[OUTLOOK]Currency adjustment talk is cheapAnyone who thought that South Korea’s impressive longer-term recovery from the Asian financial crisis would be without setbacks received a rude awakening last year. The collapse of the credit card boom and corporate governance problems contributed to a sharp fall in Korea’s economic growth in 2003 to less than half the 6 percent rate achieved in 2002. The International Monetary Fund forecasts that Korea’s growth should rebound this year to 5 percent plus, led by a surge in exports. But this depends on conditions being favorable in Korea’s major export markets. Roughly two-thirds of Korea’s exports go to the United States, the European Union, Japan and China. How the international adjustment process unfolds among the largest economies is therefore of major importance for Korea’s prospects.
Last month’s statement of G-7 finance ministers and central bank governors in Boca Raton, Florida reported that the global economic recovery has strengthened significantly and that risks have diminished. But a candid assessment suggests that some needed policy changes either are being rationalized away or delayed unduly, and that tensions in some policy areas are building.
In the United States, the current account deficit is projected to be about $540 billion this year ― just short of 5 percent of gross domestic product. A sustainable deficit would be about half that large. Given that investors prefer to hold the lion’s share of their wealth in domestic assets, continued dollar accumulation at the pace of the past few years will eventually meet increasing resistance. At that point, higher U.S. interest rates and/or a lower dollar will be required to restore equilibrium; if too sharp, such adjustments could usher in a hard landing for the U.S. economy, with adverse spillover effects on the rest of the world.
What is needed to make the U.S. current account deficit more sustainable is an improvement in the United States’ aggregate saving-investment balance and a further depreciation of the U.S. dollar. Yet the Bush administration continues to be in denial. It argues that the U.S. current account deficit is “very manageable,” that the post-2000 dramatic worsening of the U.S. fiscal position need not lead to wider current account deficits, that the Bush tax cuts should be made permanent, and that medium-term fiscal consolidation can be accomplished exclusively via expenditure restraint. None of these arguments is persuasive. Yes, the dollar has depreciated since its peak in early 2002 by about 15 percent on a real trade-weighted basis. But this is no more than half what would be required to reduce the U.S. current account deficit to a sustainable level. A further ― and more broadly based ― depreciation of the dollar is thus desirable. But how will this be accomplished without tears?
Since the dollar peak in February 2002, the euro has risen in real trade-weighted terms by over 20 percent. Euroland officials have begun to complain publicly about “excessive volatility” in exchange rates. No wonder. Euroland growth has averaged only about 1 percent over the past three years, the European Central Bank has been slow in reducing interest rates, structural reform efforts are meeting resistance, and currencies in some other surplus countries have not played their appropriate role in the global adjustment process. If the Europeans were to intervene forcefully to stop the decline in the dollar and if that intervention were effective, then the dollar decline would be halted before it did enough of its global adjustment job. Alternatively, if that exchange market intervention were ineffective, then the Europeans might become frustrated and could resort to more protectionist solutions.
Turning to Asian currencies, the recurring sound bite is that more “flexibility” of exchange rates is desirable. But since February 2002, only the Indonesian rupiah among Asian currencies has recorded more than a trivial real (trade-weighted) appreciation. The Chinese yuan has depreciated in real terms over this period by more than 10 percent ― and this in the face of surpluses on both the current and capital accounts, an overheated domestic economy, and excessive expansions in bank loans and broad monetary aggregates. The Korean won has been practically flat in real terms. If China and Japan continue to engage in large-scale, protracted exchange market intervention in one direction to maintain undervalued currencies, and if other Asian emerging economies are dissuaded from allowing appreciations for fear of losing competitiveness to China and Japan, neither a real dollar depreciation of the needed size nor a “fair” international sharing of the adjustment burden will be forthcoming. Undervalued exchange rates can also exact a heavy domestic price in terms of generating domestic financial instability.
To sum up, it is past time for the United States to put forward a credible medium-term plan for fiscal consolidation that includes both expenditure restraint and tax increases. Europe should move ahead with easier monetary policy and with an accelerated program of structural reform, while accepting some further rise in the euro. And Asian countries should accept their fair share of exchange rate appreciation. Talk in official communiques won’t get us there.
* The writer is a Dennis Weatherstone Senior Fellow at the Institute for International Economics, Washington, D.C.
by Morris Goldstein