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Exchange rates and global rebalancing

Since the beginning of the fall, the Framework for Strong, Sustainable and Balanced Growth launched at the G20 meeting of Pittsburgh one year ago seems to have degenerated into a “currency war” whereby each country would like to enjoy a weak currency. The logic of the Pittsburgh framework was to engineer a rebalancing of world […]

By: Date: November 5, 2011 Topic: Global Economics & Governance

Since the beginning of the fall, the Framework for Strong, Sustainable and Balanced Growth launched at the G20 meeting of Pittsburgh one year ago seems to have degenerated into a “currency war” whereby each country would like to enjoy a weak currency.

The logic of the Pittsburgh framework was to engineer a rebalancing of world demand from the public to the private sector, and from deficit to surplus countries. Consistently, domestic demand would be boosted in countries like China, Germany or oil-exporting countries, whereas it would grow more slowly in the United States or the United Kingdom. An agnostic view was initially taken on exchange rates, since the aim was that of rebalancing, not of exchange-rate coordination.

True, the rebalancing of the global economy would be consistent with surplus countries experiencing an appreciation of their currencies in real terms and deficit ones experiencing depreciations. Furthermore, exchange-rate adjustments can be viewed as a by-product of the rebalancing itself: with increased domestic demand in surplus countries and reduced demand in deficit countries, relative prices would need to adjust, to avoid inflationary pressures in the former and deflation in the latter while allowing the non-traded good sectors to clear.

The Federal Reserve is not clear on how QE2 would fit in the global rebalancing agenda. If it intends to sustain US domestic demand through higher inflationary expectations (and thus lower real interest rates), then the US deficit is unlikely to be reduced. Alternatively, given the limited effectiveness of lowering the real interest rate when the private sector is engaging in massive deleveraging, the monetary easing may stimulate demand just through the foreign-exchange channel. In this case, the Fed policy would be consistent with reducing the US deficit, but not necessarily with global rebalancing.

So far, the US monetary stance has mainly triggered massive capital inflows in emerging countries. Part of these inflows are helping local entrepreneurs finance productive investments, hence participate in the rebalancing. But the bulk of it is feeding nascent credit and asset price bubbles which will not provide sustainable revival of domestic demand in these countries.

In one sense, China is the only G20 country that seems to be taking the G20 growth framework seriously. The problem is that it is responding through deep structural reforms, that will progressively encourage households and firms to reduce their savings rate, without considering a change in its exchange-rate policy. Growth policies are going to make the Chinese currency appreciate in real terms through wage and price adjustments. But these adjustments are usually slower than adjustments through the nominal exchange rate. This is going to take time, and it is not clear what country in the world can sustain global demand in the meantime.

Hence, the growth framework is being endangered today not by a fundamental disagreement on the way to go, but by differing horizons between the United States (who fear a double dip in the short run) and surplus countries (who have longer horizons in mind). The recent Fed announcements have themselves encouraged US partner countries to take a longer view, for instance through raising barriers against speculative capital inflows.

Yes, the dollar will need to be weak, but only as a result of higher savings in the United States. There was perhaps something to grasp in Geithner’s proposal to set limits in current account imbalances. A complementary idea would be for the IMF to set standards of foreign exchange reserve accumulation. To the extent that reserve accumulation substitutes for currency appreciation or capital controls, the IMF could help build a shared wisdom in terms of the appropriate combination of capital inflows, reserve accumulation, and real appreciation, depending on the development level of each country and on its current account. This could help circumvent the difficulty in setting standards on exchange rates themselves. It would also open a more constructive debate with surplus countries than the mere injunction to become less competitive.


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