Oriental mercantilists
Sep 18th 2003
From The Economist print edition
Asia's addiction to cheap currencies must end,But not overnight
THE average homeowner in Peoria has probably never heard of Toshihiko Fukui,Zhou
Xiachuan,Joseph Yam,Perng Fai-nan or Park Seung,But he has a lot to thank them for,These
men,respectively bosses of the central banks of Japan,China,Hong Kong,Taiwan and South
Korea,have become the world's most enthusiastic purchasers of American government debt,
including that of the mortgage giants,Freddie Mac and Fannie Mae,Their appetite for Freddie's
and Fannie's bonds keeps the dollar relatively strong,and mortgage rates in Peoria down,
Between them,these five Asian central banks hold
around $1.3 trillion in official reserves (or over half of
the global total),most of them in dollar assets,Since
December 2001,Japan's reserves have shot up by 36%,
China's by 65% and Taiwan's by 49% (see chart 10),
The Asians' passion for American bonds is explained by
their desire to stop their currencies appreciating against
the dollar,China and Hong Kong fix their currencies
against the dollar,in Hong Kong's case through a
currency board,That means a current-account surplus or
big capital inflows automatically translate into higher
reserves,The other countries ostensibly let their
currencies float,but heavy intervention by central banks
has ensured that Japan's yen and South Korea's won
have risen by over 13% against the dollar since the beginning of 2002,compared with a 25%
increase for the euro,another floating currency (see chart 11),
For the man from Peoria (and for America's economy),
this has brought a short-term benefit,The dollar's fall
over the past 18 months has been smaller and more
gradual than it would have been without the Asians'
intervention,The trouble is that the Asian dollar binge is
putting off the inevitable adjustment to America's
current-account deficit,America continues to accumulate
foreign debt at an ever faster rate,so the eventual
adjustment will be correspondingly bigger,At the same
time a disproportionate share of whatever decline in the
dollar does materialise falls on those countries that let
their currencies float,especially the euro,
Crying foul
Small wonder,therefore,that complaints about the
Asians' behaviour are getting louder,When Europe's
finance ministers met their Asian counterparts at a
summit in Bali in July,they made a fuss about those
weak currencies,America's Treasury secretary,John
Snow,went to China earlier this month specifically to
lobby for a change in the exchange-rate regime,And
tensions are rising within Asia itself,The Japanese are
unhappy about the undervaluation of China's currency,
and the South Korean government recently suggested
that China should allow the yuan to appreciate,
Broadly speaking,those complaints are justified,Asia's
currencies must play a part if the world is to stop relying
on the single American engine,But too many of Asia's
critics oversimplify both the dilemma facing the world
economy and the difficulties facing individual Asian countries,
In the short term,Asia's central banks are right to claim that they are supporting the world
economy,not undermining it,Were Mr Fukui and his friends to give up on American bonds
overnight,the dollar would plummet and bond prices would soar,To help the world economy,
the adjustment needs to be gradual—a point that is often lost on the shrillest foreign critics,
Second,Europeans,especially,tend to exaggerate how much they are suffering,True,the euro
has borne a disproportionate share of the dollar's adjustment so far,but without the Asians'
interventions the fall in the dollar would have been steeper,so in the short term the Europeans
may not be much worse off,The point is not that the Asians are harming the Europeans in
particular,but that they are preventing the adjustment of America's imbalances,making the
long-term problem worse,
Third,although Asia's central banks are all doing the same thing (buying dollars),their
economies are by no means all in the same boat,This suggests that no single solution will suit
everyone,
Too much of a good thing
Rising foreign-exchange reserves are not necessarily a bad thing,Countries need reserves to
guard against sudden shocks; say,a big drop in exports or an unexpected drying-up of foreign
lending,As economies grow,so the level of reserves tends to rise,In general,more open
economies need more reserves than those where foreign trade is less important; and those
with a fixed currency,such as China,need more reserves than those with a floating one,
Reserves are particularly important for emerging economies,As these countries open up to
foreign capital,they need relatively more reserves,That was one painful lesson of the 1997-98
Asian financial crises,when several emerging Asian economies turned out to have insufficient
reserves given their level of short-term foreign debt,
After these crises,Asia's emerging markets rapidly built up their arsenal of foreign exchange,
According to an analysis in the IMF's latest World Economic Outlook,this build-up was justified
by economic fundamentals until about 2001,Since early 2002,however,reserves have
rocketed and are now unnecessarily high,
The suspicion,therefore,is that Messrs Fukui,Zhou,Fai-nan and company have been buying
dollars for nefarious reasons,to keep their exports artificially cheap and hold on to their
traditional export-led growth,Exports now make up 64% of the region's GDP,up from 55% in
the early 1990s,Asians seem to like it that way,Yusuke Horiguchi,chief economist of the
Institute of International Finance and former top Asia expert at the IMF,talks of a,deeply
rooted mercantilist instinct” in Asia,with an almost religious attachment to trade and current-
account surpluses”,
But this passion for trade surpluses is not without its problems,Not only does it prevent Asians
from playing their part in rebalancing demand away from America,it also contravenes the rules
of world trade,The charter of the IMF prohibits a country from manipulating its currency to
“gain an unfair competitive advantage” over its trading partners,
The definition of manipulation includes protracted large-scale intervention in one direction in
the exchange markets,That sounds suspiciously like what the Asians have been doing,
Unfortunately there is no simple answer,because all the countries' problems are different,
Japan is by far the region's biggest economy,Unlike the others,it is a rich industrial country
which has been running a current-account surplus since 1981,It already has the largest dollar
reserves in the world,and is accumulating more at a rapid clip,All this suggests that Japan
should take the biggest share of any dollar adjustment in Asia,Yet,as the previous section
explained,the country suffers from chronic deflation,A sharp appreciation in its currency right
now could undermine any hope of boosting growth in the short term,On balance,therefore,
most analysts have concluded that a boost to Japanese demand will be more helpful to the
world economy than a stronger yen,On economic grounds that is the right choice,but
politically it will make it harder to persuade other Asian countries to let their currencies
appreciate,
Collectively,the other dollar-buyers in Asia pack an even bigger economic punch than Japan,
China,South Korea,Taiwan and the region's other emerging economies together account for
20% of world trade,compared with Japan's 5%,Their combined current-account surplus in
2002 was $133 billion,larger than Japan's ($113 billion) or the euro zone's ($72 billion),That is
why they must play a big part in any global economic adjustment,
China,in particular,is crucial,Leaving aside Japan,it is the region's giant,with by far the
fastest-growing economy and the biggest stash of reserves,Most Asian countries are terrified
that China will beat them on every product,so no country will allow its exchange rate to rise
unless China's does too,
China's currency,the yuan,has been fixed at 8.3 to the dollar since 1994,In the late 1990s
China's fixed currency won it many plaudits,As other currencies in Asia succumbed to financial
crises,the yuan remained stable (appreciating sharply against the rest of Asia),China was
credited with preventing a round of dangerous competitive devaluations,
Now,however,China's attachment to its fixed rate generates hostility,After years of fast
growth and huge inflows of foreign investment,claim the critics,the yuan should be stronger,
Instead,as the dollar has fallen over the past 18 months,the Chinese currency,in effect,has
fallen with it,Clearly,they say,the yuan is undervalued,
In evidence,they point out that,according to economic theory,exchange rates in countries
with rapid productivity growth should be appreciating,China's economy has been growing much
faster than the rest of the world,and its current account has been in surplus since 1994,For a
fast-growing emerging economy with high levels of investment,a current-account deficit would
be more normal,Moreover,capital is pouring into China,Last year it was the world's largest
recipient of foreign direct investment,with inflows totalling $53 billion,Like trade surpluses,
large capital inflows should push up the currency,Lastly,the huge and accelerating build-up of
reserves suggests that,left to its own devices,the yuan would appreciate,
Estimates of the degree of undervaluation differ wildly,According to The Economist's informal
measure of currencies,the Big Mac index,the yuan is undervalued by a whopping 56%,Ernest
Preeg,an economist at America's Manufacturers Alliance,argues that if normal market forces
applied,the yuan would rise by 40%,A recent study by UBS,a bank,put the figure around
20%,Others reckon it might be only 10-15%,
The problem is that traditional gauges of undervaluation do not work well in an economy with
tight capital controls and in the midst of colossal structural changes,Nobody can be sure that
China's currency really is grossly undervalued,And if it is,it may not remain so for long,
For a start,the scale of China's current-account surplus
is frequently exaggerated,Many Americans think it has a
huge overall surplus when in fact it has a large,and
rising,bilateral trade surplus with America,which is now
bigger than Japan's bilateral surplus (see chart 12),
China's overall current-account surplus,on the other
hand,is much smaller than Japan's,and is shrinking
fast,In the first few months of 2003,China's trade
balance was actually in deficit,
This may reflect temporary factors,higher oil prices in
advance of the Iraq war,and a one-off surge in imports
delayed to take advantage of tariff cuts introduced on
January 1st,But it may also reflect a longer-term trend
towards higher imports of capital and consumer goods,
China's imports have been growing at an annual rate of
over 40% a year recently,even faster than its exports
(30% plus),Many of those imports are inputs for exports,but not all,According to Nicholas
Lardy,a China expert at the Institute for International Economics,there are signs that imports
are being fuelled by rising domestic demand,Car imports,for instance,are up more than 60%
on last year,The big tariff cuts associated with China's entry into the WTO may push up import
growth even further,If Mr Lardy is right,and China's imports are set to grow rapidly even at
the current exchange rate,the case for a large appreciation looks weaker,
Evidence from the capital account must also be treated with caution,Yes,China has recently
been the world's biggest recipient of direct investment,but according to Mr Lardy,many capital
inflows have been speculative,and might easily reverse themselves,Chinese companies,
expecting a revaluation of the yuan,are bringing home money that they had illegally stashed
abroad,Mr Lardy reckons that these,unrecorded inflows” make up a big share of the recent
rise in reserves,
Those who call upon China to revalue also point to its highly controlled capital account and its
distorted financial markets,A good dose of deregulation,they say,would break China's
mercantilist plot,But they may be overstating their case,One result of China's capital controls
is that its citizens and firms cannot legally keep their money abroad,but must entrust it to the
country's troubled banking system,According to many China watchers,this means there is a
huge pent-up demand for foreign assets,
Andy Xie,an economist at Morgan Stanley,points out that Hong Kong residents hold an
average of $30,000 each in foreign currency,whereas in mainland China the figure is a mere
$100,If Chinese residents could hold more dollars,he argues,they would,Mr Lardy says that
the distribution of deposits in Chinese banks is highly skewed,A small number of rich people
account for a huge share of total deposits,These richer,more sophisticated Chinese,he argues,
would quickly shift to dollars if they could,so that whenever China gets round to loosening its
capital controls,it could see big capital outflows,The yuan might even fall,not rise,
In short,it is hard to determine whether the yuan is undervalued today,It is even harder to
determine how far,and in what direction,it should move in future as China becomes more
integrated into the world economy,
There is a much clearer argument for making China's currency more flexible,A flexible
exchange rate would allow the yuan to move as capital and trade conditions shifted,and would
give the government the monetary autonomy to deal with economic shocks,And indeed,China
says it is gradually moving towards a more flexible exchange-rate regime,But there are few
signs that this is really happening,The government is deeply worried about the instability that
might result,For some years it has derived its legitimacy,such as it is,from the country's
continuing economic boom,It fears that meddling with the currency could raise unemployment,
aggravate deflationary pressures and cause a meltdown in the banking system,
Many of these fears are overblown,especially those about deflation,True,prices in China until
recently were falling slightly,but much of that has to do with huge productivity improvements
and excess capacity in state-owned firms,not with overall economic stagnation,It is hard to
see how an economy growing at more than 7% a year can face a Japan-style deflation problem.
The price of stability
A fixed currency may bring stability,but at a price—to China as well as to the world economy,
Part of that price is the returns forgone when the Chinese authorities pile up mountains of
reserves,they are holding low-yielding American government debt rather than investing the
money more profitably at home,There is also the risk of financial distortion,As Alan Greenspan
recently pointed out,China's accumulation of reserves will eventually distort its monetary
system,As the central bank builds up reserves by buying dollars,it must pay out yuan,Either
this growth in the money supply is sterilised—which means selling domestic bonds to mop up
the excess liquidity,an increasingly expensive process—or domestic liquidity will rise rapidly,
which could overheat the economy and cause financial bubbles,Domestic credit has already
been soaring (relative to GDP,it was up 38% in the first half of 2003),leading to isolated
property bubbles and a string of financial scandals,The longer this continues,the higher the
risk of large-scale financial bubbles,
To avoid this,China's government has been trying to reduce pressure from the reserve build-
up,but without touching the yuan,It has slightly relaxed restrictions on residents' purchases of
foreign currency; allowed firms to keep a bigger share of their foreign-exchange earnings; and
announced plans to allow some Chinese firms to buy foreign bonds and stocks from later this
year,These tentative steps towards a more open financial system are worth taking,But they
should be accompanied by a move towards greater flexibility of the currency system,
This need not mean an immediate floating of the yuan,The currency could float freely only if
capital controls were substantially lifted,Given the parlous state of China's banks,such a big
bang would be far too risky,A main lesson of the Asian crisis,after all,was that financial
opening needs to be handled carefully,
Nor does re-pegging the yuan at a higher fixed rate seem a sensible option,For a start,nobody
really knows how much the yuan should rise,if at all,Besides,a new peg would do nothing to
prepare the exchange-rate regime for dealing with future economic shocks,
The best thing China can do—both for its own economy,and to help global economic
adjustment—is to tie the yuan to a broader basket of currencies,including the euro,and widen
the band within which it can move,Increasing the wiggle room would allow the yuan to
appreciate,making the global adjustment a bit easier,And by broadening the basket of
currencies,China would ensure that it did not simply follow the dollar when,as this survey
predicts,the greenback heads down further,
Drag the others along
If China were to move to a more flexible currency regime,the chances are that other emerging
economies in Asia too would let their currencies move within wider margins,These countries do
not face the risk of sudden capital flight or financial-sector collapse,Unlike China,they have
relatively sophisticated financial systems and freer capital flows,which suggests that they are
better placed to cope with stronger currencies,Politically,however,any movement without
China is impossible,China is not just perceived as a competitive threat by many Asian
economies; it is also their biggest export market,
In sum,the safest outcome in the next couple of years for emerging Asia,as well as for the
global economy,is not a huge jump in exchange rates,but a gradual strengthening,The world
economy will still be relying on Messrs Fukui,Zhou,Yam,Fai-nan and Seung to buy dollar
assets,but not quite so many of them,
If,on the other hand,China's leadership does nothing about the yuan,protectionist pressures
may become irresistible,particularly in America,That would be a disastrous outcome,for China
as much as for everyone else,
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