Currency wars threaten global economy

12th October 2010

How quickly things change: global cooperation was meant to be the pillar upon which the financial and ensuing economic crisis would be overcome.

That initial show of togetherness at the height of the financial crisis, with developed countries joining forces with emerging ones, did not last long.

And nowhere is this parting of ways more evident than the ‘currency wars' now talking place.

Last week, as the BBC reported, Dominique Strauss-Kahn admitted as much, saying that countries were longer co-operating as well as they had during the financial crisis and that there were signs they were using their currencies as a powerful means of protecting their own interests.

Over the weekend an international meeting of finance ministers and central bankers broke up with no resolution. CNN reports Strauss-Kahn calling on countries not just to sign up to warm words but to take concrete steps. "The language is ineffective. The language is not going to change things. Policy has to be adapted," CNN says. The report includes a video interview with Strauss-Khan in the wake of the failed meeting.

Keith Wade, chief economist at Schroders says currencies have now clearly assumed critical importance in addressing global trade imbalances, borne out a "two-speed" world economy with developed countries struggling and emerging markets in Asia and Latin America bounding ahead.

On the developed side of the equation, growth in the US and Europe remains sluggish, and their policy makers are fast running out of options to stimulate their economies.

"With interest rates at rock bottom levels the exchange rate is seen as one tool that can be used to boost trade performance and take the economy forward. In the UK, Bank of England Governor Mervyn King has made no secret of the fact that the pound can play an important part in rebalancing the economy," says Wade.

The big problem is that the emerging countries, seen as being on the other side of the bargain by collectively running a large trade surplus, are unwilling to allow their currencies to rise.

And in this respect, all eyes are very much on China, which is accused of running a large trade surplus on the back of an undervalued yuan.

The US has been particularly aggressive with calls on China revalue its currency. Only last week, as The New York Times reports, US Treasury Secretary Timothy Geithner sought to secure stronger backing from his counterparts from Europe, Canada and Japan for Washington's attempts to get China to let its currency appreciate.

China now holds foreign exchange reserves of $2,250 billion, up 15% over just the past year. Wade says this rise in reserves reflects both the trade surplus and the investment capital which is currently pouring into the emerging markets.

"China is not alone in this; arrangements to fix or link currencies to the dollar are common across Asia. Foreign exchange reserves have soared across the region," he adds.

Wade hastens to point out, however, that this increase in foreign exchange reserves across emerging markets is not a new phenomenon: "Growth in Asia is based on an export led model which requires a competitive currency.

"Foreign exchange reserves have been rising for years. When the US and Europe were booming on the back of the credit boom this was not a problem as emerging countries fed the appetite of the western consumer.

"Today, though, it is a different story as consumers are focusing on repairing their balance sheets rather than shopping."

Looking ahead, Wade expects a gradual appreciation of the emerging currencies including the yuan. He warns, however, that while this will help the process of rebalancing the world economy, it is no panacea. This is partly because the benefit to the west will be limited in the short run as higher import prices will simply push up the costs of electronics and clothing. As a result, consumers will be poorer and inflation higher.

Also, he believes the long run effects of an appreciation of emerging currencies may be marginal as the competitiveness gap between China and economies like the UK is so vast.  

It is sobering indeed to note, for instance, that even after their recent strikes, as reported by the BBC, when Honda workers in China achieved a 25% pay rise, they still earned less than $3,500 a year. "Massive currency moves would be needed to close the cost gap even adjusting for productivity differences," says Wade.

In considering workable solutions to the growing currency crisis and trade imbalances, Wade concludes that if the UK and US are not going to start exporting cheap manufactures to Asia then the key to resolving the imbalances will be for China to open its markets in areas where there are clear needs which can be met by western companies: "As Chinese incomes rise the demand for services increases and this could well provide scope for a range of western products."

Unfortunately, he adds, such developments take time and in the meantime patience is running low: "Policymakers may surprise us but watch for currency wars to continue and protectionist pressure to build."

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