As the U.S. dollar is appreciating and beginning to reduce net exports, Democrats and Republicans are again talking about legislation to counter what they perceive as unfair currency undervaluation. The argument is that such “manipulation of exchange rates” allows some countries keep to their currencies artificially weak and thus unfairly make their exports more competitive.
These bipartisan efforts are promoted by the car industry and its supporters in labor unions and steel industry.
Washington sees currency manipulation as pervasive in China and several other large emerging economies. Conversely, many of the latter see the U.S. and other major advanced economies as the prime “currency manipulators.”
Since the aftermath of the global financial crisis, economies have deployed a mix of policy tools for competitive devaluation, including direct government intervention and capital controls, and indirectly quantitative easing.
The economic consequences of monetary divergence
As the U.S. is recovering but Europe and Japan are not, growth is decelerating in China, and the Federal Reserve is expected to hike the policy rate by the third quarter.
In the coming years, it is monetary divergence – the Fed’s impending hikes versus low rates and quantitative easing (QE) in Europe and Japan, and monetary easing in the East – that will make and break the wealth of nations.
In the new normal, the quest to label China and other emerging economies “currency manipulators” is not only misguided, but poorly timed.
After the global crisis, capital inflows boosted China’s large balance-of-payment surplus while the People’s Bank of China (PBOC) bought dollar-denominated assets seeking to contain upward pressures on the renminbi. This period peaked last July, when China’s foreign exchange reserves amounted to $4 trillion.
As U.S. monetary policy is reversing, so is the direction of China’s capital flows. With net capital outflows, China’s balance-of-payment surplus actually turned negative in late 2014. The PBOC did intervene but it did so to slow the renminbi’s depreciation. By January, the foreign exchange reserves had declined to $3.9 trillion.
The bottom line is simple. Even if there was a commonly accepted definition of “currency manipulation” and China would qualify as a “currency manipulator,” the free float of the renminbi would result in depreciation – not appreciation – under current market conditions.
The political motivations behind currency friction
For years, the Congress has expressed concerns with the potential impact of “currency manipulation” on international trade and the perceived failure of the international multilateral organizations to contain competitive devaluations.
The International Monetary Fund (IMF) has jurisdiction for exchange rate matters, but it cannot force a country to change its exchange rate policies. The World Trade Organization (WTO) is responsible for the rules governing international trade, but these do not seem to encompass currency manipulation. So the Congress is considering legislation to amend U.S. countervailing duty law.
In the emerging world, such unilateralism is readily seen as an attempt to sustain the hegemony of advanced nations in the world economy, which is changing, and the dominance of international multilateral organizations, which should be reformed faster.
At the local level, the bipartisan quest against currency manipulation is promoted by U.S. auto producers which have indicated opposition to the Trans-Pacific Partnership (TPP) unless the issue is effectively resolved. The quest is not philanthropic.
In the postwar era, when the U.S. still dominated the world economy, the auto industry, headquartered in the rapidly-growing Detroit, enjoyed huge profits. But by 2008, the industry would have collapsed without government support. Two years later, China supplanted the U.S. as the world’s largest auto market.
Today, America’s economic dominance has been halved, while world trade is dominated by exports from China and emerging economies. In 2013 Detroit suffered the largest municipal bankruptcy in U.S. history. Meanwhile, U.S. auto exports are hitting records, thanks to strong demand in Asia and the Middle East.
In the new normal, the car industry would prefer a weak U.S. dollar to further boost exports – hence the effort at renminbi appreciation, or the failure of the TPP, or both.
Currency wars déjà vu
As the recession exhausted the traditional instruments of monetary policy, central banks in the rich industrial countries opted for new rounds of quantitative easing (QE). And, with investors seeking higher returns, more QE drove “hot money” (short-term portfolio flows) into high-yield emerging-market economies, which contributed to inflation, appreciation and asset bubbles in Asia, Latin America, and elsewhere.
As I argued at the time, the effectiveness of rounds of QE would lessen over time, while the net effect would be a weaker dollar as speculators bet on its decline. In turn, successive waves of QE would debase the value of the dollar, thus helping to inflate away U.S. debts.
Meanwhile, developing countries were compelled to move in the opposite direction. After the Fed’s QE move, Brazilian Minister of Finance Guido Mantega blamed Washington for the “currency wars.”
True, a recovery in the U.S. would support global growth prospects (as long as American consumption would pick up), but the net effect of quantitative easing has been competitive devaluation – indirect currency manipulation.
A deepening global divide set the lingering U.S. economy against many emerging economies and commodity-producers. Now the latter are facing a “reverse déjà vu” that’s worse. After half a decade of “hot money” inflows, emerging economies must tackle disruptive capital outflows, while commodity producers face additional headwinds, thanks to the plunge of energy prices – not least due to U.S. shale gas.
Demise of the “exorbitant privilege”
Initially, the stated goal of the QE rounds was to strengthen the U.S. economy so that it would recover and continue to grow. In February 2014, the Fed began tapering its purchases, which were halted in the following October—but only after the Fed had accumulated $4.5 trillion in assets.
Despite much rhetoric of rebalancing and deleveraging, U.S. sovereign debt has not been reduced. Between 2008 and 2015, it doubled from $9 trillion to more than $18 trillion and exceeds the size of the American economy today.
The idea that currency wars ended a few years ago is naïve. They have barely begun – as exemplified by the interest rates in the advanced world.
Before the crisis year of 2008, U.S. policy rate still exceeded 4 percent. Assuming the first hike will ensue by the fall and subsequent hikes will follow incrementally, that level will not be restored until 2018-2020. Consequently, the U.S. is likely to benefit from low rates for a decade and from QE for half a decade.
In the absence of structural reforms, stagnation in America is currently being contained by historically low policy rates, excessive quantitative easing, and unsustainable leverage which, taken together, are causing a decade-long currency war. As a result, the catch-up of the emerging economies will prove far more challenging in the coming years.
In the emerging world, the new normal is unleashing questions about the global impact of quantitative easing and low interest rates in the advanced world, and the associated “collateral damage” in the emerging world.
Eventually, that will lead to even tougher questions about the “exorbitant privilege” of the U.S. dollar and the future of the international monetary system in an increasingly multipolar world economy.