[OUTLOOK]The new exchange rate environment

At the conclusion of their meeting last month in Dubai, the Group of Seven finance ministers and central bank presidents issued a statement recommending flexibility in exchange rate policy. All six Western G-7 members already determine their exchange rate by market forces, and so the communique mainly referred to the currencies of Japan, the seventh member, and China, which is not a member. Since the statement’s issuance, the Japanese yen surged to a three-year high, and the Korean won appreciated along with the strong yen. The decline of the dollar provides murky prospects for Korea’s export competitiveness and overall economy for next year.
The dollar remained weak for 10 years after the Plaza accord in 1985 until the booming “new economy” helped the U.S. currency appreciate regardless of the U.S. trade deficits. Then the information technology bubble burst and the U.S. economy started to contract in 2001, followed by falling stock prices, low interest rates and a declining foreign direct investment inflow. These factors led to skepticism about the strong dollar. The shift toward a weaker dollar was implied from the beginning of the Bush administration during the tenure of Treasury Secretary Paul O’Neill. Mr. O’Neill’s successor, John Snow, hinted at the administration’s preference for a weak dollar when he asked Beijing to remove its exchange rate peg and revalue the yuan.
The U.S. trade deficit for 2003 is expected to exceed $500 billion, equal to about 5 percent of gross domestic product, and is on the rise. In contrast, Europe has kept its trade deficit within 1 percent of GDP, and Japan’s deficit is about 3 percent of GDP. The trade gains of developing countries in Asia would amount to about 7 percent of GDP. Statistics show that Asian nations’ dollar holdings are continuously rising. The combined foreign currency holdings of the central banks of Korea, Japan, China and Taiwan top $1 trillion. The four Asian nations invited the currency revaluation pressure by showing extraordinary growth in exports, but they had bought U.S Treasury bonds with their trade profits to offset the pressure. These circumstances explain how the United States could meet its capital needs without much effort.
To make up for the trade deficit, the United States requires about $2 billion in capital income each workday. Even if the U.S. economy grows faster than that of other industrialized countries, it would be hard for the United States to continuously provide the needed capital. The size of the public-sector debt is expected to be about 6 percent of GDP, and the burden would add pressure to the already slumping economy. If the “twin deficits” of the 1980s return, the consequent sudden fluctuation in the exchange rate would send shock waves throughout the world.
A revaluation of the yen would be an obstacle to Japan’s economic recovery, which started at the beginning of this year, as well as to its efforts to fight deflation. The Bank of Japan has sold $120 billion worth of yen in an effort to keep the exchange rate at 115 yen to the dollar, and as a result export-oriented companies, the mainstay of the Japanese economy, could maintain their profits. The Japanese government is expected to intervene in the foreign exchange market to keep the rate at 110 yen to the dollar.
China currently has $350 billion in foreign currency holdings, but that cannot justify the pressure on Beijing to remove the exchange rate peg or revalue the yuan. China’s huge holdings were formed by preventing capital from being exported, instead of exporting an excessive amount of Chinese products. Foreign currency flew into China as foreign companies made direct investments in the emerging economic giant. Unless China’s banking and financial sector is stabilized and reformed, fundamental neutralizing measures for capital export barriers would not provide a reasonable solution, as we have learned from the East Asian financial crisis in 1997 and 1998. Beijing should respond with gradual changes instead of a sudden revaluation or shift to a flexible exchange rate policy.
But in the run up to next year’s elections, the Bush administration will pressure its trade partners, especially Japan and China, to revalue their currencies to appease domestic manufacturers. A weak dollar is a trend that is likely to stay for a while. Countries that are pressured have no choice but to educate themselves to adapt to the new environment.

* The writer is a former senior presidential secretary for economic affairs. Translation by the JoongAng Daily staff.

by Kim Chong-in