Last week, I had argued that to consider external imbalances only a function of savings and investment is unrealistic since the latter variable is not independent of the exchange rate. An overvalued exchange rate encourages consumption, particularly of imported goods, reducing savings; contrarily, an undervalued exchange rate encourages savings.
Coming back to the market-determined vs managed exchange rates debate, let us put the issues in perspective. The global financial architecture, put in place in the Bretton Woods, prescribed fixed but adjustable parities, administered by the International Monetary Fund (IMF). IMF would agree to the adjustment in the event of a fundamental disequilibrium, that is, an unsustainable current account imbalance, thereby explicitly accepting the direct connection between the exchange rate and the current account, which has been downplayed in the G20 communiqués.
Even after the fixed rate system collapsed, there were attempts, particularly the Smithsonian Agreement of December 1971, to bring it back. But these did not work, thanks to capital movements that were freer than ever before — in other words, market-determined or floating exchange rates have not been the result of a deliberate policy. The Plaza Agreement in mid-1985 called for an appreciation of the yen and the Deutschemark against the dollar. The background was trade tensions and protectionist sentiments in the US, thanks to rising unemployment. The agreement explicitly accepted the link between exchange rates, current account imbalances and jobs.
There is, of course, an even more important corollary to floating exchange rates. The uncertainty adds to the risks of cross-border trade in goods and services and, indeed, cross-border investments by way of foreign direct investment, thereby militating against globalisation. To quote from an interview by Nobel laureate Robert Mundell (The Wall Street Journal, October 18), “The whole idea of having a free trade area when you have gyrating exchange rates doesn’t make sense at all... These currencies should be fixed, as they were under Bretton Woods or the gold standard. All this unnecessary noise, unnecessary uncertainty; it just confuses the ability to evaluate market prices.”
One wonders if it is the uncertainty about the exchange rates between the G3 currencies that is persuading more and more central banks, including our own, to look at gold as the store of value. For two decades, after 1980, central banks of developed countries were reducing their gold holdings. This has more or less stopped in the current century. In the last few years, central banks and sovereign wealth funds, particularly in Asia, are adding to their gold stocks — central banks as a group have become net buyers of gold for the first time since 1988. The correct solution is the removal of exchange rate uncertainties, not going back to gold, that “barbaric relic”. (Central banks going back to gold merely gives respectability to “commodities as an asset class”, a game indulged in by hedge funds and other speculators, the negative consequences of which have to be borne by all of us.) Money needs to once again become the store of value.
The perversity of the present market-determined exchange rate regime is underscored heavily by the consistent profitability of the so-called carry trade — borrowing in low-interest currencies to invest in high-interest currencies on an unhedged basis. (On a hedged basis, the trade is not profitable because the forward margin negates the interest differential.) On first principles, interest rates reflect the underlying inflation rates; and that high inflation currencies should depreciate against low-inflation currencies to maintain purchasing power. But the carry trade says otherwise. A more recent example: the dollar has appreciated against both the euro and the yen since mid-October, in the face of the on-going, and significant, monetary easing in the US. Clever bank dealers, who make money from floating rates, will provide plausible, and self-serving, economic logic for these phenomenon, but it is high time policy makers stopped falling for that.
Managing exchange rates will require controlling the cross-border movement, particularly of short-term capital. There are sound empirical reasons why this should be the preferred course of action. For one thing, the fastest growing Asian economies have seen no virtue in full convertibility of the domestic currency. Even IMF’s own research does not find any positive correlation between a liberal capital account and growth rate. On the other hand, every emerging market crisis in the last 20 years has been the result of overconfidence in the economy, substantial short-term capital inflows, an appreciating currency leading to ever increasing current account deficits until a crisis results. This has been the scenario in every developing country crisis since Mexico in 1994-95.
More broadly, policy makers need to ponder over a proper balance between the financial economy and the real economy. One hopes that a better consensus other than “more market-determined exchange rate systems” would be agreed upon without another crisis. Ominously, the Chinese current account surplus in Q3 doubled over the number a year back, to more than $100 billion.