Currency Wars in China

Currency Wars in China Background The design of the international monetary system at Bretton Woods involved the management of exchange rates by only the International Monetary Fund (IMF). Changes to this system were only permitted in the event that a nation was found to exhibit both internal and external imbalance in its exchange rate.Advertising We will write a custom report sample on Currency Wars in China specifically for you for only $16.05 $11/page Learn More The approval of these changes by the IMF was dependent on the nature of the reserve stock, whereby a fall in reserves beyond a set threshold resulted in devaluing or efforts to restrain demand. Additionally, the United States was responsible for maintenance of the gold convertibility of the dollar in return for its reserve purpose. One of the reasons for devaluation of the dollar against gold was the regulation by the IMF, which prevented other nations from matching it. However, in 1971, the Bretton Woods monetary system crumpled since the US was unable to sustain the gold convertibility. Subsequently, the primary powers in the 1970s began to float their currencies, though developing markets failed to cut their ties to the dollar. The IMF proposed that any exchange rate regime was allowed with the exception of pegging to gold, though no country followed these rules.1 Following the changes in monetary systems, the US proposed that countries floating their currencies ought to examine the interests of the nation whose currency they planned to use when intervening, though the currencies to which this process was applicable was not established. Nevertheless, the countries that established their own currencies viewed their pegging value as a sovereign decision that did not require the intervention of external parties, including the issuers of their reserve currencies. This independence made the countries overlook the need to conduct regular revaluations in order to identify with the Balassa-Samuelsonâ₠¬â„¢s deductions that rapidly growing nations need to increase their real exchange rates as a control measure to undervaluation from developing. Consequently, the exchange rates of fast growing economies became undervalued.2Advertising Looking for report on business economics? Let's see if we can help you! Get your first paper with 15% OFF Learn More Analysis of Exchange Rates The past few decades have witnessed a free-for-all exchange rate environment. During this time, the dollar has become a preferred currency owing to concerns regarding the European sovereign debt. Table 1 (in the appendix) reflects an easing of the dollar floating currencies following the re-evaluation of the vigor of the US recovery, as well as prospects arising from the expectation of new US monetary. The table indicates the calculated Fundamental equilibrium exchange rate (FEER) based on levels of real effective exchange rate indexes for 30 countries collected from the IMF’s W orld Economic Outlook (WEO) early 2000. The table also shows the changes needed to reach equilibrium for both May and October of the same year, following a constant FEER. The symbols in the final column are based on assumptions made for currencies that are undervalued (U), overvalued (O), or within 2.5% of equilibrium (E).3 From the table, it can be deduced that the United States is fast approaching equilibrium following the 5% reduction in the devaluation number obtained in May. China, on the other hand, has drifted further from equilibrium owing to its ballyhooed appreciation against the dollar since its ‘flexiblization’ in June, which has failed to compensate its depreciation against many other currencies. Other undervalued currencies in East Asian economies such as Malaysia, Taiwan, and Hong Kong have not changed between the quarters. A few currencies have been overvalued, such as the euro, yen, South African Rand, and Australian dollar, with some of these increasin g their overvaluation, such as the latter two. The exchange rate interventions pursued by different economies can be regarded as either antisocial or warranted. For instance, the efforts made by a nation to curb appreciation as a remedy for undervaluation of its currency can be considered as unjustifiable. Conversely, if that nation was overvalued relative to its FEER, then the same intervention would be regarded as fair and justified according to the cooperative international behavior.4 Table 2: country categorization by currency under or over valuation in October 2010 and exchange rate intervention in recent months Advertising We will write a custom report sample on Currency Wars in China specifically for you for only $16.05 $11/page Learn More Table 2, above, categorizes the countries in table 1 based on their exchange rate intervention. The groups include purchase of foreign currency to prevent appreciation, lack of intervention, and sale of foreign exc hange to prevent depreciation. Further classifications are made based on the countries’ exchange rate position relative to the FEER target. These are undervaluation, approximate equilibrium and overvaluation, as identified in the final column of table 1. Based on the data, it is evident that no country intervened to curb depreciation by selling its reserves, though most of them took measures to avert appreciation. Most of these intervention measures were made with the view to reducing international balances, such as interventions made by overvalued countries. However, the nations with undervalued currencies intervened in a vicious manner that is likely to increase the distortion in international imbalances, such as China. The economies that were close to their FEER value, such as Korea, also applied interventions to inhibit further appreciation, though this was not done in consideration of the international economy. There are a few countries that did not conduct any market in terventions; those in the 2nd row of table 2. These countries, including New Zealand and Canada, were overvalued.5 Data in table 2 is an indication of the numerous countries seeking interventions as a way to keep the exchange rate from moving further away from a level that is appropriate for external balance, with the exception of countries in the first row and column. Cline and Williamson note that is imprudent criticize countries for their interventions in an effort to stop inflation regardless of the condition of their economy. Most of the overvalued economies lie in the floating emerging-markets category, and they should not be criticized for preventing further appreciation. It is necessary for these developing countries to prevent the appreciation of the currencies, despite having sufficient reserves, in order to safeguard their export sector.6 Relevance of macroeconomic policies for equilibrium James Meade proposed the Meadean Theory in early 1950s. According to this theory, e very country’s macroeconomic policies are aimed at attaining internal balance (IB) and external balance (EB). The definition of these terms changed over the years, with that of IB transforming from the notion of an optimum level of employment output, to encompass inflation as well. In this regard, it was settled that IB referred to the level of unemployment at the natural rate, or the level of demand imposed by a Taylor Rule. EB, on the other hand, was considered as the constant level of reserves, owing to equilibrium between current account balance and exogenous flow of capital.Advertising Looking for report on business economics? Let's see if we can help you! Get your first paper with 15% OFF Learn More This assumption was changed by the identification of a variable, rate of interest, which was common to both flow of capital and current account balance. The definition of EB was also changed due to the awareness that the policy objective may be influenced to raise the reserve level for either self-insurance or as an indication of development. Since both industrial and developing countries can borrow or lend unlimited amounts, it is required that a country limits its current account deficits to a maximum of 4% of its GDP. The Meadean Theory was useful in establishing the IB and EB targets based on the control of exchange rates and the fiscal-monetary policy using expenditure-changing and expenditure-switching policies. The latter involves maintaining the level of demand and satisfying the need using products from another economy, which is influenced by exchange rates. Expenditure changing policies, on the other hand, influence total spending regardless of where it is spent, and are d ependent on fiscal and monetary policies, as well as the level of credit expansion. The theory holds that proper management of these policies should place an economy close to both IB and EB. As such, a country can be placed in one of four zones of disequilibrium as illustrated in figure 1 below. Figure 1: the four zones of disequilibrium The implication of the zone in which a country falls in is tabulated below. Action zone I Devalue Can either expand or contract demand zone II Can devalue, revalue or neither Should expand demand zone III Needs to revalue zone IV Can either devalue (to approach EB) or revalue (to approach IB) Should contract demand The left side of IB is characterized by a shortage of demand, which is characteristic of industrial countries like the US. In addition, these countries face challenges in increasing their fiscal due to the bond market. As such, they increase their monetary expansion. However, the exchange rates of most developed countrie s are close to equilibrium with overvaluations arising due to undervaluing of China. Australia and New Zealand do not fall in this category, and are instead placed to the right and above B on the IB curve in a similar manner to emerging market economies, which have strong demand and supply struggles, making them overvalued. These developing countries are overly reliant on the export sector to boost growth. The third group comprises developing countries like China that have profoundly controlled exchange rates. These economies are undervalued and have high levels of demand. Hence, they fall on the IB curve (towards the right due to excess demand), on the border between zones II and III.7 The situation with China The Chinese exchange rate policy has been put under question for the country’s involvement in currency manipulation through the investment of 50% of its GDP in currency reserves.8 The protectionist policy adopted by the Chinese government allows the country to subsidiz e production of its exports and import substitutes. The implications of this system on global trade are enormous mainly because China is the biggest exporter in the World. The account deficit in the United States is partly due to the large Chinese surplus. The Chinese currency policies have influenced those of other economies since high-income nations, such as Japan, Germany and the US, cannot make good use of the extra earnings in the developing countries. For such high-income nations to exhibit rational household sectors and fiscal discipline, they need to increase their investments and establish a current account surplus. Since some of these economies are already in the practice of continued savings surplus, it is possible to return to stable growth in the world economy by jointly establishing a substantial current account. The macroeconomic challenges posed by China are due to its dynamic and solvent nature as a developing economy. Additionally, China is well capable of changing the current surplus towards deficit by $300bn a year, with insignificant risk.9 Figure 2: charts showing China’s exchange rates, current account, trade and foreign exchange reserves from 2000 to 2010.10 Resolving the situation and returning the balance of the world economy requires China to take up various measures including modifications of the Chinese nominal exchange rate. Such a strategy would involve an increment in inflation that would adjust relative prices. However, inflation would also increase domestic changing with respect to relative output. As such, adjustments to the exchange rate should be complemented with the inclusion of a â€Å"cap on the intervention to stop sterilization of the monetary consequences and targets for real domestic demand, household consumption and the current account†.11 Such structural adjustments to the Chinese economy would be in order, so as to prevent escalation of exchange rates that would destroy the export industry, as well as to evade the trap posed by belligerent credit extension to enhance domestic spending relative to output.12 While there appears to be a solution, the problem lies in that China is the one with the responsibility of modifying its policies. As such, experts suggest that the Group of 20 leading (G-20) countries should join forces in persuading China to enact these changes. In the event of complete failure of such efforts, there are other alternatives such as surcharging imports or capital account reciprocity. The latter involves the concerned nations inhibiting other â€Å"countries from purchasing their financial instruments, unless these countries provided reciprocal access to their financial markets†.13 However, this attack on trade is both a brutal strategy that involves discriminatory attacks on all imports, and a violation of the rules of the World Trade Organization (WTO), just to influence the Chinese. Hence, the proposal by the US for intervention in capital markets is observed as the better approach. This would involve the persuasion of Chinese to stop purchasing the liabilities of other countries provided it ensures tight regulations on capital inflows as a direct and proportionate way to open the market.14 Conclusion As discussed in the case for China, the modification of policies holds the solution to creating both internal and external balance. The implications of adjusting policies for the 30 countries are shown in table 3 in the appendix. Since China falls on the IB curve, it should combine revaluation with stimulation of domestic policies. This would involve enhancing social security and public pensions, while redirecting demand from capital-intensive manufacture to labor-intensive services to reduce private and public saving, and increase domestic employment, and subsequent demand, respectively. Some individuals are weary that a termination of Chinese purchases of US government bonds would crumble the latter, though experts suggest tha t the global private sector has the financial muscle to fill the void, and the position held by the dollar make this scenario highly improbable. In addition, a weaker dollar could yield a positive outcome.15 Economists suggest that a solution to the currency wars should reveal a world economy where the most dynamic economy is not the largest capital exporter. Considering that China has insured itself to a high level, it should adopt policies that transform its economy to a net importer in order to benefit both its citizens and the world. Bibliography Cline, R. William, and John Williamson. Policy Brief: Currency wars. Peterson Institute for International Economics, 2010: 1-11. Eichengreen, Barry. Currency War or International Policy Coordination? Berkeley: University of California, 2013. Eichengreen, Barry. Reshaping Tomorrow: Is South Asia Ready for the Big Leap? Managing Capital Inflows, (2011): 202-236. Gagnon, Joseph, Mathew Raskin, Julie Remache, and Brian Sack. The Financial M arket Effects of the Federal Reserves Large-Scale Asset Purchases. International Journal of Central Banking, 7 (2011): 3-43. Wolf, Martin. How to fight the currency wars with stubborn China. Financial Times, (2010): 1-2. Footnotes 1 Joseph Gagnon, Mathew Raskin, Julie Remache, and Brian Sack. The Financial Market Effects of the Federal Reserves Large-Scale Asset Purchases. International Journal of Central Banking, 7 (2011): 6. 2 Ibid. 10 3 William, Cline R. and John Williamson. Policy Brief: Currency wars. Peterson Institute for International Economics, (2010): 2. 4 Barry, Eichengreen. Currency War or International Policy Coordination? (Berkeley: University of California, 2013). 5 William, Cline R. and John Williamson. Peterson Institute for International Economics, (2010): 3 6 Ibid. 5 7 William, Cline R. and John Williamson. Peterson Institute for International Economics, (2010): 7 8 Martin, Wolf. How to fight the currency wars with stubborn China. Financial Times, (2010): 1. 9 Ibi d. 1 10 Ibid. 2 11 Ibid. 2 12 Eichengreen, Barry. Reshaping Tomorrow: Is South Asia Ready for the Big Leap? Managing Capital Inflows , (2011): 203 13 Martin, Wolf. Financial Times, (2010): 2. 14 Eichengreen, Barry. Managing Capital Inflows, (2011): 214. 15 Martin, Wolf. Financial Times, (2010): 2.