[Viewpoint] Currency chaos: IMF’s moment

Guido Mantega, Brazil’s finance minister, aptly captured the current monetary Zeitgeist when he spoke of a looming “currency war.” What had seemed like a bilateral dispute between the U.S. and China over the yuan’s rate has mutated into a general controversy over capital flows and currencies.

Today, every country seems to want to depreciate its currency.

China is resisting Western pressure to accelerate the snail-paced appreciation of the renminbi against the dollar. Emerging-market countries are turning to an array of techniques to discourage capital inflows or sterilize their effect on the exchange rate.

Only the euro zone seems to be bucking the trend, as the European Central Bank has allowed a rise in the short-term interest rate. But even the ECB cannot be indifferent to the risks of appreciation, because a strong euro may seriously complicate economic adjustment in countries like Spain, Portugal, Greece and Ireland.

Everyone cannot have a weak currency at the same time. Due to this fact, responsibility for preventing beggar-thy-neighbor depreciation was assigned to the IMF in 1944, whose Articles of Agreement mandate it to “exercise firm surveillance over the exchange-rate policies” of countries.

Given this mission, it would seem that the IMF should help extract concessions from China, and the rest of the world should declare a truce. However, doing so would ignore a fundamental asymmetry between advanced and emerging countries. Both have suffered from the crisis, but not in the same way.

The IMF also reckons that the advanced countries must cut spending or increase taxes by 9 percentage points of GDP on average over the current decade in order to bring the public debt ratio to 60 percent of GDP by 2030. Emerging countries, however, do not need any consolidation to keep their debt ratio at 40 percent of GDP.

Asymmetry of this magnitude requires a significant adjustment of prices. The price of the goods produced in the advanced countries (their real exchange rate) needs to depreciate vis-a-vis the emerging countries in order to compensate for the expected shortfall in internal demand.

In fact, this will happen whatever the exchange rate between currencies is.

The only difference is if exchange rates remain fixed, advanced countries will have to go through a protracted period of low inflation (or even deflation), which will make their debt burden even harder to bear, and emerging countries will have to enter an inflationary period as capital flows in, driving up reserves, increasing the money supply and ultimately boosting the price level. For both sides, it is more desirable to let the adjustment take place through changes in nominal exchange rates, which would help contain deflation in the north and inflation in the south.

But compared to July 2007, at the onset of the crisis, exchange rates between advanced and emerging countries have barely changed. While some currencies have risen and others have fallen, the adjustment that needs to take place is blocked.

For each central bank, the question is not what happens to emerging countries as a whole, but what happens to its own currency vis-a-vis competitors. So Brazil does not want to appreciate vis-a-vis other Latin American countries, Thailand does not want to appreciate vis-a-vis other Asian countries and no one wants to appreciate vis-a-vis China, fearing that renminbi appreciation would lead labor-intensive industries to migrate to Vietnam or Bangladesh. Thus, a change that is in everyone’s interest is hampered by lack of coordination.

Quantitative easing in advanced countries also raises the question of coordination. Quantitative easing is a legitimate monetary policy instrument, but the Fed and the Bank of England would probably not embrace it with such enthusiasm were it not for the anticipated exchange-rate depreciation. In fact, the ECB’s perceived reluctance to follow suit is likely to add to the expected growth effects of U.S. or British monetary-policy choices at the expense of the euro zone.

The controversy over China’s exchange-rate policy thus is no mere bilateral trade dispute, but rather a global macroeconomic clash between advanced and emerging countries. Moreover, the lack of coordination in both advanced and emerging countries suggests that the solution to currency wars is not to declare a truce, but to recognize the nature of the issue and overcome the problems that stand in the way of agreed common solutions.

This is not to say that the renminbi’s exchange rate is a secondary issue. On the contrary, its importance stems from the fact that China holds the key to global adjustment.

So now is the IMF’s moment. It should propose a conceptual framework for the discussions to be held on exchange-rate problems by providing objective assessments of needed adjustments, and by facilitating settlement within the multilateral framework. The IMF cannot substitute for governments’ choices, but it can help in the search for a solution.

*The writer is director of Bruegel, the European think tank.
Copyright: Project Syndicate, 2010.

By Jean Pisani-Ferry