Thursday, October 21, 2010

"Currency war, the United States cannot win.

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Yves here. This post cites a number of recent Western commentaries on China’s currency policies; I suggest, for one stop shopping, you read Martin Wolf comment, “Why America is going to win the global currency battle.”

There are several points in the argument below that are curious, to say the least. One is the notion that the US came out the loser as the result of forcing the yen up through the Plaza accords. If this was so terrible for the US, why is China resisting taking the same moves now? I’d say the contrast between the reasonably prosperous, if unsustainable two decades starting in 1986 in the US, versus the bubble turned to stuck-in-the-mire bust for Japan says any Japanese victory way Pyrrhic. Second is the contention that the US can’t influence the level of the renminbi. Narrowly correct, but irrelevant. If the US forces the dollar down, China will have to keep buying more dollars to suppress the remninbi. Its foreign exchange purchases are now so large that it can’t fully sterilize them, so a bigger level of purchases will generate even more inflation. A fixed currency peg with rising prices means higher export prices and thus worse competitiveness. Third, he argument the US needs China to fund its deficit is also incorrect (see our many posts on modern monetary theory or MMT; the constraint on spending is inflation, which is no where in sight right now, in fact, the Fed is so desperate to create some inflation that it is about to embark on QE).

There are plenty of reasons not to like QE (see our earlier post for a good recap) and we are not fans. But if the reasoning below is widely shared within China, it says China is asserting that the US has downside that the US does not believe it has. So the US is not likely to be deterred, and per above, the US believes it can impose costs on China regardless (worsening its terms of trade).

Now despite the Fed winking and nodding about QE2, the Fed was very slow to act in the crisis, then overreacted, and there isn’t much reason to expect a change in behavior. But the contrast between the Western assessment of the benefits and costs of currency depreciation versus the Chinese stance (at least as presented below) suggests we are indeed on a collision course.

By Yiping Huang, Professor of Economics at the China Center for Economic Research, Peking University. Cross-posted from VoxEU.

The ongoing global imbalance has strengthened calls for the US to declare trade war with China. This column argues that the US did not emerge victorious from the last currency war with Japan, and against China the chances are even slimmer. Instead the upcoming G20 meeting should focus on a broad range of structural adjustments from both sides.

A new currency war is looming. The US Congress has already passed a bill for imposing currency import tariffs, although becoming an actual policy is still a long shot. Tim Geithner is urging the IMF and the international community to play more active roles in promoting more flexible exchange-rate regimes. Martin Wolf, following up the ideas of Gros (2010), prefers capital market restrictions, such as preventing China from purchasing US Treasury bills, as a way of avoiding trade sanctions the fight with ‘stubborn’ China (Wolf 2010). Fred Bergsten proposed countervailing currency intervention for the US to sell dollars to offset China’s intervention in foreign exchange markets (Bergsten 2010). And Paul Krugman has long advised the US government to declare trade war with China (Krugman 2010a, 2010b).

The upcoming G20 Summit in Seoul could potentially become a battlefield of a new currency war. Geithner already indicated earlier his intention of using G20 to pressure China for faster currency appreciation. After all, global rebalancing was one of the policy items identified by G20 leaders from the very beginning. But it remains unclear about the best approach for G20 to deal with the imbalance problem. Economist Bill Cline proposed a new Plaza arrangement several years ago (see Cline 2005). Current discussions indicate that some major deficit countries hope for G20 to move in that direction. Like its predecessor, a Plaza Accord II could demand substantial appreciation of currencies in major surplus economies like China, Japan, Germany, and oil exporting countries.

In order to predict likely forms and outcomes of a new currency war, we need to address the following four questions.

  • Would most G20 members support a Plaza II or a currency war against China, Japan, and other surplus countries?
  • How would the US and its close allies like UK fight this new currency war?
  • Are flexible exchange rates sufficient conditions for resolving the imbalance problems?
  • What would be the best strategy for G20 for the purpose of global rebalancing?

Let’s take these issues one by one.

The Plaza Accord was signed by G5 – major deficit countries of UK and US, major surplus countries of Germany and Japan, and France. A replay, however, is highly unlikely within the G20. While the US may be a strong supporter of some forms of Plaza II, the positions within the European Union may vary, from large deficit countries like UK to large surplus countries like Germany.

Given its previous experiences, Japan will probably be very reluctant to sign Plaza II. And Japan is one of the biggest beneficiaries of economic boom in China. Most importantly, China is not Japan. China will never let the US to force upon it any currency decisions. Other Asian members of G20 like Korea and Indonesia are also running current-account surpluses. So to start with, US and UK probably won’t be able to find enough G20 members to sign a new Plaza arrangement.

But that’s not the end of the story. If a war didn’t break out in the meeting rooms of the G20 Summit, the US still has the option of taking China and other major surplus countries to war alone, or with a couple of its close allies. And there are already enough weapons suggested for the US to use, including import tariffs, countervailing intervention, and capital market restrictions.

The trouble, however, is that all these measures are impractical.

  • Taking import tariffs threatened by the US Congress as an example, even if the US survives the potential WTO rulings, such protectionism measures would mean much more expensive consumer goods and much higher inflation in the US. Is the US prepared to accept these consequences, without necessarily adding jobs?
  • The so-called countervailing intervention probably won’t work, either, at least for China.

Bergsten’s idea is that the US should sell dollars to offset China’s intervention in foreign exchange market. For this to work, the US would have to sell dollars and buy renminbi. But this is impossible given China’s capital-account controls. Where would the US authorities find renminbi?

  • The proposal to prevent China from purchasing the US Treasury bills is somehow ironic. Even if the US is able to ban China in the primary market of the Treasury bills, it has no effective way of stopping China from accessing to the secondary markets.

More importantly, China and Japan each accounts for more than 20% of the Treasury market. Does the US really have stomach for this given its gigantic fiscal problems?

A fundamental issue we need to understand is the importance of exchange-rate regimes for external imbalances. Does currency matter? Of course, it does. Exchange rate is price of one currency relative to another. An undervalued currency promotes exports, inhibits imports and, therefore, improves trade balance. Thus a more flexible exchange rate should be preferred, especially for major imbalance economies.

But does the exchange rate hold all the keys to the imbalance problem? The answer is, definitely, no.

Lessons from Plaza I
Experts who are interested in Plaza II should first study carefully the experiences of the original Plaza Accord. The yen/dollar rate dropped from 250 in early 1985 to 150 in early 1988 and further to about 80 in mid-1995. But Japan’s current-account surpluses did not disappear.

Likewise, the real effective exchange rate of the US dollar fluctuated during the past three decades, but the US current-account deficits continued to climb, especially during the ten years preceding the global crisis. If the Plaza Accord did not achieve its original goal, why all of a sudden people became interested in this old idea again?

The US politics of beating the war drums
The truth is that it is driven more by political considerations than economic factors. American politicians should know that the US loss of manufacturing jobs over the past decades was caused mainly by changing comparative advantage. And the current high unemployment rate is a symptom of recession. Forcing China to revalue its currency, however, yields political benefits for these politicians – even if it does not yield economic benefits for America as a whole.

Sadly, if there were a Plaza II, it would not be based on rational economic calculation. The danger of politically driven process is that it is easy to over-kill. That could be extremely damaging for both the Chinese and American economies. Perhaps this was what Wen Jiabao worried about when he spoke of export and job implications of the exchange rate.

A better way forward
The G20 does have an important role to play in global rebalancing. But it is far better for focus on a comprehensive package centred on structural reforms in both surplus and deficit countries. Exchange rates should be an important part of that package. For instance, in order to reduce the current account deficits, the US has to raise its saving ratio. But simply devaluing the dollar would not be sufficient for that purpose.

Likewise, the current-account surpluses in China were caused by a broad set of distortions, especially in the factor markets. For instance, the currency may be undervalued, but the interest rates are probably also repressed. All these distortions in costs of labour, capital, land and resources artificially improve competitiveness of Chinese products in the international markets (Huang 2010). Therefore, correction of China’s external imbalances also requires elimination of all these distortions. If all these needed adjustments are concentrated on the currency alone, we could easily get over-sized exchange-rate adjustment and major adjustment difficulties for the real economy.

The good news is that rebalancing is already occurring. The US current-account deficits and Chinese surpluses, as shares of their respective GDPs, have both at least halved from their respective pre-crisis peaks. There might be some cyclical reasons for such correction, but the bulk of reductions of the imbalances were structural improvement and thus sustainable (Freund 2010). It’s surprising that none of the American politicians take notice of such improvement. It is perhaps even more disappointing that these important changes slipped the eyes of fame-chasing, not truth-seeking, commentators like Messrs. Bergsten, Wolf, and Krugman. Rebalancing needs to continue, but we have travelled some distance already.

In China, structural improvement also took place, mainly because of changes in factor markets. Factor costs are already rising across board, from wages to electricity tariffs. These have led to effective appreciation of renminbi, even though the nominal exchange rates were relatively stable (Xiaolian 2010). China’s official CPI is currently running at 3%-3.5% year-on-year. But most economists share a consensus view that the official rate is substantially underestimated. The month-on-month annualised rate, however, is already way above 7%. If we take this as the annual rate, then renminbi actually appreciates by more than 5% in real terms against currencies of most advanced economies.

These are the types of changes that the international community should encourage and the G20 agenda should focus on. A currency war could only lead to lose-lose situation. The US did not win the past currency war with Japan. It is less likely to win a new war with China.

Bergsten, Fred (2010), “We can fight fire with fire on the renminbi”, Financial Times, 3 October.

Cline, William R (2005), “The case for a new Plaza arrangement”, Policy Briefs in International Economics, Number PB05-4, Institute of International Economics, December.

Freund, Caroline (2010), “Adjustment in global imbalances and the future of trade growth”, in Stijn Claessens, Simon Evenett and Bernard Hoekman (eds.), Rebalancing the Global Economy: A Primer for Policymaking, A Publication, 23 June.

Gros, Daniel (2010), “How to avoid a trade war: A reciprocity requirement”,, 8 October.

Huang, Yiping (2010), “What caused China’s current account surplus?”, in Simon Evenett (ed.), The US-Sino Currency Dispute: New Insights from Economics, Politics and Law, A Publication, 15 April.

Krugman, Paul (2010a), “Chinese New Year”,, 1 January.

Krugman, Paul (2010b), “China’s Swan Song”, The New York Times, 11 March.

Wolf, Martin (2010), “How to fight the currency wars with stubborn China?”, Financial Times, 5 October.

Xiaolian, Hu (2010), “Coordinated relationship between factor price adjustments and exchange rate policy reform”, People’s Bank of China website, July.

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