The G7 and Asian Currency Policies.
March 03 (Thursday) 2005
The focal point of attention before and during the London G7 Meeting is the question if Asian governments - and especially China - can finally be persuaded into accepting a weaker Dollar. Any currency related comment by American, European, and, for the first time, Chinese policy makers therefore drives speculative moves of Asian currencies - even though all G7 participants seem to agree that no major change in policy stance (and not even a mere change in the currency-related statement of last year's Florida-meeting) would emerge.
Basically, the seeming mismatch between market speculation and the apparent willingness (or ability) of governments to act is due to the fact that Asian governments have already started to accept a weaker Dollar, while deficit imbalances in the U.S. and growth deficits in the EU have not changed at all. From October 2004 alone, the Japanese Yen lost more than 7% against the Dollar, while the Korean Won gained more than 10%. Even the Taiwan Dollar gained more than 6%, despite its heavy management, its close links to the Yuan and the Dollar, and its high exposure to the Chinese and American economies. Even more remarkably, these appreciations unfolded at a time when the region saw their exports decreasing, their terms-of-trade deteriorating, and their economies slowing - while the U.S. economy kept growing strongly. Current speculative moves are therefore closely related to the changing position of the U.S. Dollar in Asia, and its likely destabilizing impact, and not the expected outcome of this week's G7 meeting.
China, on the other hand, entered the currency debate despite the fact that its government consistently argues that it needs to keep a stable Dollar-anchor to focus on the stabilization of its domestic economy, while the healing of worldwide disequilibria by revaluation remains beyond its policy reach. But behind only half-shut doors, even China started to contemplate revaluating its currency against the Dollar because it needs an additional instrument to effectively cool its overheated industrial sectors and regions. Its current policy instruments, which basically consist of ad-hoc ceilings for credit and regional investment restrictions, have not been effective enough and have started to hurt important foreign investors. At the same time, however, China's government is still shying away from the use of more conventional interest rate instruments, because it considers its banking system and financial markets as too underdeveloped to transmit interest rate signals effectively. Under such conditions, any interest rate hike is expected to hurt the fragile domestic household demand the most, while effects on the overheating investment and export sectors would be very limited. An alternative revaluation of the Yuan, with a possible move to a currency basket, on the other hand, would seem to be more effective - as long as it does not result in destabilizing capital flows, which would certainly overwhelm China's fragile financial sector. To be effective and credible, any revaluation of the Yuan would therefore need to be linked to further changes in Chinese market conditions, and not to outside (or speculative) pressure.
Given this fragile currency situation in Asia, increasing diplomatic pressure from the G7 on Asian governments would almost certainly do more harm than good. Even if Asian currencies would continue to revaluate, including a one-time appreciation of the Yuan, the likely outcome wouldn't be a stabilization of the Dollar or the Euro. On the contrary, Asian central banks would start to drive the Euro even higher, because they would simultaneously increase their diversification of central bank holdings into Euro reserves. Furthermore, even for the Dollar and the U.S. manufacturers the intermediate effect would not be much more positive, because Asian producers would most likely react to increasing deflationary pressures at home by triggering another round of export price wars.
At the London Meeting, it would therefore be better to let some steam off current debates about Asian currency revaluations. Instead, the G7 could follow the advice from Britain and Japan, and simply continue with the currency-related program of the last G7 meeting in Florida (but getting serious about it): increase saving rates in the U.S., growth rates in the EU, and exchange rate flexibility in Asia. As it looks today, Asia has already started to accept a lower Dollar. Now, the U.S. would have to present convincing plans for a reduction of its budget deficit, and the EU would have to produce some evidence about the effects of its famed market reforms.
But beyond such rather indirect encouragements (which might influence the world's currency relations only in the longer run), the G7 should certainly continue to shift its main focus from currency monitoring towards agreements on pressing economic issues from trade negotiations to disaster relieve and stabilization programs for developing countries. As a start in London, the G7 could kick-start the WTO Doha Round by putting pressure on food-importing developed countries, and by getting serious about debt relieve programs for Africa.