Understanding the issue of Currency Wars

William Cline and John Williamson of Peterson Institute have a nice paper on the topic.

Many countries, including Brazil, China, India, Indonesia, Israel, Japan, Korea, Malaysia, the Philippines, Singapore, South Africa, Switzerland, Taiwan, and Thailand, are reported recently to have engaged in exchange market intervention and/or capital controls to curb currency appreciation.

There are fears that currency appreciation may be worsened by the additional quantitative easing (the so-called QE2) in the United States. Because many countries are simultaneously  seeking to improve their trade position, either (or both) because they regard themselves as short of aggregate demand or because their existing current account position  is weaker than they would wish, many countries are seeking a more competitive exchange rate. The laws of mathematics mean that some must be disappointed: A weaker exchange rate  of one country implies a stronger rate of some other country or countries. The questions are, Who is to accept this outcome and how will it be decided who that is to be?

The authors base their calculation on the fundamental equilibrium exchange rate (FEER) concept (need to read this). They calculate what FEER should be vs what it is. Based on this they calculate exchange rate misalignment (much like Big Mac index). So some countries like China, HongKong and Singapore have undervalued exchange rates (and hence need to appreciate) and some like India, Australia, Japan etc have overvalued exchange rates (and need to depreciate).

They then classify countries on the basis of intervention. Some countries have intervened to appreciate and some have not. No country has intervened to prevent depreciation which is a huge change from the earlier emerging market crisis where depreciation and its fears led to so much damage. From fear of floating currencies and depreciation the situation has changed to fear of appreciation  (Eduardo Levy-Yeyati and Federico  Sturzenegger wrote about this shift in 2007).

The authors  plot the countries on the basis of FEER and intervention  so far (see page 4 of the paper). We have following main points:

  • There are countries that have intervened to prevent appreciation but FEER shows undervalued currency – CHina, HK, Malaysia, Singapore, Taiwan etc. The intervention is unjustifiable.
  • There are countries that have intervened to prevent appreciation but FEER shows  currency in equilibrium – Argentina, Indonesia, Korea etc. Again, intervention is unjustifiable.
  • There are countries that have intervened to prevent appreciation but FEER shows  currency overvalued- India, japan, Brazil etc. Here , intervention is justifiable.
  • Then you have countries whose currency is in equilibrium and overvalued but have not intervened – Euroarea, Canada, Mexico, US, UK, NZ, Australia etc (mainly developed economies who have prefered not to intervene so far)

Hence, any discussion on currency war should classify countries in this manner. Based on above authors say:

Any agreement reached at Seoul to prevent an exchange rate war should be based on a distinction between countries
with overvalued and undervalued currencies and should be designed to seek appreciation of the latter but not to debar the former from actions to prevent a further magnification of disequilibrium.

Countries that are already overvalued on an effective basis—primarily floating emerging-market economies, but also Australia and New Zealand—should not be condemned for resisting further appreciation. The question is sometimes asked as to why a country with adequate reserves does not simply let the currency appreciate. The usual answer is that many countries, especially those not fully developed, desire to protect their export sector (so as to avoid succumbing to Dutch disease). This seems to us to be a legitimate reason.

The authors then take the analysis further and use James Meade analysis and classifies countries on the basis of whether they need internal balance or excess supply.

Most advanced economies are suffering from excess supply and need more demand where as emerging economies need to balance internally. As China is a country with undervalued exchange rates and also needs internal balance, it can contribute to world economy:

As discussed above, our analysis points clearly to the desirability of revaluation by China and a number of other East
Asian currencies. Since China lies on the IB curve, however, it needs to accompany revaluation by actions to stimulate domestic demand.

First, note that China has the potential to expand demand domestically. There are myriad unmet needs in China, in particular involving improved social security and public pensions (see Bergsten, Freeman, Lardy and Mitchell 2009, chapter 6). Increasing these might reduce private as well as public saving, insofar as private saving is motivated by precautionary considerations.

Second, note that a replacement of foreign demand by domestic demand could be expected to increase rather than reduce domestic employment. The effect on the growth of GDP is perhaps ambiguous, since it is widely believed that the growth of manufacturing has beneficent externalities

Third, note the presumption that welfare would increase, as current expenditure for the benefit of Chinese consumers would rise and replace the low-return accumulation of US securities. Fourth, note that this is exactly what is meant by “rebalancing” world demand.

The other part of what is required to rebalance world demand is a decline in US consumption (and that of other
deficit countries) relative to what was experienced in the precrisis years. This does not require a depression of consumption at the present time, since output is depressed below its full-potential level. But as and when US output recovers, it will have to undertake a similar contractionary fiscal policy to that already launched in many countries of Europe. This would seem a sensible quid pro quo for emerging-market economies to seek in Seoul.

Interesting analysis. Nice framework to think about the issue of currency wars.

One Response to “Understanding the issue of Currency Wars”

  1. Understanding the issue of Currency Wars « Mostly Economics » Best Forex Techniques Says:

    […] the original: Understanding the issue of Currency Wars « Mostly Economics Related Posts:Currency Wars and Rumors of Currency Wars : A PART OF NY “America is also pursuing […]

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