Currency Management Needs Coordinated Action

Over the past two years, most currencies’ exchange-rates fluctuated at an unprecedented pace. This high volatility is due to two global policy responses to the 2008 crisis. First, borrowing is cheap. Paradoxically, more money was thrown at a problem generated by exceptionally low interest rates and poor financial regulation. Three years later, real rates are still negative in most countries across the world. There is plenty of liquidity out there. As a consequence, investors chase scarce opportunities (including currencies), but – given the fragility of global growth – money is withdrawn as soon as risks rise. In other words, excess liquidity in a frail macroeconomic environment creates foreign-exchange volatility. Second, in a crisis currency devaluation is an attractive alternative to cutting public spending. In most developed countries, fiscal consolidation risks hampering growth and causing another recession. Instead, depreciating the exchange rate is an easy way to spur exports, limit imports, attract investment and tourism, and create jobs. Today, the US, Europe and Japan – but also China, Brazil and Russia – would prefer a weak currency. Alas, competitive devaluation is not an option for the entire world economy: it cannot be done simultaneously by all. If everybody exports, who imports? Somebody has to buy.

Led by Asia, emerging markets – with their healthy balance sheets – are a candidate for sustaining global demand, and their exchange-rate choices are likely to be globally felt. Hence, the question on everybody’s mind: “how is Asia going to manage its currencies?”

Over the next two years, Asian countries are likely to keep a not-overvalued real exchange-rate. In order to contain volatility, minimize vulnerability to external shocks, maintain regional competitiveness in global markets, and sustain growth, Asian Central Banks will try to maintain exchange-rate stability without giving up monetary independence. To achieve this delicate balance, they are likely to avoid either “fixed” or “flexible” exchange-rate regimes – the so-called “corner solutions”.  A fixed exchange-rate (achieved via a currency union, a currency board or a hard peg) entails giving up monetary independence, while a flexible one (e.g., free-floating or managed float) brings about currency volatility. Asian policy makers want neither, and are likely to keep opting for “intermediate regimes”, by pegging their exchange-rates to the currencies of major trading partners (via basket pegs or crawling bands). Their goal is to maintain high domestic savings, and – as competitive exchange-rates increase demand for exports – enjoy current account surpluses. The resulting boost in import substitutes and aggregate demand accelerates investment and employment. China is the present-day example, but in recent years this was the case of high performing Asian economies (South Korea, Malaysia, and Thailand). Unfortunately, this is a status-quo-scenario, in which the lessons of the 2008 crisis are not learned and global imbalances are to persist.

Over the next three to five years, Asia will have to accept important – and inter-linked – developments: first, its currencies need to gradually move away from supporting the export-led model. The overall export strategy has to evolve: as the West reduces its borrowing and consumption, Asia will have to increase competitiveness via home-grown innovation – and not by managing currencies or technology transfers. Second, investors want emerging markets exposure. These fast-integrating markets are increasingly creating wealth and accumulating net claims on the rest of the world. From 1995 to 2010, emerging markets’ share of international trade rose from 30 to 45 percent. Today, one third of FDI flowing into emerging markets comes from other emerging markets. While in 1990 the developed economies held two thirds of total official foreign reserves, in 2010 it was the emerging markets that held two thirds of the total. Sovereign Wealth Funds have become a key source of international investment. All of this will translate into international demand for Asian currencies. Third, Asia – more established as a new world power – will have to increasingly accept its rising monetary responsibilities (but also enjoy the benefits). Regrettably, today there is an asymmetric distribution of benefits and costs: emerging markets have almost no role in the international monetary system, but they also don’t participate in “system maintenance”. Today’s negative real interest rates in most Asian countries are at odds with Asia taking monetary responsibility at the global level.

Ten years from now, the global financial system will have less national currencies (not all of the approximately 180 currencies existing today are likely to last), a few monetary zones of regional significance, and more than one reserve currency. The centrality of the US dollar in the global monetary system will be gradually re-appraised, as the greenback will have continued its downward trend against other major currencies and its position as a reserve currency will have slowly deteriorated. The Chinese Renminbi will incrementally be accepted in trade settlements and outbound investments. Managing such a multi-polar global economy will present serious challenges, unlikely to be solved with local policies. Firstly, the G-8 needs to allow a change in the geopolitical monetary hierarchy. Not a frictionless task. In turn, Asia needs to cooperate in global currency management, promote regional integration, and deepen its domestic bond markets. As the EU crisis shows, currency co-habitation and sovereignty do not mix (to avoid a Euro-breakup, national fiscal sovereignty will have to eventually be sacrificed). In sum, the system needs to be redesigned, and – as the new financial architecture needs coordinated global answers – a reformed IMF should play a key role in helping distribute costs and responsibilities. For Asia there are also clear benefits (not only the above mentioned costs): as the Renminbi becomes global, China will be able to enjoy the financial advantages of printing a reserve currency (seignorage, in economic jargon), domestic macro-economic autonomy, balance of payments flexibility (i.e., it will be able to run sustained current account deficits), low borrowing costs, and a financial markets hedge.

Prepared as supporting material for the session: “Currency Volatility: Balancing Flexibility and Stability”, World Economic Forum on East Asia, 2011.