Exchange Rate Disorder

NEW YORK – Two troubling features of the ongoing economic recovery are the depressed nature of world trade and the early revival of international global payment imbalances. Estimates by the International Monetary Fund and the United Nations indicate that the volume of international trade in 2010 will still be 7% to 8% below its 2008 peak, while many or most countries, including industrial nations, are seeking to boost their current accounts.

Indeed, if we believe the IMF’s projections, the world economy’s accumulated current-account surpluses would increase by almost $1 trillion between 2009 and 2012! This is, of course, impossible, as surpluses and deficits must be in balance for the world economy as a whole. It simply reflects the recessionary (or deflationary) force of weak global demand hanging over the world economy.

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Under these conditions, export-led growth by major economies is a threat to the world economy. This is true for China, Germany (as French Finance Minister Christine Lagarde has consistently reminded her neighbor), Japan, and the United States.

Countries running surpluses must adopt expansionary policies and appreciate their currencies. More broadly, to the extent that major emerging-market countries will continue to lead the global recovery, they should reduce their current-account surpluses or even generate deficits to help, through increased imports, spread the benefits of their growth worldwide.

But, while that implies that emerging-market currencies must strengthen, disorderly appreciations would do more harm than good. To use an American saying, it might mean throwing out the baby (economic growth) with the bathwater (exchange rate appreciation).

Consider China, which accounts for the largest share by far of world trade among emerging economies. Real appreciation of the renminbi is necessary for a balanced world economic recovery. But disorderly appreciation may seriously affect China’s economic growth by disrupting its export industries, which would generate major adverse effects on all of East Asia.

China needs a major internal restructuring from exports and investments, its two engines of growth in past decades, to personal and government consumption (education, health, and social protection in the latter case). But this restructuring will tend to reduce, not increase, import demand, as exports and investment are much more import-intensive than consumption.

Moreover, a sharp appreciation of the renminbi could risk domestic deflation and a financial crisis. Chinese authorities certainly seem to have that interpretation of the roots of Japan’s malaise in mind as they seek to avoid rapid revaluation.

The only desirable scenario, therefore, is a Chinese economy that transmits its stimulus to the rest of the world mainly through rising imports generated by rapid economic growth (i.e., the income effect on import demand), rather than by exchange-rate appreciation (the substitution effect). This requires maintaining rapid growth while undertaking a major but necessarily gradual domestic restructuring, for which a smooth appreciation is much better suited.

Now consider other major emerging markets. Here currency appreciation is already taking place, pushed by massive capital inflows since the second quarter of 2009, and in some cases it can already be said to be excessive (for example, in Brazil).

These countries can, of course, resist upward pressure on their currencies by accumulating foreign-exchange reserves, like they did before the global financial crisis. The result is, of course, paradoxical: private funds that flow into these countries are recycled into US Treasury securities via investment of accumulated reserves. Why should emerging-market countries’ central banks undertake this peculiar financial intermediation, which represents a major cost, as the yield of private funds is higher than that of reserves?

The implication here is that relying on free movement of capital to achieve exchange-rate appreciation and current-account deficits may generate a myriad of problems, including slower economic growth and the threat of asset bubbles and financial crises of their own. So, a more orderly way to induce current-account deficits without risking disruption of emerging economies’ growth should be considered.

One solution (already advocated by some, including me, and adopted to some extent by a few countries) is broader use of capital-account regulations. Surprisingly, however, this issue has been entirely absent from current global debates on financial reform. Fortunately, the IMF opened the door to discussion of this issue in a recent staff position paper.

Equally important, a desirable global scenario is possibly one in which most developing countries run current-account deficits. But this requires major reforms in the global financial system to reduce the vulnerabilities that such deficits generated in the past, and that were reflected in major financial crises in the developing world.

These past crises gave rise to a form of “self-insurance” among developing countries through reserve accumulation. This helped many of them weather the recent storm, but it also contributed to global payments imbalances.

Recent IMF reforms are just a step in the direction of trying to create better financial instruments to help these countries. It is essential, in particular, to create reliable large-scale financing for developing countries during crises, through a mix of counter-cyclical issuance of SDRs and emergency financing without onerous conditions.