[VIEWPOINT]Why the won should be revaluedThe United States is facing trade and current account deficits of $550 billion, about 5 percent of its gross domestic product. That deficit has increased by almost one percentage point of GDP in five of the last six years. As a result, the net foreign debt of the United States is now approaching $3 trillion and is rising by about 20 percent annually. The United States must import $4 billion of foreign capital every working day to finance the current account deficit and its own outward foreign investments.
The trade-weighted average exchange rate of the dollar rose by almost 40 percent from 1995 to early 2002. Every one percent rise in the dollar produces an increase of about $10 billion in the current account deficit. Hence, the currency’s large appreciation over this recent six-year period accounts for most of the present imbalance.
The situation is unsustainable in two senses. First, dollar overvaluation and growing external deficits have traditionally been the most accurate leading indicators of protectionist trade steps in the United States. Second, a hugely overvalued dollar will eventually fall sharply and substantially, risking serious disruption to both the U.S. and world economies.
Cutting the deficit roughly in half from current levels, to about $250 billion per year or 2.5 percent of GDP, would stabilize the ratio of U.S. foreign debt to GDP at 30-35 percent. This requires a decline in the average exchange rate of the dollar of about 30 percent from its peak level in early 2002.
The dollar has already begun to achieve that correction, declining by about 10 percent on average over the past year and a half in a very gradual and orderly manner. But this represents only about one third of the needed adjustment. The dollar needs to fall, against the average of other currencies, by about 20 percent more.
The decline of the dollar to date, moreover, has been very unbalanced among trading partners. It has dropped by about 40 percent against the euro and by about 20 percent against the Canadian dollar. But it has fallen only 10-15 percent against the yen and the won. It has not dropped at all against the renminbi because China pegs its currency to the dollar.
The next, and hopefully concluding, phase of the dollar’s adjustment must include the Asian currencies. The large Asian economies have run by far the world’s largest current account surpluses over the past few years, accumulating massive reserve levels of more than $550 billion in Japan, $350 billion in China and well over $100 billion in Taiwan and Korea. All these economies have intervened heavily, limiting the market’s desire to strengthen their currencies and thus the necessary downward adjustment of the dollar and the U.S. external deficit.
China is the key to the currency equation. By pegging to the dollar, the renminbi “rides the dollar down” when the U.S. currency falls and increases China’s competitiveness. Korea and other Asian countries are understandably reluctant to let their currencies rise against the dollar when doing so would produce an equivalent rise against the renminbi, the money of their toughest competitor.
Hence the United States and the finance ministers of the Group of Seven have called on China to let its currency rise. Calculations at our institute suggest that a renminbi appreciation of 20-25 percent would convert China’s modest global current account surplus into a modest deficit that could be readily financed by inflows of foreign direct investment and other private capital. We believe that China should achieve this appreciation through a one-shot revaluation of the renminbi, widen the band around its new parity and alter its peg from the dollar to a basket that also includes the euro and yen. This would be far more practical and desirable than floating its currency and opening its capital account, which would be distinctly premature in light of the continued fragility of its banking system and the lessons of the Asian financial crisis.
A renminbi revaluation of 20-25 percent would permit Korea, Taiwan and perhaps other Asian economies to participate constructively in the necessary global adjustment by letting their rates float upward by 10-15 percent against the dollar in response to the market forces that clearly want to push them in that direction. This would result in a depreciation of their currencies against the renminbi from present levels that would roughly match their appreciation against the dollar.
It would also be appropriate for the Japanese yen to rise further against the won and the Taiwan currency in light of Japan’s continuing huge global surpluses and massive reserve buildup. At its recent Dubai meeting, the G-7 also prodded Japan to let the yen appreciate, and it has done so to some extent. Hence the won might fall against the yen and indeed depreciate modestly on a trade-weighted basis.
The result of these changes would be a reduction of about $50 billion in the U.S. current account deficit, a downward shift of perhaps $30-40 billion in the Chinese current account position and small changes in the positions of the other Asian countries. The rest of the needed U.S. adjustment would come from the rise in the euro, the Canadian dollar and the currencies of other major U.S. trading partners. The Asian and other surplus countries will of course need to boost domestic demand to avoid adverse effects on their economic growth.
Korea would gain directly from the improvement in its competitive position with respect to China and probably Japan. It would benefit from the reduction in protectionist trade pressures in the United States and from the lower risk of a dollar crisis if the present overvaluation persisted.
* The writer is the director of the Institute for International Economics.
by C. Fred Bergsten