In September 2010, Brazilian Finance Minister Guido Mantega shocked the world by launching the opening salvo in what he called a “currency war”. Mantega claimed that emerging markets were being squeezed by a combination of a depreciating US dollar and an undervalued Chinese renminbi.
Only weeks later, French President Nicolas Sarkozy placed reform of the international monetary system atop the G20 agenda under France’s chairmanship, prompting the IMF and other organisations to launch a host of events and studies on the issue. Meanwhile, Congress renewed its bid for legislation to brand China as a currency manipulator, while China, Brazil, and other countries condemned the US for its quantitative easing policies, claiming that their real purpose was to devalue the dollar (see for instance, Evenett 2010 on this site).
In our recent report (Dadush and Eidelman 2011) we argue that the international monetary system has performed well during an extraordinarily tumultuous time and does not need a major overhaul. The real cause of currency tensions lies in misguided domestic policies and the disequilibrium caused by the crisis in the reserve currency countries. One very important contributing factor is Chinese exceptionalism. China, the world’s largest exporter, is the only major trading nation to maintain a pegged and nonconvertible currency, and also remains almost entirely insulated from global financial markets. This situation requires reforms in China.
The implication is that reformers should focus on putting the reserve currency countries back on an even keel and on making China less exceptional. But, in fact, only incremental changes are needed in the international monetary system. In short, the rules of the game do not need a big change; rather, the big players need to raise their game. Until they do, no conceivable reform of the rules can provide stability.
The international monetary system and the financial crisis
In contrast to its predecessors – the gold and dollar standards – the current international monetary system has served the global economy well, even in the most difficult of times. During the Great Recession – the worst downturn in seventy years – the system exhibited great flexibility and resilience. Countries with flexible exchange rates, which account for 80% of global GDP, used them to good effect as shock absorbers. Several countries with pegged rates switched to more flexible regimes during the crisis and some switched back again when confidence returned. These changes were nearly always orderly, with most currencies following a common path against the dollar, which retained its safe-haven status despite the fact that the US was at the epicentre of the crisis: Currencies depreciated against the dollar during the worst of the crisis and then appreciated again once it ended. Though some currencies saw large real appreciation, most remained in line with fundamentals; misalignments occurred in only a few instances, usually related to the dysfunctional institutional set-up of the Eurozone monetary union. Overall, the global economy avoided the balance of payments crises and protectionist responses that characterised previous episodes of acute economic turmoil.
For these reasons, it is difficult to conclude that today’s exchange-rate system is fundamentally flawed. At the same time, a number of undesirable developments and responses have occurred in the aftermath of the Great Recession:
Some developing countries have excessive reserves;
Several countries have reluctantly resorted to capital controls;
A few countries, including Brazil, Switzerland, and Japan, have seen very large exchange-rate appreciations;
The Eurozone is in deep crisis; and
Fear persists that global imbalances may widen again.
Tensions in the core countries
The roots of these problems, however, lie not in inadequate international exchange-rate arrangements, but in the fact that countries and regions holding the main reserve currencies – the US, the Eurozone, Japan, and the United Kingdom – are severely off balance. Their output gap (actual versus potential GDP) is large, unemployment is high, public debt is soaring, monetary policy remains extremely loose, and divergences in economic performance and fiscal management within Europe have placed the survival of the euro itself in question. Not surprisingly, doubts about the soundness of these economies have big repercussions. No one welcomes currency appreciation when demand is weak and uncertainty reigns; nervousness about exchange-rate levels and competitiveness, and hot money flowing into emerging markets, are two of the most severe manifestations of the turmoil. At the same time, China’s extraordinary advances in world markets have compounded these fears, as perceptions that the renminbi is undervalued are widespread, and China’s capital controls have kept out inflows that are flooding other, much smaller developing economies.
In response to the sharp domestic imbalances that were the main cause and are now also the effect of the financial crisis that engulfed them, the reserve currency economies – beginning with the US and the Eurozone – are scrambling to find an international fix to their problems. It is often easier to place the focus on reducing ‘global’ imbalances or on reform of the international monetary system than to recognise that the politically thorny solutions to their problems lie at home.
The US’ fundamental problem is not a loss of competitiveness, and it will not be corrected by dollar devaluation – nor, as is more politically correct in Washington these days, by demands that China and other countries allow their currencies to appreciate. Instead, the US must find ways to durably raise its household savings rate and reduce its budget deficit.
The Eurozone must move faster toward fiscal and labour market integration in support of its single currency, while the countries in its periphery must accelerate their structural reforms and budget consolidation if they are to regain access to the government debt markets.
China cannot aspire to be both the world’s largest trading nation and largest economy while conducting itself as if it were an outsider to the international monetary system. It must move faster on the far-reaching reforms required to internationalise its currency, open its capital markets, and make the renminbi more flexible.
All of these moves are necessary not only to ease currency tensions – which may be alleviated naturally as the reserve currency economies regain their footing and as the renminbi plays an increasingly important role in international transactions – but also, and more importantly, to restore the health of the advanced economies and to make China’s growth more balanced and sustainable.
The international monetary system
Meanwhile, any efforts to reform the international monetary system should recognise the resilience that the system has shown during the crisis, and that the changes needed are incremental rather than revolutionary. These changes include encouraging more exchange-rate flexibility where appropriate, increasing the diversity of reserve holdings, and further expanding IMF resources and the organisation’s surveillance role. While these improvements will make the international exchange-rate system work more smoothly and help alleviate currency tensions, they are of secondary importance to the reforms needed in the major countries.
Dadush, Uri and Vera Eidelman (eds.) (2011), “Currency Wars”, Carnegie Endowment for International Peace.
Evenett, Simon (ed.) (2011), The US-Sino Currency dispute: New insights from Economics, Politics, and Law, A VoxEU.org Publication, 15 April.