-performing loans in the banking system and set back the goal of rebalancing growth by promoting private consumption. An aging population and a rocky leadership transition strengthen the bears’ case.

However, there are grounds for hope. Recent political turmoil, including the Bo Xilai affair, put reactionary forces in the Communist Party of China on the defensive. Meanwhile, reform-minded officials pushed through some modest but significant financial market reforms.

The government has long recognised that reforming the financial sector is needed to improve the balance and sustainability of growth. Why has it not acted more forcefully before? The present system works well – for some. State-owned banks provide cheap financing for state enterprises, which are key fiefdoms of political patronage. Banks also provide financing to powerful provincial officials through shell corporations that bankroll pet investment projects. This is financed by paying Chinese households low or negative inflation-adjusted returns on their voluminous bank deposits.

All of this needs fixing, but the best of intentions can backfire. In an economy with many policy problems, getting rid of one or two can have unintended consequences. In 2008, asking banks to limit credit growth and avoid new non-performing loans were sensible moves. But banks had a lot of outstanding loans to weak state enterprises – starving them of credit would have turned those loans into non-performing loans in short order. So banks continued lending to state enterprises and shut off lending to the private sector, meeting the government’s conditions but thwarting its intentions.

Recent moves indicate that the government has learnt its lesson. It increased the flexibility of the exchange rate (in principle) when the renminbi was not under pressure to appreciate, relaxed the cap on interest rates paid on deposits, increased foreign investors’ access to capital markets and encouraged certain informal financial companies to become part of the formal banking system. Each of these moves has broader significance.

For example, giving informal financial companies the opportunity to join the formal banking system serves multiple ends. It brings them under the ambit of the banking regulator and reduces the risks they pose to financial stability. Moreover, they now provide more overt competition for established banks.

The need for interest rate liberalisation is widely recognised inside and outside China. Freeing up deposit rates and abandoning the fixed spread between deposit and loan rates would result in better returns for depositors and encourage banks to sharpen their lending practices. The big banks have resisted this fiercely as it would cut into profits. So the government cleverly took a small step when it cut rates recently – freeing up banks to offer deposit rates marginally higher than the base rate, arguing that this would make the rate cut more palatable to depositors.

A one-shot approach to breaking up big banks or freeing interest rates risks a backlash and concerted opposition that could block changes altogether. Reform-minded officials are taking a more subtle approach – using a megaphone to draw attention to the problems and introducing small but tangible changes.

One can make a strong case that, with its economy growing more complex and market-oriented, China needs to move beyond this cautious approach. The 12th five-year plan issued last year laid bare the range of problems, including corruption and dismal corporate governance among Chinese enterprises, and deficiencies in the policy making process. Given the severe political constraints China’s leaders face, however, modest reforms by stealth are better than no reforms at all.

This strategy may slowly turn China in the direction it needs to go. Whether this will be enough to outrun the many demons China faces remains the big question.

Authors

Eswar Prasad

Publication: Financial Times

Image Source: Aly Song / Reuters

West, Iran Have Different Ideas About Iran’s Economic Health

Djavad Salehi-Isfahani — Wed, 13 Jun 2012 12:54:00 -0400

It is widely believed that a dismal economy hurt by sanctions was the main reason Iran returned to negotiations with the five permanent members of the UN Security Council plus Germany in April.

Early hopes of quick progress were dashed last month in Baghdad, with Iran rejecting tough demands by the P5+1. If the latter’s negotiating position was influenced by the common wisdom that sanctions have pushed Iran’s economy to a point of imminent collapse, then it makes sense for them to maintain a hardline position hoping for a rapidly weakening economy to soften the Iranian side. In that case, there is little reason to be optimistic about the next round of negotiations scheduled in Moscow June 18-19.

For their part, the Iranians do not seem to be behaving as if their economic clock is ticking. Are they bluffing or looking at a different set of facts? Whereas reports in the West paint a dire picture of a failing economy, data supplied by Iran to international organizations depict an economy that, while facing serious challenges, is not on the verge of collapse.

Because Iran’s economy is at the center of the nuclear standoff, it is important to examine a few of the major issues of contention that drive these divergent narratives.

Standard of living

A comparison with Turkey helps show why Iran’s economy has not performed as badly as is generally believed.

The 2011 Human Development Report placed Iran above Turkey, using an index that combines income, education and health. According to the World Bank’s World Development Indicators, a publicly available database (which is curiously underused by reporters), Iran’s Gross Domestic Product per capita was about 90% of Turkey’s in 2009, the last year data are available for both countries.

In the prior ten years, Iran’s economy enjoyed a robust rate of economic growth, averaging about 4.7% per year, which was higher than Turkey’s 3.9%. Of course, Iran’s growth was oil driven, while Turkey’s was due more to rising productivity. Since 2009, when Iran ceased releasing reliable data, all indications are that Iran’s economic growth has ground to a near halt while Turkey’s growth has accelerated.

Inflation

Inflation is the indicator of economic distress that Iranians mention most when asked about the economy, and is the most widely reported in the Western press. There is reason for its prominence. Since 1985, according to official figures, the inflation rate in Iran has averaged close to 20% per year. During the last decade, it declined to an average of 15%, and fell to about 10% in 2010, before turning up sharply. In the last 12 months, inflation has averaged more than 25% and last month it increased to an annualized rate of 34%.

After nearly three decades of inflation, Iranians do not appear to be any more used to it, but given the length of time it has persisted, the government does not see inflation per se as particularly threatening. It is concerned about high inflation, because that is a daily annoyance that unites a divided population against it.

In any case, the current high level of inflation is not directly related to sanctions. Two factors are most responsible: the inflow of record amounts of oil revenues and recent subsidy reforms.

Government expenditures of oil revenue always bring some inflation because they raise the price of non-traded goods and services and with them, the general price level. For this reason, prices of housing, medical care and fresh fruit are particularly sensitive to oil-induced expansions. Iranians like their oil rent, but they hate the inflation that comes with it.

The other major cause of the current inflation rate is a daring subsidy-reform program launched in December 2010 which raised prices on energy products by factors ranging from 3 to 9, fueling price increases across the board. To make the program politically acceptable, the government redistributed the money it collected by giving each Iranian a $45 monthly stipend.

Reporting in the Western media on the program has been generally negative, but the government believes the reform is actually quite popular. Last month, Iran’s parliament approved extending the program. Subsidy reform has likely reduced poverty and inequality because the energy subsidies accrued disproportionately to the rich (the poorest decile received $1 for every $10 of the gasoline subsidy received by the rich) while the cash rebate of about $1.50 per person per day has helped many under the international $2 per day poverty line escape poverty.

Finally, there is no evidence that inflation affects the lower-income groups, which form the government’s power base, worse than any other. Not everyone can lose, since higher rents or produce prices must accrue to someone.

Details aside, the very fact the government would embark on such a risky program at the height of its standoff with the West suggests that it does not believe that it is staring into the economic or political abyss just yet.

The exchange rate

The government faced its first palpable and serious economic crisis in December 2011 when, after several years of stability, Iran’s rial collapsed, losing about 80% of its value in one week. The devaluation was clearly triggered by the tightening of the financial sanctions against Iran, passed by the US Congress earlier that month, but it was overdue by several years.

Inflation had put Iranian producers at a huge disadvantage in the face of competition from Chinese imports. Since 2005, Iranian-produced goods had become on average 50% more expensive relative to foreign goods, causing waves of bankruptcies and massive layoffs. While sections of the Iranian society that had enjoyed cheap foreign currency were hurt, others who would soon find jobs in industries revived by devaluation stood to benefit.

Apart from the fact that sanctions have disrupted Iran’s foreign trade, the foreign-exchange situation of Iran is the envy of the developing world, with virtually no foreign debt and substantial reserves of various currencies and gold.

Iran’s economic conditions may not be dire, but they present its leadership with numerous challenges. The sanctions are yet to take their full effect, and the West can bet that when they do in the coming months, they will severely limit Iran’s ability to export its oil, to spend its proceeds on critical imports or to arrange for barter with a few key countries, such as China and India.

The time for Iranian leaders to turn this crisis into opportunity may have passed — they still disagree on whether sanctions have hurt at all — and the national unity needed to achieve it may no longer exist. But they have reason to be confident that with some policy corrections to improve the domestic climate for business, Iran can weather this storm and the economy can coast for quite a while so that the leadership does not have to give in to what it considers unreasonable Western demands — especially with no prospect of a serious rollback in sanctions.

What would the West do if, for the sake of the argument, it were to abandon its belief in a crippled Iranian economy? Would a compromise at Moscow or later in the year be more likely?

The answer depends on how realistic the war option is for the West. If bombing Iran’s nuclear facilities is a feasible option, the West may not care much about whether Iran’s economy is collapsing. It is like a poker player with a gun who plays carelessly because he knows he can clean up anyway. If, on the other hand, the war option is very costly, having a more realistic picture of the Iranian economy would help the West play its cards more wisely.

Authors

Djavad Salehi-Isfahani

Publication: Al Monitor

Image Source: © Damir Sagolj / Reuters

@ Brookings Podcast: China’s Currency Policy

Kenneth G. Lieberthal — Fri, 14 Oct 2011 12:00:00 -0400

China's long practice of undervaluing its currency continues to take a toll on the U.S. economy; it has led to a growing increase in the trade deficit between the two countries, reduced U.S. GDP and has eliminated more than two million Americans jobs, by some estimates. As Congress and the Obama administration wrangle over ways to even the playing field for U.S. interests, expert Kenneth Lieberthal takes a closer look at China's currency policy.

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The Renminbi: The Political Economy of a Currency

Arthur R. Kroeber — Wed, 07 Sep 2011 14:59:00 -0400

The Chinese currency, or renminbi (RMB), has been a contentious issue for the past several years. Most recently, members of Congress have suggested tying China currency legislation to the upcoming votes on the free trade agreements with South Korea, Colombia and Panama. While not going that far, the Senate Majority Leader, Harry Reid, and Senator Charles Schumer have promised a vote on the issue some time this year.

The root of the conflict for the United States—and other countries—is complaints that China keeps the value of the RMB artificially low, boosting its exports and trade surplus at the expense of trading partners. Recent government data show that the bilateral trade deficit between the U.S. and China grew nearly 12 percent in the first half of 2011—fueling efforts to boost job creation domestically by authorizing import tariffs and other restrictions on countries that manipulate their currencies.

Although the U.S. Treasury has repeatedly stopped short of labeling China a “currency manipulator” in its twice-yearly reports to Congress, it has consistently pressured China to allow the RMB to appreciate at a faster pace, and to let the currency fluctuate more freely in line with market forces. The International Monetary Fund (IMF), the World Bank and many economists have also argued for faster appreciation and a more flexible exchange rate policy as part of a broader program of “rebalancing” the Chinese economy away from its traditional reliance on exports and investment, and towards a more consumer-driven growth model. Partly in response to these pressures, but more because of domestic considerations, China has allowed the RMB to rise by about 25 percent against the U.S. dollar since mid-2005. Yet the pace of appreciation remains agonizingly slow for the United States and other countries in Europe and Latin America whose manufacturing sectors face increasing competition from low-priced Chinese goods.

The international conversation over the RMB remains perennially vexed because China and its trade partners have fundamentally divergent ideas on the function of exchange rates. The United States and other major developed economies, as well as the IMF, view an exchange rate simply as a price. Consistent intervention by China to keep its exchange rate substantially below the level the market would set is, in this view, a distortion that prevents international markets from functioning as well as they could. This price distortion also affects China’s own economy, by encouraging large-scale investment in export manufacturing, and discouraging investment in the domestic consumer market. Thus it is in the interest both of China itself and the international economy as a whole for China to allow its exchange rate to rise more rapidly.

Chinese officials take a very different view. They see the exchange rate—and prices and market mechanisms in general—as tools in a broader development strategy. The goal of this development strategy is not to create a market economy, but to make China a rich and powerful modern country. Market mechanisms are simply means, not ends in themselves. Chinese leaders observe that all countries that have raised themselves from poverty to wealth in the industrial era, without exception, have done so through export-led growth. Thus they manage the exchange rate to broadly favor exports, just as they manage other markets and prices in the domestic economy to meet development objectives such as the creation of basic industries and infrastructure. These policies do not differ materially from those pursued by Japan, South Korea and Taiwan since World War II, or by Britain, the United States and Germany in the 19th century. Since the Chinese leaders perceive that an export-led strategy is the only proven route to rich-country status, they view with profound suspicion arguments that rapid currency appreciation and markedly slower export growth are “in China’s interest.” And because China—unlike Japan in the 1970s and 1980s—is an independent geopolitical power, it is fully able to resist international pressure to change its exchange-rate policy.

A second issue raised by China’s currency and trade policies is the persistent trade surplus since 2004 which has contributed about three-quarters of the nearly US$3 trillion increase in China’s foreign exchange reserves over the past eight years. Close to two-thirds of these reserves are invested in U.S. treasury debt. Some fear that China has become the United States’ banker, and could cause a collapse in the U.S. dollar and the U.S. economy by dumping its dollar holdings. Others suggest that China’s recent moves to increase the international use of the RMB through an offshore market in Hong Kong signal China’s intent to build up the RMB as an international reserve currency to rival or eventually supplant the dollar. All of these concerns are based on serious misunderstandings of both international financial markets and China’s domestic political economy. China is not in any practical sense “America’s banker;” it is more a depositor than a lender, and its economic leverage over the United States is very modest.

And while China’s leading position in global trade makes it quite sensible to increase the use of the RMB for invoicing and settling trade, it is a huge leap from making the RMB more internationally traded to making it an attractive reserve currency. China does not now meet the basic conditions required for the issuer of a major reserve currency, and may never meet them. Most importantly, the RMB is unlikely to become more than a second-tier reserve currency so long as Chinese leaders cling to their deep reluctance to allow foreigners a significant role in China’s domestic financial markets.

China’s Currency Policies

China’s exchange-rate policy must be understood within the context of two political-economic factors: first, China’s overall development strategy which aims to build up the nation’s economic and political power with market mechanisms being tools to that end rather than ends in themselves; and second, China’s geopolitical position.

The Chinese development strategy, which emerged gradually after Deng Xiaoping began the process of “reform and opening” in 1978, is based on a careful study of how other industrial nations got rich—and in particular, the catch-up growth strategies of its east Asian neighbors Japan, South Korea and Taiwan after World War II. A key lesson of that study is that every rich nation, in the early stages of its development, used export-friendly policies to promote domestic industry and to accelerate technology acquisition. In earlier eras, when the use of the gold standard made it impossible to maintain permanently undervalued exchange rates, countries used administrative coercion and high tariffs to achieve the same effect of favoring domestic manufacturers over foreign ones. Britain’s policies of using colonies as captive markets for its manufactured exports, and prohibiting the colonies from exporting manufactures back to Britain, were important components of that nation’s rise as the world’s leading industrial power in the late 18th and 19th centuries. Resentment of those policies was one cause of the American Revolution; once independent, the United States spurred its economic development through the “American system,” which featured high tariff walls (often 40 percent or more) through the 19th and into the early 20th century. Germany used similar protective policies to foster its industries in the late 19th century. Countries did not become advocates for free trade until their firms were secure in global technological leadership and the need for protection waned for Britain, this occurred in the mid-19th century; for the United States, the mid-20th.

After World War II, undervalued exchange rates became an important tool of export promotion, partly because new global trading rules under the General Agreement on Tariffs and Trade (GATT, which morphed into the World Trade Organization in 1995) made it more difficult to maintain extremely high levels of tariff protection. The testimony of post-war economic history is quite clear. Countries that maintained undervalued exchange rates and pursued export markets enjoyed sustained high-speed economic growth and became rich. These countries include Germany, Japan, South Korea and Taiwan. Countries that used other mechanisms to block imports and encouraged their industrial firms to cater exclusively to domestic demand—so-called “import substitution industrialization,” or ISI, which usually involved an overvalued exchange rate—in some cases grew quite rapidly for 10 years or more. But this growth could not be sustained because the ISI strategy includes no mechanism for keeping pace with advances in global technology. Most ISI countries, including much of Latin America and the whole of the Communist bloc, experienced severe financial crisis and fell into long periods of stagnation.

As it tried to accelerate growth by moving from a planned to a more market-driven economy in the 1980s, China gradually depreciated the RMB by a cumulative 80 percent, from 1.8 to the dollar in 1978 to 8.7 in 1995. Since then, however, the RMB has only appreciated against the dollar, moving up to a rate of 8.3 by 1997, and holding steady at that rate until mid-2005 after which gradual appreciation resumed. Since 2006 the RMB has appreciated at an average annual rate of about 5 percent against the dollar, to its current rate of about 6.4, and it is likely that this average rate of appreciation will be sustained for the next several years. This history demonstrates that supporting export growth, while important, is not the sole determinant of China’s exchange-rate policy. During the Asian financial crisis of 1997-1998, the consensus of most economists held that the RMB was overvalued; despite this, Beijing kept the value of the RMB steady, on the grounds that devaluation would further destabilize the battered Asian regional economy. As a consequence, China endured a few years of relatively anemic growth in exports and GDP, and persistent deflation. The leadership decided that this was a price worth paying for regional economic stability.

Conversely, the appreciation since 2005 reflects Beijing’s understanding that clinging to a seriously undervalued exchange rate for too long risks sparking inflation. This occurred in many oil-rich Persian Gulf countries in 2005-2007, which held fast to unrealistically low pegged exchange rates and suffered annual inflation rates of 20 percent to 40 percent. For Chinese leaders, an inflation rate above 5 percent is considered dangerously high, and the most rapid currency appreciation in the last few years has occurred when inflationary pressure was relatively strong. A second reason for switching to a policy of gradual appreciation was the view that an ultra-cheap exchange rate disproportionately benefited manufacturers of ultra-cheap goods, whose technology content and profit margins were low. While these industries provided employment for millions, they did not contribute much to the nation’s technological upgrading. A gradual currency appreciation, economic policymakers believed, would eventually force Chinese manufacturers to move up the value chain and start producing more sophisticated and profitable goods. This strategy appears to be bearing fruit: China is rapidly gaining global market share in more advanced goods such as power generation equipment and telecoms network switches. Meanwhile, it has begun to lose market share in low-end goods like clothing and toys, to countries like Vietnam, Cambodia, Indonesia and Bangladesh.

In short, China’s exchange-rate policy is mainly driven by the aim of enhancing the nation’s export competitiveness. But other factors play a role, namely a desire to maintain domestic and regional macro-economic stability, keep inflationary pressures at bay, and force a gradual upgrading of the industrial structure. From the point of view of Chinese policy makers, all of these objectives suggest that the exchange rate should be carefully managed, rather than left to unpredictable market forces. While economists may argue that long-run economic stability is better served by a more flexible exchange rate, Chinese officials can point to the excellent track record their policies have produced: consistent GDP growth of around 10 percent a year since the late 1990s, inflation consistently at or below 5 percent, export growth of more than 20 percent a year, and a steady increase in the sophistication of Chinese exports. Until some kind of crisis convinces them that their economic policies require major adjustment, China’s economic planners are likely to stick with their current formula.

International pressure to accelerate the pace of RMB appreciation is unlikely to have much impact. The basic reason is that other countries have very little leverage that they can bring to bear. In the 1970s, the United States was able to pressure Germany and Japan to appreciate their currencies because those countries were militarily dependent on America. (Moreover, the United States was able unilaterally to engineer a devaluation of the dollar by going off the gold standard in 1971.) Japan’s position of dependency forced it to accede to the Plaza Accord of 1985, which resulted in a doubling of the value of the yen over the next two years. China, being, geopolitically independent, has no incentive to bow to pressure on the exchange rate from the United States, let alone Europe or other nations such as Brazil. The only plausible threat is that failure to appreciate the RMB could lead to a protectionist backlash that would shut the world’s doors to Chinese exports. Yet this threat has so far proved empty: even after three years of the worst global recession since the Great Depression, trade protectionism has failed to emerge in the United States or Europe.

Other considerations further strengthen the Chinese determination not to give in to foreign pressure on the exchange rate. One is the Japanese experience after the Plaza Accord. The generally accepted view in China is that the dramatic appreciation of the yen in the late 1980s was a crucial contributor to Japan’s dramatic asset-price bubble whose collapse after 1990 set the former world-beating economy on a two-decade course of economic stagnation. Chinese officials are adamant that they will not repeat the Japanese mistake. This resolve was strengthened by the global financial crisis of 2008, which in China thoroughly discredited the idea—already held in deep suspicion by Chinese leaders—that lightly regulated financial markets and free movements of capital and exchange rates are the best way to run a modern economy. China’s rapid recovery and strong growth after the crisis are deemed to vindicate the nation’s strategy of a managing the exchange rate, controlling capital flows, and keeping market forces on a tight leash.

The Internationalization of the RMB

Despite this generally self-confident view of the merit of its exchange-rate and other economic policies, Chinese leaders are troubled by one headache caused by the export-led growth strategy: the accumulation of a vast stockpile of foreign exchange reserves, most of which are parked in very low-yielding dollar assets, principally U.S. treasury bonds and bills. For a while, the accumulation of foreign reserves was viewed as a good thing. But after the 2008 financial crisis, the perils of holding enormous amounts of dollars became evident: a serious deterioration of the US economy leading to a sharp decline in the value of the dollar could severely reduce the worth of those holdings. Moreover, the pervasive use of the dollar to finance global trade proved to have hidden risks: when United States credit markets seized up in late 2008, trade finance evaporated and exporting nations such as China were particularly hard hit. The view that excessive reliance on the dollar posed economic risks led Chinese policy makers to undertake big efforts to internationalize the RMB, beginning in 2009, through the creation of an offshore RMB market in Hong Kong.

Before considering the significance of RMB internationalization, it is worth addressing some misconceptions about China’s large-scale reserve holdings and investments in U.S. treasury bonds. Because China’s central bank is the biggest single foreign holder of U.S. government debt, it is often said that China is “America’s banker,” and that, if it wanted to, it could undermine the U.S. economy by selling all of its dollar holdings, thereby causing a collapse of the U.S. dollar and perhaps the U.S. economy. These fears are misguided. First of all, it is by no means in China’s interest to cause chaos in the global economy by prompting a run on the dollar. As a major exporting nation, China would be among the biggest victims of such chaos. Second, if China sells U.S. treasury bonds, it must find some other safe foreign asset to buy, to replace the dollar assets it is selling. The reality is that no other such assets exist on the scale necessary for China to engineer a significant shift out of the dollar. China accumulates foreign reserves at an annual rate of about US$400 billion a year; there is simply no combination of markets in the world capable of absorbing such large amounts as the U.S. treasury market. It is true that China is trying to diversify its reserve holdings into other currencies, but at the end of 2010 it still held 65 percent of its reserves in dollars, well above the average for other countries (60 percent). From 2008 to 2010, when newspapers were filled with stories about China “dumping dollars,” China actually doubled its holdings of U.S. Treasury securities, to US$1.3 trillion.

The other crucial point is that China is not in any meaningful sense “America’s banker,” and its economic leverage is modest. China owns just 8% of the total outstanding stock of US Treasury debt; 69% of Treasury debt is owned by American individuals and institutions. Measured by Treasury debt holdings, America is America’s banker—not China. And China’s holdings of all US financial assets – equities, federal, municipal and corporate debt, and so on – is a trivial 1%. Chinese commercial banks lend almost nothing to American firms or consumers. The gross financing of American companies and consumers comes principally from U.S. banks, and secondarily from European ones. It is more apt to think of China as a depositor at the “Bank of the United States”: its treasury bond holdings are super-safe, liquid holdings that can be easily redeemed at short notice, just like bank deposits. Far from holding the United States hostage, China is a hostage of the United States, since it has little ability to move those deposits elsewhere -- no other bank in the world is big enough.

It is precisely this dependency that has prompted Beijing to start promoting the RMB as an international currency. By getting more companies to invoice and settle their imports and exports in RMB, China can gradually reduce its need to put its export earnings on deposit at the “Bank of the United States.” But again, headlines suggesting that internationalization of the RMB heralds the imminent demise of the current dollar-based international monetary system are premature.

The simplest reason is that the RMB’s starting point is so low that many years will be required before it becomes one of the world’s major traded currencies. In 2010, according to the Bank for International Settlements, the RMB figured in under 1 percent of the world’s foreign exchange transactions, less than the Polish zloty; the dollar figured in 85 percent and the euro in 40 percent. There is no question that use of the RMB will increase rapidly. Since Beijing started promoting the use of RMB in trade settlement (via Hong Kong) in 2009, RMB-denominated trade transactions have soared: around 10 percent of China’s imports are now invoiced in RMB. The figure for exports is lower, which makes sense. Outside China, people sending imports to China are happy to be paid in RMB, since they can reasonably expect that the currency will increase in value over time. But Chinese exporters wanting to get paid in RMB will have a difficult time finding buyers with enough RMB to pay for their shipments. Over time, however, foreign companies buying and selling goods from China will become increasingly accustomed to both receiving and making payments in RMB – just as they grew accustomed to receiving and making payments in Japanese yen in the 1970s and 1980s.

Since China is already the world’s leading exporter, and is likely to surpass the United States as the world’s leading importer within three or four years, it is quite natural that the RMB should become a significant currency for settling trade transactions. Yet the leap from that role to a major reserve currency is a very large one, and the prospect of the RMB becoming a reserve currency on the order of the euro—let alone replacing the dollar as the world’s dominant reserve currency—is remote. The reason for this is simple: to be a reserve currency, you need to have safe, liquid, low-risk assets for foreign investors to buy; these assets must trade on markets that are transparent, open to foreign investors and free from manipulation. Central banks holding dollars and euros can easily buy lots of U.S. treasury securities and euro-denominated sovereign bonds; foreign investors holding RMB basically have no choice but to put their cash into bank deposits. The domestic Chinese bond market is off-limits to foreigners, and the newly-created RMB bond market in Hong Kong (the so-called “Dim Sum” bond market) is tiny and consists mainly of junk-bond issuances by mainland property developers.

Again, we can reasonably expect rapid growth in the Hong Kong RMB bond market. But the growth of that market, and granting foreigners access to the domestic Chinese government bond market, remain severely constrained by political considerations. Just as Chinese officials do not trust markets to set the exchange rate for their currency, they do not trust markets to set the interest rate at which the government can borrow. Over the last decade Beijing has retired virtually all of its foreign borrowing; more than 95 percent of Chinese government debt is issued on the domestic market, where the principal buyers are state-owned banks that are essentially forced to accept whatever interest rate the government dictates. There is absolutely no reason to believe that the Chinese government will at any point in the near future surrender the privilege of setting the interest rate on its own borrowings to foreign bond traders over whom it has no control. As a result, it is likely to be many years before there is a large enough pool of internationally-available safe RMB assets to make the RMB a substantial international reserve currency.

In this connection the example of Japan provides an instructive example. In the 1970s and 1980s Japan occupied a position in the global economy similar to China’s today: it had surpassed Germany to become the world’s second biggest economy, and it was accumulating trade surpluses and foreign-exchange reserves at a dizzying rate. It seemed a foregone conclusion that Japan would become a central global financial power, and the yen a dominant currency. Yet this never occurred. The yen internationalized – nearly half of Japanese exports were denominated in yen, Japanese firms began to issue yen-denominated “Samurai bonds” on international markets, and the yen became an actively traded currency. Yet at its peak the yen never accounted for more than 9 percent of global reserve currency holdings, and the figure today is around 3 percent. The reason is that the Japanese government was never willing to allow foreigners meaningful access to Japanese financial markets, and in particular the Japanese government bond market. Even today, about 95 percent of Japanese government bonds are held by domestic investors, compared to 69 percent percent for US Treasury securities. China is not Japan, of course, and its trajectory could well be different. But the bias against allowing foreigners meaningful participation in domestic financial markets is at least as strong in China as in Japan, and so long as this remains the case it is unlikely that the RMB will become anything more than a regional reserve currency.

Implications for U.S. Policy

The above analysis suggests two broad conclusions of relevance to United States policymakers. First, China’s exchange-rate policy is deeply linked to long-term development goals and there is very little that the United States, or any other outside actor, can do to influence this policy. Second, the same suspicion of market forces that leads Beijing to pursue an export-led growth policy that generates large foreign reserve holdings also means that Beijing is unlikely to be willing to permit the financial market opening required to make the RMB a serious rival to the dollar as an international reserve currency. A related observation is that an average annual appreciation of the RMB against the dollar of about 5 percent now seems to be firmly embedded in Chinese policy. An appreciation of this magnitude enables China to maintain export competitiveness while achieving two other objectives: keeping domestic consumer-price inflation under control, and gradually forcing an upgrade of China’s industrial structure.

Generally speaking, these trends are quite benign from a U.S. perspective. In substantive terms, there is little to be gained from high-profile pressure on China to accelerate the pace of RMB appreciation, since the United States possesses no leverage that can be plausibly brought to bear. While the persistent undervaluation of the RMB will present increasing difficulties for American manufacturers of high-end equipment, as Chinese manufacturers gradually become more competitive in these sectors, the steady appreciation of the currency will increase the purchasing power of the average Chinese consumer and the total size of the Chinese consumer market. United States policy should therefore de-emphasize the exchange rate, where the potential for success is limited, and instead focus on keeping the pressure on China to maintain and expand market access for American firms in the domestic Chinese market, which in principle is provided for under the terms of China’s accession to the World Trade Organization.

This paper is part of a series of in-depth policy papers, Shaping the Emerging Global Order, in collaboration with ForeignPolicy.com. Visit ForeignPolicy.com's Deep Dive section for discussion on this paper.

Authors

Arthur R. Kroeber

Publication: FP.Com Deep Dive

Image Source: © Petar Kujundzic / Reuters

China's Currency Policy Explained

Arthur R. Kroeber — Wed, 07 Sep 2011 09:28:00 -0400

Arthur Kroeber expands upon a recent paper, answering questions about China's monetary policy on the valuation of the renminbi and the political issues this raises.

1. The Chinese currency, or renminbi (RMB) has been a contentious issue for the past several years. What is the root of the conflict for the United States and other countries?

The root of the conflict for the United States—and other countries—is complaints that China keeps the value of the RMB artificially low, boosting its exports and trade surplus at the expense of trading partners. Although the U.S. Treasury has repeatedly stopped short of labeling China a “currency manipulator” in its twice-yearly reports to Congress, it has consistently pressured China to allow the RMB to appreciate at a faster pace, and to let the currency fluctuate more freely in line with market forces. The International Monetary Fund, the World Bank and many economists have also argued for faster appreciation and a more flexible exchange rate policy. Partly in response to these pressures, but more because of domestic considerations, China has allowed the RMB to rise by about 25% against the U.S. dollar since mid-2005. Yet the pace of appreciation remains agonizingly slow for the U.S. and other countries in Europe and Latin America whose manufacturing sectors face increasing competition from low-priced Chinese goods.

2. What impact does exchange rate control have on the economy?

According to foreign observers, consistent intervention by China to keep its exchange rate substantially below the level the market would set is a price distortion that prevents international markets from functioning as well as they could. This price distortion also affects China’s own economy, by encouraging large-scale investment in export manufacturing, and discouraging investment in the domestic consumer market. Thus, it is in the interest both of China itself and the international economy as a whole for China to allow its exchange rate to rise more rapidly. However, Chinese policy makers do not agree with this view, and believe the managed exchange rate is broadly beneficial for economic development.

3. What is the Chinese view of their policies toward exchange rate control?

Chinese officials see the exchange rate—and prices and market mechanisms in general—as tools in a broader development strategy. The goal of this development strategy is not to create a market economy but to make China a rich and powerful modern country. Market mechanisms are simply means, not ends in themselves. Chinese leaders observe that all countries that have raised themselves from poverty to wealth in the industrial era, without exception, have done so through export-led growth. Thus, they manage the exchange rate to broadly favor exports, just as they manage other markets and prices in the domestic economy in order to meet development objectives such as the creation of basic industries and infrastructure.

Since they perceive that an export-led strategy is the only proven route to rich-country status, they view with profound suspicion arguments that rapid currency appreciation and markedly slower export growth are “in China’s interest.” And because China is an independent geopolitical power, it is fully able to resist international pressure to change its exchange rate policy.

4. What are some misconceptions about China’s large-scale reserve holdings and investments in U.S. Treasury Bonds, specifically the idea that China is “America’s banker?”

Because China’s central bank is the single biggest foreign holder of U.S. government debt, it is often said that China is “America’s banker,” and that, if it wanted to, it could undermine the U.S. economy by selling all of its dollar holdings, thereby causing a collapse of the U.S. dollar and perhaps the U.S. economy. These fears are misguided. China is not in any practical sense “America’s banker.” China holds just 8% of outstanding US Treasury debt; American individuals and institutions hold 69%. China holds just 1% of all US financial assets (including corporate bonds and equities); US investors hold 87%. Chinese commercial banks lend almost nothing to American firms and consumers – the large majority of that finance comes from American banks. America’s banker is America, not China.
It is more apt to think of China as a depositor at the “Bank of the United States:” its treasury bond holdings are super-safe, liquid holdings that can be easily redeemed at short notice, just like bank deposits. Far from holding the United States hostage, China is a hostage of the United States, since it has little ability to move those deposits elsewhere (no other bank in the world is big enough).

5. What are the implications for U.S. policy and how should policymakers react?

China’s exchange-rate policy is deeply linked to long-term development goals and there is very little that the United States, or any other outside actor, can do to influence this policy. Also, the same suspicion of market forces that leads Beijing to pursue an export-led growth policy generating large foreign reserve holdings also means that Beijing is unlikely to be willing to permit the financial market opening required to make the RMB a serious rival to the dollar as an international reserve currency.

In substantive terms, there is little to be gained from high-profile pressure on China to accelerate the pace of RMB appreciation, since the United States possesses no leverage which can be plausibly brought to bear. U.S. policy should therefore de-emphasize the exchange rate, and instead focus on keeping the pressure on China to maintain and expand market access for American firms in the domestic Chinese market, which in principle is provided for under the terms of China’s accession to the World Trade Organization.

Authors

Arthur R. Kroeber

Image Source: Â© Petar Kujundzic / Reuters

The U.S.-China Strategic and Economic Dialogue: A Preview of Key Economic Issues

Eswar Prasad — Fri, 06 May 2011 13:55:00 -0400

Expectations for the U.S.-China Strategic and Economic Dialogue meeting are muted—perhaps a good sign as it shows a maturing in the U.S.-China relationship. The focus has shifted to making methodical if slow progress rather than on resolving major conflicts or arriving at dramatic breakthroughs. There are of course differences in the objectives of the two sides and different perceptions of what constitutes progress. This enhances the value of the U.S.-China dialogue even if there are few high-profile successes to trumpet.

The rhetoric on both sides has ratcheted down as progress has been made on some of the most visible points of tension. The currency issue continues to fester but recent developments have transformed this into a problem for the rest of the world rather than just for the U.S.-China relationship. However, there are storm clouds gathering on the horizon as more fundamental and contentious issues, with high stakes on both sides, come to the fore.

In the coming months, discussions on economic policy will be increasingly overshadowed by the political calendars in the two countries, which herald a gradual hardening of positions and less room for maneuver on both sides. This makes it unlikely we will see any major policy shifts in the bilateral relationship, unless dictated largely by domestic political and economic circumstances.

The two countries are increasingly dealing with each other on an even footing and recognize that collaboration is in their mutual long-term interests. However, there lies a rocky road ahead, as domestic economic and political priorities and constraints drive the short-term dynamics of this relationship.

Do not count on any surprises or major breakthroughs next week.

The U.S. Spells Out Its Position

In a speech earlier this week, U.S. Treasury Secretary Geithner reiterated a clear quid pro quo that defines the overall parameters of the bilateral economic relationship [1]. The speech makes the U.S. position clear that in order to attain China’s objectives in the bilateral relationship, China must adequately satisfy U.S. interests. China’s objectives are seen as including access to high technology products, investment opportunities in the U.S. and market economy status.

For its part, U.S. interests lie in greater market access for its companies, including in government procurement; stronger protection of intellectual property rights; and other reforms that would ensure a level playing field within China for domestic and foreign producers. Secretary Geithner’s speech acknowledges the commitments made on some of these issues during President Hu’s visit to Washington in January but, with good reason, reserves judgment on China’s implementation of these commitments.

Secretary Geithner also urges faster implementation of China’s own reform agenda—financial market reforms, a more flexible exchange rate regime, and growth rebalancing to stoke private consumption and make the economy less dependent on exports or investment. While there are differences in opinion about the desired pace of these reforms, there is agreement on both sides that such reforms would promote the sustainability and durability of China’s growth and also contribute to the global rebalancing effort.

The U.S. has also been quite supportive of China’s increasingly ascendant role in international financial institutions. At a recent G-20 conference, Secretary Geithner was explicit in his support for eventually including the renminbi in the basket for the IMF’s Special Drawing Rights (SDR), subject to certain conditions like currency convertibility being met.

Trade and Currency—A Bilateral Perspective

The ebbs and flows of the U.S.-China relationship have turned largely on trade flows although bilateral financial flows have become increasingly important [2]. Indeed, the bilateral trade deficit gets far more attention than it rightly deserves. This bilateral deficit shrank to $227 billion in 2009, compared to $266 billion in 2008. In 2010, it rebounded to an all-time high of $273 billion. The 12-month moving average and the rising import demand from a recovering U.S. economy portend a continued high bilateral deficit in 2011 (Figure 1).

This will no doubt direct further attention to China’s currency policy. Following its re-depegging from the dollar in June 2010, the renminbi has appreciated by about 5 percent in nominal terms against the dollar (Figure 2). On an inflation-adjusted basis, this implies that the renminbi is appreciating at a rate of about 8 percent a year in real terms relative to the dollar. Quibbles about the pace of appreciation aside, this means that the currency issue is no longer front and center in the bilateral dialogue.

China’s Currency Policy—A Broader Perspective

While China’s currency has been appreciating against the dollar, the dollar has of course been in retreat against other major currencies. Since June 2010, the dollar has depreciated in trade-weighted inflation-adjusted terms by about 8 percent (last two columns of Table 1). Consequently, despite its nominal appreciation against the dollar and the high inflation rate in China, the renminbi’s real effective exchange rate has actually depreciated modestly over the past year (Table 1).

This creates a difficult situation for the rest of the world as the two largest economies now have depreciating currencies. But it is no longer a U.S. problem and in principle it should foster an alliance among the U.S. and China’s major trading partners, especially other emerging markets, to push China to allow its currency to appreciate more rapidly. This is not a slam-dunk, however, as the rest of the world has still not quite forgiven the U.S. for QE2 and the damage it ostensibly wrought on their economies. So the battle between these two superpowers for the hearts of other countries rages on.

The broader battle has been muddied by the fact that China’s trade and current account surpluses relative to GDP have continued to shrunk since their peaks in 2007 (Figure 3). There is a sharp divergence of views among analysts about the direction in which these surpluses are headed. One view is that China has made durable progress in rebalancing its economy and reducing its dependence on exports. An alternative view is that China’s shrinking trade surplus is largely a cyclical phenomenon. China has grown strongly, sucking in huge quantities of imports, while its major export markets in the euro zone and the U.S. are just getting back on their feet after the global financial crisis.

This spills over into a raging debate about whether China has actually made significant progress on rebalancing its economy and contributing less to global imbalances. This is summarized by the stark difference between two key institutions in their forecasts for China’s current account to GDP ratio—the IMF pegs it at over 6 percent in 2012 while the World Bank puts it a shade under 4 percent (Table 2). My view is that both China’s trade and current account surpluses will rebound sharply as cyclical factors unwind, especially if China manages to clamp down on credit growth while the U.S. and Europe solidify their recoveries (all of which remain slightly dubious propositions at this stage).

In any event, currency dynamics show that China continues to intervene massively in foreign exchange markets to counter pressures for renminbi appreciation. China accumulated $448 billion of foreign exchange reserves in 2010, matching the pace in 2009 (Figure 4). The merchandise trade surplus of $185 billion (goods trade) accounts for less than half of this reserve accumulation in 2010 (the overall trade surplus on goods and services was lower at about $165 billion). It is also unlikely that valuation effects can account for the rapid pace of accumulation in 2010 [3].

China’s torrid pace of reserve accumulation continued in the first quarter of 2011, when it accumulated another $196 billion of foreign exchange reserves (Figure 4, lower panel). Valuation effects could account for about $50-60 billion of this increase [4]. On the other hand, China recorded a marginal deficit on its trade account in this quarter.

Even assuming significant returns on its existing stock of reserves, the implication is that capital continues to seep into China through a variety of channels despite all the controls on inflows. Managing capital flows and their impact on domestic liquidity and inflation will be a major challenge for the Chinese government during 2011, especially if it continues to strongly resist currency appreciation.

All of this makes it perplexing that China has not used currency appreciation more aggressively as a tool in the fight against inflation. Indeed, inflation in China has continued to rise despite modest increases in interest rates and sharp increases in reserve requirements, both of which have helped moderate credit growth (Figure 5). It seems that a huge political bar has to be crossed before the Chinese leadership accepts the use of currency policy as a tool against inflation.

China’s Concerns

During the dialogue, China will not be on the defensive. Its delegation will bring two concerns to the table--the more immediate issue of the prospect for a U.S. debt default and the longer-term issue of U.S. policy toward Chinese investment.

The Chinese delegation will certainly have some tough questions for the U.S. Treasury about the possibility and implications of a technical default on government debt if gridlock on Capitol Hill doesn’t get resolved before the U.S. hits its legal debt ceiling. But the tough questions don’t translate into a credible threat or a strong bargaining position. China has few alternatives and simply cannot take a significant fraction of its Treasury holdings elsewhere. Indeed, for all its worries and aggressiveness on the issue, the stark reality is that China has little choice but to accumulate even more U.S. government debt if it continues to pile up reserves at the rate of $150-200 billion dollars each quarter.

The U.S. has effectively countered the aggressive approach that China has taken on its purchases of U.S. debt. The Obama administration has quite clearly shifted the narrative around from the perspective that China has the upper hand in this relationship due to its ownership of U.S. Treasuries. Indeed, the administration has made it quite clear that it encourages China to reduce its intervention in currency markets, which would result in less reserve accumulation and reduced purchases of U.S. government debt. Fears that Chinese expressions of concern about U.S. public finances are a cloaked threat to dump U.S. debt are hyperbole.

China now has a massive stash of cash that it wants to use to purchase high-quality hard assets, especially foreign firms with strong R&D and technology that will help Chinese industries move up the value-added chain. The U.S. is prime hunting ground for such assets but there are major political constraints to Chinese investments in the U.S. An investment treaty would break down many of these barriers and uncertainties, and is eagerly sought by the Chinese. But it remains a prize that the U.S. will extract a significant price for and it is unlikely that the U.S. will substantially lower the safeguards against foreign investment in key sectors of its economy.

The Political Context

With the unemployment rate now below 9 percent and job growth modestly positive, next week’s meetings will take place against a more benign economic backdrop in the U.S. Moreover, Republicans in Congress have made it clear that currency legislation against China is not a priority. This gives the administration a little more leeway (and perhaps a little less bargaining power) in its dealings with the Chinese.

The political calendars of the two countries will drive the debate on economic issues. The Chinese leadership transition that begins in early 2012 and the U.S. presidential elections in the fall of 2012 could lead to a hardening of positions on both sides and also to some degree of policy paralysis, especially on bilateral issues.

China is keen to ensure a smooth transition to its new leadership in early 2012, making it unlikely that there will be significant policy shifts or initiatives in the latter half of 2011. The reformist credentials of the presumed heirs to President Hu Jintao and Premier Wen Jiabao are unclear and untested. In any event, the jockeying for senior positions and the work the new leadership needs to do to consolidate its power all point to the low probability of any major policy shifts during the first half of 2012.

The waters will appear calm and friendly at next week’s discussions but there remain deep and difficult tensions hidden beneath the surface.

Footnotes:

[1] The text of Mr. Geithner’s remarks is available at (http://www.treasury.gov/press-center/press-releases/Pages/tg1160.aspx). These remarks essentially carry over from his speech in January 2011, ahead of President Hu’s visit to Washington, where this explicit quid pro quo was introduced (http://www.treasury.gov/press-center/press-releases/Pages/tg1019.aspx).

[2] For a more detailed analysis of different facets of the bilateral economic relationship, see “Rebalancing the China-U.S. Relationship” by Eswar Prasad and Grace Gu, Brookings Institution Report, January 2011.

[3] Indeed, the dollar appreciated slightly relative to the euro during the year. The dollar-euro rate was 1.43 on Dec. 31, 2009 and 1.34 on Dec. 31, 2010. Assuming that most of China's foreign exchange reserves are held in instruments denominated in dollars or euros, this means that the valuation effects in fact held down the pace of reserve accumulation in dollar terms.

[4] The euro appreciated relative to the dollar by about 6 percent during the first quarter. Assuming that about one-third of China's reserves are held in euro-denominated investments, the valuation effects in dollar terms could account for about $55 billion (2.84 trillion * 1/3 * 0.06). The Japanese yen, by contrast, depreciated slightly relative to the dollar during the quarter.

Authors

Eswar Prasad

Image Source: © Kevin Lamarque / Reuters

Curbing Success in Latin America

Mauricio Cárdenas and Eduardo Levy-Yeyati — Thu, 14 Apr 2011 14:57:00 -0400

There are two Latin Americas and one is thriving. While Central America and the Caribbean are still struggling with the effects of the 2008 economic crisis and may grow below 2 percent this year, the stellar seven (Argentina, Brazil, Chile, Colombia, Mexico, Peru and Uruguay) passed with flying colors the test of the global slowdown. These seven countries are expected to grow at an average rate of 5 percent in the near future, fueled by apt domestic policies, favorable terms of trade and considerable amounts of foreign capital inflows.

However, success has come at a price. These seven countries are facing overvaluations in their currencies. Many worry that the region is catching a mild case of Dutch disease — a term coined by The Economist in 1973 to refer to the decline of the manufacturing sector in the Netherlands after the discovery of a large natural gas field in 1959. Dutch disease is an illness that kills jobs and competitiveness (sometimes permanently) in industrial sectors that are adversely affected by the appreciation of the currency.

Traditional Dutch disease has been linked primarily to the effects of high commodity export prices or volumes in one sector at the expense of other sectors. The symptoms are already apparent in commodity exporting countries like Argentina, Brazil, Chile and Colombia, where the volumes of non-primary net exports have been falling rapidly and industrial output and employment are starting to dwindle despite solid GDP growth figures.

But the Latin American seven (with the notable exception of Argentina) are also suffering from a new strain of the disease, the so-called “financial-Dutch disease”, which is driven by capital flows that exacerbate exchange rate appreciation pressures, making many of these countries too expensive for their own good. Initially dominated by foreign direct investment, capital flows are increasingly supplemented by portfolio flows.

In other words, if the traditional Dutch disease is linked to China, this new variety has its source in U.S. monetary policy.

Brazil deserves a special note in this regard. Its diversified manufacturing exports account for the country’s trade surplus. Thus, it is hard to argue that the country’s competitiveness is at stake due to a traditional case of Dutch disease triggered by booming metals and soybean prices. On the contrary, Brazil appears to epitomize financial Dutch disease, losing competitiveness at the hands of enthusiastic global speculators.

Understanding the nature of the disease is critical in order to prescribe a medicine that can cure the ailment. Traditional-Dutch disease from commodity booms calls for sector–specific interventions, such as a mix of taxes and subsidies designed to mitigate its impact on the relative competitiveness of the industry or sector stabilization funds to save the dollars from the external surplus abroad to limit its effect on the exchange rate.

But these measures are ineffective when it comes to a financial-Dutch disease, which requires a macroeconomic dam to keep away the dollar flood; for example, through sterilized exchange rate interventions or capital controls.

Sterilized interventions have become a permanent guest of the macroeconomic policy framework in the seven Latin jaguars (with the exception of Mexico). Capital controls that put sand-in-the-wheels of international finance are less pervasive. But Tobin taxes or unremunerated reserve requirements on selected foreign inflows, although admittedly more controversial, are also becoming part of the standard toolkit.

Micro-prudential measures, such as limits to banks´ foreign exchange positions and lifting of capital restrictions on outflows, are in the same category. An innovative addition to the policies under the macro-prudential umbrella is the use of standard commercial bank reserve requirements (as is the case in Turkey) or taxes on short-term lending (as is the case in Brazil) to widen the wedge between the deposit interest rate that determines the currency carry and the lending rate that governs the transmission of monetary policy.

These seven economies are increasingly attracted to these policy options, but two caveats are in order. First, as we argue in a recent Brookings report, both sterilized interventions and sand-in-the-wheel capital controls are effective, but only marginally and possibly decreasingly so over time.

Precisely because of this, neither the standard inflation-targeting framework nor its extended and expanded version (inflation targeting 2.0, which keep an eye on the potential deleterious influence of the global financial cycle) will be capable alone of delivering macroeconomic stability. In addition, these seven economies have been slow to unwind the fiscal stimulus implemented during the recent economic crisis, for reasons that have to do with elections in Argentina and Peru, natural disasters in Chile and Colombia, or more broadly the political cost of adjustment in an age of heightened expectations in Brazil.

At any rate, it is clear that these policies are not substitutes. A clever combination of exchange rate, monetary and fiscal policies is needed to prevent overvaluation and overheating, and to avoid a hard landing once the global financial cycle makes the inevitable turn.

Authors

Image Source: © Paulo Whitaker / Reuters

U.S. Politics after Seoul: The Reality of International Cooperation

Paolo Guerrieri and Domenico Lombardi — Tue, 23 Nov 2010 14:01:00 -0500

In light of the apparently disappointing conclusion of the G-20 Summit in Seoul, it is important to review the expectations that preceded the summit, and to situate them in a realistic context of international relations among systemic economies after the U.S. Congressional elections on November 2.

Encouraged by the historically significant results of the London G-20 Summit in April 2009, where the G-20 succeeded in stabilizing the expectations of the financial markets, together leaders carved out for themselves a “premier” role in international economic cooperation at the Pittsburgh G-20 Summit later that year.

In support of such role, President Barack Obama proposed the so-called framework for strong, sustainable, and balanced growth. This framework is in effect a peer review mechanism that the United States, throughout modern history, had tacitly but consistently refused—even when, with the Second Amendment to the IMF’s Articles in the late 1970s, and under pressure from Europe, the U.S. reluctantly approved the regulatory powers of the Fund embedded in Article IV of its charter.

However, it was this issue of how to make the agreed framework operational and credible that caused the Seoul Summit to come to a standstill. This happened despite the fact that U.S. Treasury Secretary Geithner’s proposal to anchor the external adjustment of the systemic economies to numeric parameters had not been openly ruled out by the Chinese delegation at the G-20 finance ministers meeting in Gyeongju three weeks earlier. If anything, the Chinese delegation appeared to be inclined to give the proposal some consideration by emphasizing the need for a “reasonable” approach that would not be excessively penalizing and would pragmatically combine quantitative and qualitative indicators geared towards the medium term. Furthermore, the openness showed by the U.S. administration helped push forward the IMF reform package, which broadly surpassed any expectations in the run-up to the Gyeongju meeting.

What then caused the G-20 Seoul Summit to stall? First, the Chinese position grew increasingly rigid in the days leading up to the summit. The Chinese government has traditionally been reluctant to lock itself into a set of formal multilateral obligations that might restrict its field of policy action. Also, there were a series of contingent factors that simultaneously arose during the days preceding the summit, which reduced the bargaining flexibility of the countries involved.

Second, the U.S. Federal Reserve’s decision to buy $600 billion in U.S. Treasury bills—in the context of its well-known hyper-expansionary policy known as “QE2”—was unfortunately announced on the eve of the summit. This deepened the worries and irritation of the Chinese monetary authorities and those of other emerging economies against the backdrop of growing difficulty in containing spillovers effects.

Meanwhile, German leadership from the time of the Gyeongju finance ministers’ meeting worked to establish a united front against any variant of the U.S. proposal on targeting current account imbalances by unilaterally approaching the Chinese delegation.

However, the final nail in the coffin was the defeat of the Democrats in the U.S. midterm elections, only a week before the G-20 Summit. President Obama was left with a lame-duck Congress, while facing the prospect of a newly-elected Congress now deprived of a moderate centrist majority. This made him more vulnerable to the extreme factions of the two opposing parties, both unwilling to give political backing to initiatives that would have required generous concessions. As a result, the ability and willingness of the White House to take further risks in connection with new and uncertain political initiatives was heavily constrained.

It was no coincidence that in the days immediately preceding the summit, negotiations on the bilateral free trade treaty with Korea completely broke down as a result of opposition from powerful industrial groups. This proved embarrassing for the Korean hosts of the summit, not only for the breakdown but also for its unfortunate timing, just as the summit was imminent.

What will remain of this G-20 summit? Failure to reach an (admittedly difficult) agreement on a piloted across-the-board adjustment of balance-of-payments should not overshadow the rapid agreement achieved with regard to the Basil III Accord, which would not have been possible without the political momentum provided by the G-20 leaders.

The other significant outcome is IMF reform. Specifically, China will be elevated to the ranking of third largest IMF shareholder, surpassing Germany, as part of an overall 6 percent transfer of voting power to dynamic and under-represented economies. For the first time in the IMF’s recent history, this quota review will entail a re-composition of its Executive Board with a view to offering emerging economies a broader representation in the face of the corresponding reconfiguration of the Western European presence.

In the end, the White House played an important hand in making emerging economies, particularly China, responsible stakeholders in the international monetary system. This is exemplified by the growing awareness that greater voting rights and a stronger representation in IMF governance are necessary conditions if emerging market countries are to be called on to act as good citizens of the international community in the long term.

Paolo Guerrieri is Professor of Economics at the University of Rome “La Sapienza” and Vice President of Istituto Affari Internazionali.

Domenico Lombardi is President of the Oxford Institute for Economic Policy and Nonresident Senior Fellow at the Brookings Institution.

Authors

Paolo Guerrieri
Domenico Lombardi

The G-20 Can Stop Currency War

Kemal Derviş — Tue, 09 Nov 2010 11:03:00 -0500

Alarmist concerns about impending currency wars were temporarily moderated by the G20 finance ministers’ pre-summit meeting in Gyeongju, where they agreed to work towards limits on the current account deficits and surpluses of their balance of payments.

But they flared up again with the launch of a new round of quantitative easing—QE2—by the US, triggering fears of dollar devaluation and floods of hot money into emerging markets. Is it peace or war now on the currency front? Is the Gyeongju “agreement” just another pious wish without practical implications? What does it mean for the G20 summit?

Sceptics will highlight that the agreement does not specify numerical ceilings. A symmetric upper bound of 4 or 5 per cent for deficits and surpluses was under consideration, but was dropped. The communiqué states that “national or regional circumstances” would be considered, highlighting the situation of commodity exporters, whose current accounts vary considerably with prices.

It was also agreed the International Monetary Fund would provide guidance on how to implement the agreement, but it is not clear how it will do this. It is unlikely anything more concrete can be agreed at this week’s summit, except perhaps more detail on indicators to determine current account limits, but no more. Some will therefore dismiss the agreement on targeting upper bounds for current accounts as inconsequential and argue the G20 is losing credibility as a “potential steering group” for the world economy.

In fact the agreement, if it is endorsed by the leaders, may constitute a significant step forward for international economic co-operation. First, it is right that the focus has shifted to “outcomes”, in the form of current account imbalances, and away from the exchange rates themselves. After all, if the Chinese surplus were to dwindle to a small amount, with China importing almost as much as it exported, while the Chinese exchange rate remained the same, the world would stop worrying about Chinese exchange rate policy.

Conversely, if, as has been the case for Japan in the past, a large surplus persisted, despite an exchange rate appreciation, the global deflationary impulse from the Chinese surplus would continue to pose a challenge.

Second, the proposed agreement is cast into a multilateral and symmetric framework, lessening the US-China tensions and rightly encompassing the problem of other significant imbalances, including notably the German and Japanese surpluses and the US deficit. Many emerging countries are also threatened by imbalances because of the recent surge of short-term capital inflows they are receiving, largely caused by low interest rates in advanced countries.

The new round of quantitative easing by the US Federal Reserve will amplify these capital flows to emerging markets, with some such as Brazil, South Africa, Turkey and India already facing not only currency appreciation but also widening current account deficits.

Third, the call for an increased role for the IMF can strengthen the necessary linkage between the G20 process and the more inclusive work of the IMF. Both the rich G7 countries that traditionally did not pay much attention to the IMF, and the emerging market countries always suspicious of the IMF’s encroachment on their sovereignty, are now calling for a greater role for the IMF to help implement the agreement to limit imbalances.

In that context, the IMF governance reforms likely to be endorsed in Seoul, shifting more than 6 per cent of quota shares to dynamic emerging economies and underrepresented countries by 2012, and two executive director chairs from the advanced European countries to emerging countries, will increase the legitimacy of IMF governance, although these are only partial steps in the right direction and they should be implemented more rapidly.

Finally, when evaluating the G20, it is important not to focus too much on the actual meetings and communiqués, and more on the process itself. In the past, the G7 meetings had led to close and repeated personal contacts between key economic policymakers and civil servants of the club of advanced countries. The familiarity and often personal trust that such repeated substantive interaction creates may not be visible, but is nonetheless very important to international co-operation, particularly at times of crisis. Indeed many G7 officials complain that the G20 has reduced the degree of informal familiarity that they used to enjoy. That is a small price to pay for now having the enlarged group of countries reflecting the world of the early 21st century around the table.

It may take some time, but the G20 process is likely to lead to much greater personal familiarity and a more common understanding of the key policy challenges for policy makers and their staff, which in turn can greatly contribute to tackling problems and co-operation. Indeed, it was the shuttle diplomacy of some senior civil servants of G20 countries that made the Gyeongju agreement possible and diffused tensions.

Behind the fanfare and excessive theatrics of the summits, a global network is growing that could become the backbone of international economic co-operation in this age of accelerating change and interdependence. We should give it a chance to work.

Authors

Kemal Derviş

Publication: Financial Times

Image Source: © POOL New / Reuters

What Drives Reserve Accumulation (And At What Cost)?

Eduardo Levy-Yeyati — Thu, 30 Sep 2010 00:00:00 -0400

Editor’s Note: This commentary was originally published on VoxEU.org. Total foreign exchange holdings are larger than ever, largely due to reserve accumulation by emerging and developing economies. Eduardo Levy-Yeyati investigates the driving forces behind the accumulation of foreign exchange reserves and finds that exchange-rate smoothing, rather than precautionary stockpiling, is the main driver.

The argument against reserve accumulation by emerging economies is often built on three premises:

reserves introduce negative externalities: they perpetuate global imbalances and depress interest rates, stimulating asset bubbles (Aizenman 2009);
reserves are costly: most indebted emerging economies need to pay a carrying cost roughly proportional to the sum of their sovereign credit risk premium and the term premium in the reserve currency of choice; and
reserves are precautionary: they are purchased to build self-insurance “liquidity war chests” to prevent or defend against a sudden capital-account reversal.

Of these three premises, the first one reflects a complex coordination problem that exceeds cost-efficiency considerations by individual countries. The other two, in turn, merit some important qualifications.

Read complete article at VoxEU.org »

Authors

Eduardo Levy-Yeyati

Publication: VoxEU.org

Bashing Beijing Will Not Help Our Trade Deficit

Robert C. Pozen — Fri, 20 Aug 2010 10:04:00 -0400

Pressured by the U.S. and other countries, China announced in June that it would adopt a "flexible" exchange rate for the yuan. Yet to date there has been minimal appreciation against the dollar, so the pressure is back. Responding to reports on China's rising trade surplus in July, Sen. Charles Schumer (D., N.Y.) said last week: "These numbers show just how little motive China has to end its currency manipulation."

Many American politicians want the yuan to appreciate relative to the dollar in order to reduce the U.S. trade deficit—by making Chinese exports more expensive, and encouraging Chinese consumers to buy more imports. However, the value of the yuan is not the main driver of the U.S. trade deficit. The wages and social safety net of Chinese workers are more important. Labor is the most significant component of most goods exported from China to the U.S. If wages go up in China, then the prices of its exports will rise—absent a proportional increase in labor productivity. Wages are direct costs of producing Chinese exports, which cannot be easily avoided by currency hedging.

The higher prices of exports from China should reduce the incentive of U.S. consumers to buy low-end goods from China like toys and clothing. While higher prices for Chinese exports will also increase the prices of consumer goods in the U.S., a little price inflation would be a welcome antidote to the dangers of potential deflation in the U.S.

And if wages rise in China, its workers would have more money to spend. Admittedly, Chinese workers are big savers, not spenders, because of the weak social safety net there. Ironically, in the People's Republic of China, most Chinese workers must rely mainly on their own resources to pay for health care and retirement. Nevertheless, higher wages have been closely correlated with higher private consumption in China, according to the World Bank.

Between 1993 and 1995, for example, wages rose to 54% of GDP from 50% as private consumption rose to 49% from 47% of GDP. Conversely, between 1999 and 2006, wages declined to 40% from 52% of GDP as private consumption dropped to 37% from 47% of GDP.

Over the last two months, the average minimum wage in China has increased by an average of 20% in at least 18 provinces, including Beijing and Shenzhen. These increases in minimum wages reflect the smoldering labor disputes at many Chinese plants. For instance, striking workers at the Honda plants in southern China recently accepted wage increases of 24% to end their strikes. As higher wages are reflected in higher prices of Chinese-made goods, fewer of these goods will be purchased by consumers in America and Europe.

By contrast, the value of the yuan is not closely correlated with the size of the U.S. trade deficit with China. Although the relative value of the yuan to the dollar rose by 20% between 2005 and 2008, the U.S. trade deficit with China climbed to a record $268 billion in 2008, from $202 billion in 2005. There are several reasons for this disconnect between currency values and trade deficits.

First, many exports from China to the U.S. are only assembled in China; as with Apple's iPod, most of the components are made elsewhere. Since the Chinese input constitutes no more than 10% of such exports, even a 20% appreciation in the yuan would at most increase the prices of these exports by 2%.

Second, the appreciation of the yuan relative to the U.S. dollar may cause China to lose low-end exports to countries like Bangladesh and Vietnam—thus leading to job losses and lower imports by Chinese workers. However, such a shift in low-end exports from China to other countries will not reduce the overall volume of exports to the U.S., just the country of origin. Third, the volume of U.S. exports to China is primarily influenced by competition with countries such as Germany and Japan on high-end capital goods like supercomputers and jet engines. The critical determinant in this high-end competition is not so much the value of the yuan, but more the value of the dollar relative to the euro and yen.

In short, American politicians should not push so hard for yuan appreciation—which has, by provoking resistance in China, been counterproductive. Instead, they should support higher wages and a stronger safety net for Chinese workers. These measures would not only help reduce the U.S. trade deficit but also would be consistent with recent efforts of China's officials to improve the living standard of its workers.

Authors

Robert C. Pozen

Publication: The Wall Street Journal

Image Source: © Stringer Shanghai / Reuters

China's Yuan on the Global Stage

Kenneth G. Lieberthal — Tue, 22 Jun 2010 00:00:00 -0400

After much international criticism, China announced on June 19 that it would loosen its control over its currency’s peg to the dollar and allow it to appreciate. Kenneth Lieberthal places China’s recent decision in the context of the 2010 G-20 Summit.

Video

China's Currency Announcement and the U.S. Congress

Kenneth G. Lieberthal — Tue, 22 Jun 2010 16:14:00 -0400

With the G-20 Summit set to begin in Toronto on June 26, China announced over the weekend that it would increase the flexibility of its exchange rate and allow its currency to appreciate In this video, Kenneth Lieberthal discusses China’s exchange rate and how the U.S. Congress has responded to the issue.

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Authors

Kenneth G. Lieberthal

Rebalancing the U.S. Economy in a Post-Crisis World

Barry P. Bosworth and Susan M. Collins — Tue, 11 May 2010 10:01:00 -0400

Abstract

The objective of this paper is to explore how the external balance of the United States might evolve in future years as the economy emerges from the recession. We examine the issue both from the domestic perspective of the saving and investment balance and from the external side in terms of the basic determinants of exports and imports and the role of the real exchange rate.

Using these two respective perspectives, we highlight (1) causes and consequences of low private and public saving in the U.S., and (2) sensitivity of trade to variations in the real exchange rate. We highlight the need for sustained depreciation of the dollar to improve the competitiveness of U.S. exports and argue that the current exchange rate is consistent with a significant reduction in the size of the trade deficit.

However, the favorable external outlook is very inconsistent with a projected domestic situation of low rates of private saving and a very large public sector budget deficit matched by a cyclically depressed rate of investment. Changes in U.S. corporate tax structure, reconsideration of capital controls, and perhaps some further decline in the level of real exchange rates could help soften the impact of a potentially very hard post-recession landing for the United States.

Paper prepared for the “Trans-Pacific Rebalancing” Conference jointly organized by Asian Development Bank Institute and The Brookings Institution, March 3-4, ADBI, Tokyo.

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Currency Conversion during Korean Unification

Yeongseop Rhee — Tue, 06 Jan 2009 13:05:54 -0500

This commentary is based on a longer paper by the author titled “Currency Conversion during the Period of Transition: The Case of North Korea,” presented at an IMF-SNU conference on 17-18 June 2008 and at a Brookings CNAPS seminar on 13 November 2008.

Recent news reports on the absence of North Korean leader Kim Jong-Il from important functions have sparked speculation about his health and North Korea’s future. Since very little is known about North Korea, the spectrum of anticipated scenarios after Kim is very wide, but can be divided broadly into two groups.

One group thinks that a collective leadership among the party, the military, and the security apparatus is likely to emerge and that North Korea will follow a gradual and step-by-step transformation. The other group, in contrast, puts more weight on the possibility of North Korea’s collapse: in this case, it is presumed that an enormous exodus of refugees will flow from North Korea to South Korea, China, and even Japan and that the Korean peninsula may be placed in a very risky situation.

Although stability and gradual reform is the most desirable scenario for North Korea, we don’t know at all what will happen. It is anybody’s guess how North Korea will change after Kim Jong-Il’s departure. But it is certain that Kim’s health problems have created a sense of urgency in preparing against a worst case scenario. Some movements in this direction have already been recognized: for example, it was reported that U.S. has proposed that South Korea quickly develop the contingency plan (CONPLAN 5029) into an action plan (OPLAN 5027) in case of North Korea collapse.

It is also clear that preparing for change after the death of Kim requires both the development of a very comprehensive plan and attention to specific issues. This short article addresses one of those issues: monetary unification. In particular, how will a conversion rate be determined between North Korean currency and South Korean currency (or another foreign currency such as the U.S. dollar); and when during the unification process should the two currencies be integrated. For purposes of analysis, I assume that the two Koreas will eventually be unified and that the unification will follow a rapid process rather than a gradual one.

Choice of Conversion Rates

The establishment of an appropriate conversion rate is very important in transforming the North Korean economy. A proper rate can stabilize the economy, encourage trade at undistorted prices, and even speed up the process of transition to a more market-based economy. But it is very difficult to find an appropriate rate for the North Korean currency, in particular because the data on North Korea’s economy are very limited.

Given the difficulty, one may be tempted to use existing exchange rates.[1] According to the official trade exchange rate, the value of the North Korean won against the U.S. dollar had been stable at around 2.20 won to the dollar before the reform in July 2002. After July 2002, the official exchange rate jumped nearly 70 times to a rate of 153.50 : 1. However, the won has steadily depreciated in the unofficial market. One North Korean won is now considered worth only 1/3000 of one U.S. dollar, or one third of the South Korean won, in the free market. Obviously, there is a huge gap between the official and unofficial rates.

<Figure 1> Official exchange rates (North Korean wons per U.S. dollar)

<Figure 2> Unofficial exchange rates (North Korean wons per U.S. dollar)

<Figure 3> Gap ratio of unofficial rate to official rate

This trend implies that the official trade exchange rate is not at all reliable and of no economic significance. But using the unofficial rate is also problematic. Data are collected only sporadically and vary significantly depending upon the sources. Also, users generally prefer foreign currencies to North Korean currency; thus, the unofficial rate includes a high premium for foreign currencies and hardly reflects the North Korean economy. This suggests that we need to estimate a conversion rate using available data so that the rate can better reflect changes in the North Korean economy.

Despite the limited and inaccurate figures, there are some data that could be used for calculation of conversion rates. For example, as unofficial markets such as farmer’s and black markets are expanded, their price data exhibit price flexibility and reflect market changes. Thus, we may be able to collect information on a conversion rate that is included in currently available data. Also, despite some drawbacks of traditional models of exchange rate determination, two approaches – PPP (purchasing power parity) approach and monetary approach – are applicable to the case of North Korea even with limited and incomplete data.

According to the PPP approach, the exchange rate between two currencies is determined by the ratio of the two countries’ price levels. Following a process similar to that of the ICP (International Comparison Project) of the World Bank for empirical analysis uncovered some noteworthy results. First, there was a huge gap between conversion rates based on the official PDS (price distribution system) price data and those based on unofficial price data. Second, the gap between the two exchange rates is much wider in the agricultural sector than in the non-agricultural sector. This implies that the food problem was very serious in North Korea, more serious than the decline of the economy in general. Third, despite the reform in 2002 which narrowed the gap between official and unofficial prices in the short term, the gap remains and has begun widening again in recent years. It implies that the reform is not yet functioning as expected.

The second monetary approach produces similar results. According to the monetary approach, a certain amount of money is needed to support economic activity. So, when the two Koreas are unified, if the North Korean economy is 1/10 the size of the South Korean economy, the added money from North Korea should be 1/10 the amount of South Korean money so that there is no additional inflationary pressure. Comparing South Korean and North Korean GDPs and their monetary stocks,[2] we can calculate the rate to convert North Korean currency to South Korean currency. The basic implications are similar to those using price data. During the 1990s, the value of the North Korean won plunged and the gap between the official and unofficial rates widened. Even after the 2002 reform, the North Korean currency seems to have lost significant value; North Korea’s monetary stock is believed to be much larger now than before, and accordingly the value of the North Korean won now seems much lower than before.

The calculation of conversion rates based on the PPP and monetary approaches suggests that one North Korean won is recently worth less than 1/1000 of one U.S. dollar, or less than one unit of South Korean currency. With better and more complete data we may be able to calculate the rates more accurately and use them as a guide to convert North Korean currency during monetary unification. But an equilibrium rate that well reflects the market is not necessarily optimal for unification. The choice of a conversion rate for unification requires additional consideration: the conflicting effects of a conversion rate choice on various policy objectives – such as price (and macroeconomic) stability, firms’ competitiveness and job opportunities, the standard of living of local residents, and the government budget – must be examined.

For example, an overvaluation of North Korean currency will increase the injection of additional money into a unified Korea and produce inflationary pressure. Thus in terms of the inflation criterion, the choice of a conversion rate undervaluing North Korean currency would be desirable. Also, if North Korean currency is overvalued, it will hurt the competitiveness of North Korean firms and reduce job opportunities in North Korea; the undervaluation of North Korean currency would be desirable in this respect as well. On the other hand, an overvaluation of North Korean currency can increase wage payments and the value of financial assets for North Korean residents, creating a short-term positive effect on the standard of living. Finally, the overvaluation of North Korean currency may have either a positive or negative effect on the government budget,.

The decision on a conversion rate will depend upon which policy objective is the most important. Considering their relative impacts and past experiences, I suggest that price/macroeconomic stability and competitiveness of North Korean industries should have the high priority: undervaluation of North Korean currency is therefore more desirable.[3] The experiences of other socialist countries show that inflation was one of the most difficult problems at the beginning of economic reforms. Even though the details of each country’s reform path depend upon the state of the economy, price/macroeconomic stabilization has to be the initial priority. Once price/macroeconomic stability is guaranteed, foreign capital – which North Korea eagerly needs for its successful transformation and development – can be attracted.

The undervaluation of North Korean currency is also desirable in terms of labor migration. According to studies on German unification,[4] the most important reason for migration from East to West was not the high incomes in West Germany, but the lack of job opportunities in East Germany. This implies that the overvaluation of North Korean currency to improve the standard of living of the North Korean people would cause more migration because of suffering competitiveness of North Korean firms and job opportunity, and would further place a higher burden on the government budget.

Timing of Currency Unification

Another major issue will be the timing of monetary integration during the unification process. There are of course pros and cons between an early currency union and a late currency union.[5] For example, an early union would remove uncertainties about the unification and provide an important symbol for the unification. It would also lead to quick macroeconomic stability in North Korea and attract foreign investment. In addition, an early currency union would reduce transaction costs and encourage interregional transactions, speeding up economic reforms in North Korea. But an early union has several drawbacks as well. For example, an early union results in the loss of the exchange rate policy instrument which may be needed for absorbing shocks. Also, since we most likely will not have much information on the North Korean economy in the early stages of the unification, there is serious risk of establishing an inappropriate conversion rate based on incorrect or incomplete information, which would cause serious costs, such as the devastation of North Korean industries and labor migration. Such a misstep would destabilize the North Korean economy and hinder economic reforms.

The German experience of an early currency union revealed many problems with this model and some suggest that a later currency union would be more desirable for Korea. But a late currency union has also both benefits and costs. To choose the timing, we need to understand not only the effects on policy objectives but also the feasibility of alternatives and the status of the North Korean economy. With these factors in mind, I suggest that an early currency union is preferable to a late one.

First, most proponents of a late currency union argue that currency unification needs to be delayed for a few years until North Korean economy is stabilized and improves to a certain level. However, a temporary delay of a few years will not guarantee the improvement of the North Korean economy to a certain level but is more likely to lead to its deterioration. Even though the North Korean economy may improve, it actually must grow much faster than South Korean economy for a long time to reach a certain compatible level. For example, even assuming North Korean economic growth of 10 percent per year – which would be extremely difficult – it will still take nearly one generation for North Korean per capita income to reach one half of the South Korean level. This suggests that it is impossible to improve the North Korean economy to a certain level compatible with South Korea’s within a few years. Thus, in terms of feasibility, an early union is better.

Second, a gradual strategy for economic reform and opening, such as China has chosen, would not be applicable to North Korea. In comparison with China, North Korea is over-industrialized like Eastern European countries. In this type of economy where the state sector is dominant, there is little reserve of labor outside the state sector that can provide the engine for growth for a new non-state sector, and gradualism cannot work in that context. A sharp downturn in industrial production upon the outset of market reforms is inevitable, and a significant loss of employment in the industrial sector should be expected and accepted as a structural adjustment in North Korea. Thus, the unified fiscal and monetary policy framework to promote structural reforms should be prepared as soon as possible through an early currency union.

Third, according to the theory of optimum currency area, if there exists an adjustment mechanism such as flexible prices and wages or other measures to absorb asymmetric shocks, it is more likely for two countries to form an optimum currency area. When the two Koreas are unified, large fiscal transfers from South Korea to North Korea can play that role of adjustment mechanism because asymmetric shocks to North Korea can be compensated by these fiscal transfers. The two Germanys could form an optimum currency area after the unification because of the centralization of the fiscal system. Thus, as long as fiscal transfers are guaranteed, which will be a sure fact in the case of Korean unification, the loss of the exchange rate policy instrument would not matter much in terms of absorbing asymmetric shocks, and an early monetary union is preferable.

[1] In North Korea, there used to be various kinds of exchange rates such as the official exchange rate, the trade exchange rate, the traveler’s exchange rate, and unofficial exchange rates (farmer’s market and black market exchange rates). The official and the traveler’s exchange rates appear to have been abolished around the beginning of the 1990s. The trade exchange rate is currently considered the official exchange rate.

[2] North Korean monetary stocks were estimated benchmarking ex-socialist countries’ data and using survey data from North Korean refugees.

[3] When we actually convert North Korean currency to South Korean currency during unification, we will need to apply different conversion rates to different cases. But it is still better that on average those rates undervalue North Korean currency.

[4] Akerlof, G., A. Rose, J. Yellen, and H. Hessenius (1991), “East Germany in from the Cold: The Economic Aftermath of Currency Union,” in W. Brainard and G. Perry (eds.), Brookings Papers on Economic Activity 1, Brookings Institution.

[5] An early currency union would integrate the two currencies at the beginning stage, before political and economic unification while a late currency union would maintain two separate currencies until the last stage of the whole unification process.

Authors

Yeongseop Rhee

Lame Duck Meets Hobbled Panda: The China-U.S. Strategic Economic Dialogue

Eswar Prasad — Thu, 04 Dec 2008 12:00:00 -0500

The biannual meetings of the Strategic Economic Dialogue between China and the U.S. are taking place in Beijing against the backdrop of the worldwide financial and economic crisis. Even as the two countries are reeling from economic carnage, the old thorn in their bilateral relationship—Chinese currency policy—is back at center stage.

The steady but languorous appreciation of the renminbi has ground to a complete halt and even reversed slightly in recent days. This prompted U.S. Treasury Secretary Hank Paulson to call for a stronger renminbi, arguing that it was necessary to correct global imbalances. Beijing promptly rebuffed his call, responding that the focus on the Chinese currency was misplaced and counterproductive, especially in the midst of a crisis.

Plus ça change, plus c’est la même chose? Not quite. The ground has shifted on both sides of the Pacific and it has become more important than ever for these two economies to get their bilateral relationship straight, for their own sakes and for the greater good of the world economy.

China and the U.S. are two key players in the world trade and financial systems, and together they epitomize the sources and dangers of global macroeconomic imbalances. U.S. regulatory and macroeconomic policies bear the lion’s share of the blame for the current crisis. But there is a deep irony in the fact that Chinese virtue—its high national saving rate—and its policy of tightly managing the external value of its currency abetted U.S. profligacy by providing cheap goods and cheap financing for those goods. The consequences of those policies are now rebounding on the Chinese economy.

The mutual dependence of these two economies has increased and they are now locked in a death embrace of sorts. As China continues to run current account surpluses by exporting to the U.S. and other advanced country markets, it has little alternative to buying U.S. treasuries with the reserves it accumulates while managing its exchange rate. The U.S. needs willing buyers for the treasuries issued to finance its budget deficit, which is bulging even more due to bailout and fiscal stimulus operations. This very combination of policies provided tinder for the financial crisis—surely we can’t forget our lessons so quickly.

Chinese and U.S. policymakers are rightly using all macroeconomic tools at their disposal to prop up growth. One risk is that some of the steps China is taking—letting bank credit flow easily and halting currency appreciation—will only hinder its ability to reform its banks and shift away from export and investment-led growth. Understandably, rebalancing growth may not be a priority when growth is unraveling, but the chickens will eventually come home to roost. Likewise, U.S. macro policies are now focused on staving off an ugly recession, but they will have to be resolutely brought under rein once the crisis passes.

One result of the crisis is that the U.S. no longer holds the high ground to lecture the Chinese on financial or macroeconomic policies. This may actually help turn their relationship into a more equal partnership, with less posturing on both sides. For instance, future bilateral discussions should focus on policies that would be good for China—a more flexible exchange rate and a more independent monetary policy—and couch them in terms of Chinese and global economic interests, rather than sideshows such as the U.S-China bilateral trade deficit or the level of the renminbi-dollar exchange rate, which U.S. politicians tend to focus on.

With Paulson’s departure from government imminent, it is a good time to ask if the SED—which he initiated in December 2006—has delivered on its promises to strengthen the China-U.S. relationship. As it turns out, there are few concrete guideposts that the SED’s success can be judged against. But this may be an unfair standard.

The SED was always more about dialogue rather than substance. I do not mean this pejoratively. Regular high-level dialogues help in building trust and a deeper awareness of political and other constraints that may be driving economic decisions on both sides. Both countries have complex internal political dynamics that are difficult for outsiders to comprehend. Even in China, there are different locuses of power that are often at odds on matters of economic policy. Influencing the right people in both countries and helping them to influence others is as much a part of changing policy as is the substance of the message.

Ongoing dialogue is especially important at this juncture to ensure that economic exigencies do not result in protectionist policies, especially on international trade. Cynics may say that talk is cheap, but perhaps the SED should be judged by destructive actions such as tariff wars that did not come to pass—despite saber-rattling from both sides—rather than more grandiose positive actions.

As for Hank Paulson, I suspect the latest round of meetings is a welcome respite from the mess on his hands in Washington. Perhaps he wouldn’t mind hanging out a bit longer with his comrades in Beijing.

Authors

Eswar Prasad

Top 10 Global Economic Challenges Facing America's 44th President

Fri, 10 Oct 2008 12:00:00 -0400

The 2008/2009 Top 10 Global Economic Challenges report focuses on the most critical issues facing America’s 44^th president. From restoring financial stability to establishing a U.S. policy on climate change and engaging the emerging economic powers, the report contains timely analysis and recommendations by Brookings leading global economic experts.

Download the full 2008/2009 report »

Introduction » (PDF)
by Lael Brainard
Given its enormous stake in a strong and resilient economy, it will be critical for America to lead on today’s main global economic challenges. In this introduction to the 2008/2009 Top 10 report, Lael Brainard discusses the global context and America’s opportunity.

The top 10 global economic issues, as identified and ranked by Brookings Global, include:

1. Restoring Financial Stability » (PDF)
by Eswar Prasad
With U.S. financial troubles at the center of the current global vortex, the U.S. has important obligations to strengthen the global financial system, including by enhancing financial regulation and diminishing reliance on foreign credit.

2. Setting the Right Green Agenda » (PDF)
by Warwick McKibbin, Adele Morris and Peter WilcoxenFor the U.S., it is time to muster the political will to act on climate change at the national level while also working to forge international agreement so that markets and regulatory policy will provide a consistent set of incentives to wean the economy from carbon foundations.

3. Exercising Smart Power » (PDF)
by Lael Brainard and Noam Unger
Investing in the education, health, livelihoods, and the security of the world’s poorest not only makes Americans feel good about themselves but also makes the world feel good about America. It is critical to increase not only resources but also the impact of each dollar spent.

4. Reimagining Global Trade » (PDF)
by Paul Blustein
Americans feel most secure about global engagement when they are well equipped to compete and have insurance against economic risks. This requires vigorously enforcing the trade rules and investing in economic competitiveness.

5. Navigating China’s Rise » (PDF)
by Wing Thye Woo
On issues such as climate change, enforcement of trade rules and exchange rate adjustment, where the stakes are simply too high to ignore, America should look for cooperative mechanisms to advance its goals where possible but continue to press bilaterally with China and better deploy regional and international mechanisms where necessary.

6. Deciphering “Russia, Inc.” » (PDF)
by Clifford Gaddy
Difficult as it may be to accomplish, America nonetheless has significant interests in alternately coaxing and goading a resurgent, resource nationalist Russia toward international norms and cooperation on energy, trade, financial integration and security more broadly.

7. Engaging an Emerging India » (PDF)
by Eswar Prasad
America has enormous interests in India’s successful integration into the global economy as the world’s most populous democracy engages in the task of lifting hundreds of millions out of poverty. America must look for areas of cooperation where possible and deepen bilateral engagement broadly in order to make progress on its agenda.

8. Revitalizing Ties to Latin America » (PDF)
by Mauricio Cárdenas and Leonardo Martinez-Diaz
America must become a stronger partner to its neighbors and engage on issues of mutual concern, including on energy, environmental protection, economic competitiveness and social policies.

9. Supporting Africa’s Growth Turnaround » (PDF)
by John Page
America can become a stronger and steadier partner to Africa as it navigates economic challenges by supporting global standards for natural resource management, opening markets to African products, supporting vibrant private enterprises, supporting African efforts to enhance regional security and build resilience to climate change, and both increasing and improving the quality of development assistance.

10. Pursuing a Positive Agenda for the Middle East » (PDF)
by Navtej Dhillon, Djavad Salehi-Isfahani and Tarik Yousef
America can build partnerships in the Middle East based on trust and mutual respect if it aligns its agenda on economic and political reform with the aspirations of the majority of the region’s people: the young who are striving for opportunity and global integration.

Download the full 2008/2009 report »

View the 2007 report »

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