by Sara Eisen
• First, with an average increase of more than US$180 billion per quarter, international reserves have now reached US$3.2 trillion, well above the levels needed for precautionary purposes.
• Second, the yuan appreciated in real effective terms by about 53/4 percent during 2011, but, from a longer-term perspective, the yuan is in real effective terms close to where it was in the late 1990s (see Figure 6-12), despite significantly higher productivity than China’s trading partners since then.
• Finally, despite important progress that has been made in many policy areas, the critical mass of measures needed to decisively change the incentives for saving and investment and achieve a lasting decline in the current account surplus is not yet in place. Indeed, simulations using the IMF multicountry model suggest that there will be pressure on China’s current account surplus to rise again over the medium term, albeit to a smaller level than before the crisis (see Figure 6-13). As the global economy recovers, so will external demand for China’s exports. This, together with the fiscal position moving back to budget balance and assuming a constant real effective exchange rate, means that there is a potential for somewhat larger current account surpluses to reassert themselves. The accumulation of net foreign assets will also put upward pressure on the current account surplus through its impact on income flows.
Figure 6-12 Real Effective Exchange Rate
(Index 2005 = 100; increase = appreciation)
Figure 6-13 Current Account Balance
(Percent of GDP)
The Chinese authorities have long recognized the need to transform China’s economic growth model. This concern was reflected in Premier Wen’s declaration during the National People’s Congress press conference in March 2007 that “the biggest problem with China’s economy is that the growth is unstable, unbalanced, uncoordinated, and unsustainable.” Exchange-rate appreciation is a key ingredient—and in many ways a prerequisite—for accelerating the transformation of China’s economic growth model. For example, exchange-rate appreciation closer to the level consistent with medium-term fundamentals and greater flexibility will allow the central bank to run a more independent monetary policy and increase real interest rates to combat inflation pressures in a more efficient manner. At the same time, greater two-way movement of the yuan will reduce the liquidity injection needed to limit appreciation pressures and the subsequent reliance on reserve requirements and issuance of central bank paper to absorb liquidity in the domestic money market.
With higher real interest rates and less pressure on domestic liquidity from large-scale foreign exchange intervention, the government will be able to move ahead with financial-sector liberalization while avoiding the risks that financial liberalization and excess liquidity can fuel. These include the serious risks of asset price bubbles and deteriorating credit quality, culminating in a full-blown crisis. In the real sector, an undervalued exchange rate also creates distortions in relative prices that act as headwinds to the government’s efforts to raise household income and to develop the service sector.
A faster pace of appreciation would open the way to move ahead with the structural reforms highlighted earlier. Moreover, a stronger yuan would help increase the purchasing power of households, raise the labor share of income, and reorient investment toward nontradable (service-oriented) sectors. Finally, a more appreciated currency would improve the potential for the yuan to be used internationally. In particular, it would reduce the risks of a one-sided use of the yuan for trade settlements, as expectations of currency appreciation would favor yuan settlement for imports at the expense of exports.
What Would Be the Benefits of Rebalancing Growth in China?
Rebalancing the economy away from exports and investment and toward consumption would have several advantages. First, it would make China less reliant on demand from its trading partners in advanced economies and less exposed to external shocks. Second, a more balanced economy—particularly with investments in social support systems and rising household income—would lessen income inequalities and increase the inclusiveness of China’s growth. Finally, transforming the growth model would make China less energy- and capital-intensive and more environmentally friendly, and, over time, would add to the pace of job creation.
Nevertheless, in the near term, the shift toward domestic consumption is likely to reduce growth somewhat as the economy adjusts to the various elements of reform—in particular, because it will take some time to build productivity in the service industries. In the labor market, rebalancing will imply moving a large number of less-skilled workers from the tradable to the nontradable sector, and this process could be accompanied by short-term costs. Mitigating these costs will require labor-market policies to cushion the employment impact during the transition, particularly in meeting the skills gap that exists between workers in the tradable sector and those in the service sector.
More vigorous Chinese domestic demand would help support the global economy in many ways, including the absorption of more imports with positive spillovers to much of the rest of the world. To achieve this rebalancing, a stronger yuan will be needed as part of a comprehensive package, as it would open the way to move ahead with structural reforms, help increase the purchasing power of households, raise the labor share of income, and reorient investment toward nontradable sectors.
CHAPTER 7
CURRENCY WARS AND A GROWING ROLE FOR THE INTERNATIONAL MONETARY FUND
JAMES RICKARDS
“The role of the SDR has not been put into full play due to limitations on its allocation and the scope of its uses. However, it serves as the light in the tunnel for the reform of the international monetary system.”
—Zhou Xiaochuan, People’s Bank of China Governor, March 2009
The history of the international monetary system over the past 150 years is one of relatively long periods of stability interspersed with periods of dysfunction and punctuated by abrupt changes in the prevailing rules of the game. The periods of stability are the classical gold standard period of 1870–1914, the Bretton Woods gold-backed dollar period of 1944–1971, and the strong dollar period of 1982–2010. The periods of dysfunction include the beggar-thy-neighbor devaluations of the 1920s and 1930s, beginning with the Weimar hyperinflation of 1921 and continuing through the Tripartite Agreement of 1936, called Currency War I.1 Another period of dysfunction came in the aftermath of President Nixon’s abandonment of the link between gold and the U.S. dollar in 1971, which was followed by repeated devaluations of the dollar and hyperinflation in the United States, part of what is described as Currency War II.2
The occasional shocks are even more dramatic than the currency wars. In 1914, nations around the world abruptly abandoned the gold standard in order to finance their participation in World War I with fiat money. In 1933, President Franklin D. Roosevelt issued an executive order suddenly ending the convertibility of dollars into gold by U.S. citizens. In 1971, President Nixon surprised the world by suspending the convertibility of dollars into gold by sovereign nations, including the United States’ largest trading partners.
These alternating periods of calm and dysfunction and periodic shocks should serve as a warning to market participants that nothing is forever in the international monetary system. Despite the apparent solidity of global financial arrangements when viewed in freeze frame, the dynamic rise and fall of international currency regimes is very much the norm. The greatest danger in international currency markets is posed exactly when the system is on the brink of one of these shocks. Most market players expect more of the same and are either unaware of the danger or unprepared for the ground to shift beneath them. In this chapter, we look at some of the forces pressing on the international monetary system today and assess the chances for a once-in-a-generation shift in prevailing arrangements and the roles of the major reserve currencies—especially the U.S. dollar.
Background to a New Currency War
Currency wars are nothing more than an effort by one country to s
teal growth from others by devaluing its currency in order to promote exports and create jobs. Currency wars produce inflation or trade wars in the long run, but they appear to have short-run benefits that make them irresistible to politicians.
A new currency war, the third in the past century, broke out in 2010. It was most famously identified by Guido Mantega, finance minister of Brazil, who said, “We’re in the midst of an international currency war” on September 27, 2010.3 However, the new currency war had been declared even earlier by President Barack Obama in his State of the Union address on January 27, 2010, when he announced the National Export Initiative, which was intended to double U.S. exports by 2015. Although the president did not explicitly call for the devaluation of the U.S. dollar, in fact, there was no way to meet the goal of doubling exports without devaluing the dollar, since other ways of increasing exports, such as productivity increases or a greatly expanded network of free trade agreements, could not possibly work in such a short time frame.
The seeds of the new currency war had been sown even earlier, at the September 2009 summit meeting of the G-20 in Pittsburgh. At that meeting, the heads of state of 20 of the most powerful economies in the world agreed on a global growth plan under the name rebalancing. The intention was to rebalance elements of global growth so that Europe substituted investment for exports, China substituted consumption for exports, and the United States substituted exports for consumption. This reshuffling of the global economic deck implied a stronger euro, a stronger yuan, and a weaker dollar.
Whether this global grand bargain will play out as intended remains to be seen. However, the deal struck in Pittsburgh in 2009 and backed by Washington in early 2010 was clearly having some effects, as evidenced by the complaints from Brazil in late 2010. A new currency war had well and truly begun. As in all wars, there would be winners—and losers.
The Rise of the G-20
The two previous currency wars had been mediated through a series of conferences and agreements among the principal nations involved. These were done on an ad hoc basis with different parties at different stages, and they tended to address whatever issue was most pressing or acute at the time.
Currency War I had included the Genoa Conference of 1922, the Dawes Plan of 1924, the Young Plan of 1929, and the Tripartite Agreement of 1936. Currency War II had been mediated by the Smithsonian Agreement of 1971, the Plaza Accord of 1985, and the Louvre Accord of 1987.
The new currency war would be different. A more coherent and continuous organization was now in place in which the same participants would meet regularly, once or twice per year, to discuss the shape of the international monetary system and mediate any complaints about exchange-rate imbalances. This new organization was the G-20, which included the United States, China, Japan, Germany, France, Italy, the United Kingdom, Brazil, Russia, India, and South Korea, among others.
The G-20 had existed since 1999, but it was only in 2008, in the immediate aftermath of the collapse of Lehman Brothers and AIG and in the depths of the Panic of 2008, that the group was upgraded from a meeting for finance ministers to a leaders’ summit involving heads of state. The first two G-20 summits after the panic—Washington in November 2008 and London in April 2009—were widely credited with coordinating a successful response to the global financial collapse. This response included coordinated monetary easing, information sharing, and a determination to avoid protectionism and to increase bank capital requirements.
By the time of the Pittsburgh G-20 summit in September 2009, the emphasis had turned from preventing collapse to stimulating growth. It was at Pittsburgh that the plan for rebalancing was approved, which was taken by the United States as a green light for a cheaper dollar and the appreciation of the yuan and the euro.
The role of the G-20 will become even more high profile in the years ahead as the currency wars spread. The bilateral struggle between the dollar and the yuan is sometimes carried out in two-party discussions between the United States and China nicknamed “G-2.” However, many of the losers in the currency wars, such as Brazil, South Korea, and Indonesia, have no particular leverage to offset the U.S. drive for a cheap dollar and will seek to have their concerns addressed in the context of the G-20, where coalitions can be assembled to push back against the U.S. devaluation policy.
Despite the power and the visibility of the G-20, it operates with very few staff members and no permanent secretariat. At times it seems to resemble the mythical village of Brigadoon, which emerges from an empty spot on the map, only to disappear after a single day and later reemerge. In fact, preparation for each G-20 meeting and follow-up on its goals and missions goes on continuously in the separate finance ministries and central banks of the member states.
The G-20 is not without extensive technical resources. Its members have chosen to use the International Monetary Fund (IMF) as a kind of outsourced secretariat. IMF representatives attend the G-20 meetings and receive instructions for what is called “mutual assessment”—a kind of IMF report card on the progress of individual nations toward the goals agreed to at the G-20 summit. The IMF conducts these and other analyses between G-20 meetings and reports back to the G-20 in advance of the next summit as an aid to setting the agenda. The emergence of the IMF as the handmaid of the G-20 is one of the most important developments in international finance in recent years.
Reinventing the IMF
As late as 2007, experts on the international monetary system were raising serious questions about the role and future of the IMF and whether the time had come to abolish it. The IMF was created as part of the Bretton Woods Agreement in 1944, which reestablished the international monetary system after the wreckage of World War II.
The Bretton Woods system was based on a fixed exchange rate between the dollar and gold and a set of fixed exchange rates between the dollar and all other participating currencies. This meant that the other currencies had an indirect link to gold via the dollar. However, the dollar-gold relationship was the anchor of the system. It was assumed that from time to time, certain currencies might revalue relative to the dollar; however, such revaluations were expected to be rare.
What was foreseen was that certain countries might run persistent trade deficits, which would put downward pressure on their currencies. In order to maintain the peg to the dollar, those countries would have to engage in structural economic adjustments to reestablish favorable terms of trade and convert deficits into surpluses. This is not unlike the process that Greece is going through, although that process is designed to reestablish creditworthiness and solvency within the euro, since Greece does not have its own currency. However, these adjustment processes can take several years. In contrast, currency crises can drain a country’s reserves in a matter of weeks or months.
The IMF was created to give countries that were experiencing currency stress time to implement their adjustment policies without running short of reserves in the meantime. The IMF would provide a kind of bridge loan from the resources of its entire membership to aid the country that was undergoing an adjustment so that it would not run out of reserves while waiting for the new policies to have the intended effects and restore the balance of trade.
This bridge loan function was rendered obsolete after 1973, when countries abandoned the Bretton Woods structure and adopted floating exchange rates. Now, instead of painful multiyear adjustment programs, countries could adjust their terms of trade immediately by allowing their currencies to devalue in the open market.
By the 1980s, the IMF had reinvented itself as a bridge lender and financial cop on the beat to emerging-market countries in Latin America, Africa, and Asia. These were countries that had not been a major part of global capital markets and currency flows during the Bretton Woods period, but that were now becoming more important as trading partners for sellers of manufactured goods and buyers of natural resources.
This new role for the IMF ended disastrously during the Asian financial crisis of 1997–1998. When the worst-affected
countries, such as Thailand, Malaysia, Indonesia, and South Korea, needed financial assistance to fight off a wholesale flight of hot money out of their banking systems, the IMF provided resources, but it also imposed austerity plans that were entirely unsuitable for what were potentially fast-growing, export-driven economies. The IMF applied a remedy that was more suitable for a solvency crisis when its clients were actually facing a short-term liquidity crisis. The result was worsening economies, riots, destruction, and death in the streets.
By the early 2000s, the IMF had lost its original function among the advanced economies and had terribly mishandled its adopted function among the emerging economies. It seemed to have no role and no future. This changed radically with the Panic of 2008.
Suddenly the world needed a financial cop, think tank, enforcer, and proto-central bank all at once. Despite its poor performance in the late 1990s, the IMF did have a large, highly regarded staff of experts along with a global membership, a governance structure, a budget, and a massive database. While the G-20 had power, the IMF had all of the other things that the G-20 lacked in the way of structure and resources. This institutional legacy proved decisive in helping the IMF to survive and find a new mission.
By 2009, the G-20 had “adopted” the IMF as its eyes and ears to monitor developments in the international monetary system along with progress toward stated G-20 goals. The IMF performed these functions at the request of the G-20, but it did so using its own techniques and staff, and therefore gained a measure of autonomy in the global economic rebalancing process.
This role as the expert mediator and monitor of the international monetary system was just the beginning of the emergence of a new, more powerful IMF, albeit under the direction of the G-20. By early 2011, the IMF was taking concrete steps to establish itself as a world central bank that was capable of issuing its own world money—the Special Drawing Right (SDR).