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A global currency war?
Monday, 18 October 2010 13:46

US Secretary of the Treasury, Tim Geithner, recently announced that there is no risk of a “global currency war” erupting.  But if you read his recent speeches, you can see that Geithner has launched a war cry at China!  Who will win?  That is the question! 


A bit of exchange rate theory

Before we examine this, let’s have a look at how exchange rates are determined.  The exchange rate is the price that links the domestic economy to international economy. 


In a steady-state equilibrium, most countries are either capital exporters or capital importers.  This is determined in the following way.  In a closed economy context – no openness to the world – some countries will have high domestic interest rates, and some will have low interest rates.  A country with high domestic interest rates might be a poorer country with low savings and low stocks of capital, and high investment opportunities, like Thailand.  A country with low domestic interest rates might be a rich country which already has high savings and high stocks of capital, but has saturated many of its investment opportunities. 


When these two countries open up to capital flows, world interest rates will be determined somewhere between the high and low levels, and capital will tend to flow from the low interest rate country to the high interest rate country.  In this steady state, each country’s debt or asset position will be a constant share of GDP.


So how do exchange rates start moving?  If there is ever a shock which increases or decreases the equilibrium debt or asset position, then markets will shift the exchange rate up or down to restore equilibrium.  While in reality exchange rates often have “bubble-and-crash” dynamics, this model is very helpful for looking at the US and China situation, and the tense relations between China and the US.


In short, it does not make economic sense for the US to be importing so much capital from the rest of the world, and for China to be exporting so much capital to the rest of the world.


Over to Geithner


Let’s come back to Geithner and his very forthright recent speech at the Brookings Institution.  What did he say?  


“… for the recovery to be sustainable, there must also be a change in the pattern of global growth.  For too long, many countries oriented their economies toward producing for export rather than consuming at home, counting on the United States to import many more of their goods and services than they bought of ours. 


The United States will do its part to achieve this adjustment.  Private savings have increased significantly, and, as the recovery strengthens, we will bring down our fiscal deficits to a sustainable level. 


But as America saves more, countries overly reliant on exports to us for their own growth will need to change their policies, or else global growth will slow and all of us will be worse off.  Countries that chronically run large surpluses need to undertake policies that will boost their domestic demand. 


… we believe it is very important to see more progress by the major emerging economies to more flexible, more market-oriented exchange rate systems.  This is particularly important for those countries whose currencies are significantly undervalued. 


This is a problem because when large economies with undervalued exchange rates act to keep the currency from appreciating, that encourages other countries to do the same. 


… This problem exposes once again the need for an effective multilateral mechanism to encourage economies running current account surpluses to abandon export-oriented policies, let their currencies appreciate, and strengthen domestic demand.  This is a necessary complement to the adjustments being undertaken by countries running current account deficits.  A cooperative rebalancing of policy in this direction would be better for overall growth.


… When the world's leaders met in London in April of 2009 and then in Pittsburgh in September that year … we agreed to give emerging economies a greater stake in the most important institutions for economic and financial cooperation, to increase the resources available to the international financial institutions, and to make the G-20 the centerpiece of cooperation, replacing the role traditionally played by the G-7.


We agreed to pursue these two paths in parallel.  Each involved a change in the rights and responsibilities of the major economies, both emerging and advanced. 

We have made some progress on the "Framework," but that achievement is at risk of being undermined by the limited extent of progress toward more domestic demand-led growth in the surplus countries and by the extent of foreign exchange intervention as countries with undervalued currencies lean against the pressures for appreciation.


On the governance front, we are now making progress toward agreement on a very important set of reforms to create a stronger IMF. … an agreement to modernize the governance of the IMF needs to be accompanied by more progress in encouraging countries, particularly the surplus countries, to pursue more market-oriented exchange rate policies and policies that will reduce reliance on exports and strengthen domestic demand.


.. We have moved aggressively to do our part to help bring the world out of crisis.  We are working very hard to repair our financial system, to fix what was broken, and to reduce the future risk of financial crises here at home.  We have seen a very significant increase in private savings by households.  Our external deficit has fallen sharply, and we are financing at home a much larger share of the fiscal deficits we inherited.”


The Chinese response


The speech of Zhou Xiaochuan, the Governor of the People’s Bank of China, to the recent IMF meeting shows how far apart the two sides are:


“The strong recovery in emerging markets has primarily benefited from bold reforms adopted before and during the crisis …  However, facing the global financial crisis, emerging markets also face many problems, including rising asset prices and asset values, external demand uncertainties, and volatile capital flows.  In particular, the continuation of extremely low interest rates and unconventional monetary policies by major reserve country issuers have created stark challenges for emerging market countries in the conduct of monetary policy.  In addition to continuing to press ahead with their own structural reforms, emerging markets also depend on global institutions to strengthen their surveillance and coordination of the macroeconomic policies of the major reserve currency issuers… 


At the same time, the early effects of structural adjustment began to appear, with a reduced surplus of current account in relation to GDP.  From January through August 2010, the trade surplus is down 14.7 per cent from the same period last year; reserve growth slowed down; and the financial system remained stable.  On June 19 of this year, China further advanced the reform of the Renminbi exchange rate mechanism to allow great flexibility. …


Although the overall trend in economic development looks good, China remains a developing country.  China’s gross domestic product per capita is only US$3,743, ranking its below the world’s top 100.  …


At present, the international community is attaching great importance to the Fund’s own reform process … its fundamental objective is to increase the voice and representation of emerging market and developing countries, so that quota shares of members are in line with their relative weights in the world economy. …


The impact of the current financial crisis illustrates that inappropriate fiscal, monetary, and financial sector policies of the developed countries, particularly those of reserve currency issuers, are more damaging to global economic growth, employment, trade, and the international monetary system, and the remedies for such failures are more difficult. … there must be conscientious strengthening of the surveillance of fiscal, monetary, financial, and structural policy, and the focus must no longer be exchange rate alone.  Second, surveillance must be fair and evenhanded.  The recent European sovereign debt crisis demonstrated that countries can trigger systemic risks, regardless of their size.  … “


Some concluding comments


Both Geithner and Zhou are right.  But the world economy depends great of both of them meeting each other half way, a compromise.  Let’s hope that after the US mid-term elections that they will do just that.





Williamson, John.  Exchange Rate Economics.  Working Paper No.2.  Commission on Growth and Economics.



Secretary of Treasury Timothy F. Geithner Remarks at the Brookings Institution



Statement by the Honorable Zhou Xiaochuan, Governor of the People’s Bank of China and Governor of the IMF for China at the Twenty-Second Meeting of the International and Monetary Financial Committee.  Washington, DC, October 9, 2010.


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