<b>A V Rajwade:</b> 'Manipulated' and 'managed' exchange rates

The two terms are not synonymous, something US President Donald Trump should keep in mind

After he came into public life, the “extra-curricular” activities of President Donald Trump often reminded me of another famous “Don”, namely Don Juan the philanderer. During the election campaign and after his swearing-in as president, Trump’s fulminations against other countries, the justice system, the media, etc are comparable to Don Quixote, Cervantes’ famous 17th century creation, who saw enemies everywhere, was famous for tilting at windmills, and set out to bring justice to the world. In Trump’s case it is a question of bringing justice not so much to the world as to the United States. To quote one recent statement: “We’re taken advantage of by every nation in the world virtually. It’s not gonna happen any more.” He also considers the media “the enemy of the people”, one crime being criticism of his tweet about Sweden, which nobody understood and the press ridiculed. Shades of George Orwell’s 1984, and “Newspeak”? What a “leader of the free world” US voters have elected!

This apart, as far as the global economy is concerned, perhaps what is far more important is Trump’s threat to “punish” countries, which have a trade surplus with the United States. Some of the countries accused are Germany, Japan, China. He seems to believe this is the result of exchange rate “manipulation”. The euro and the yen are floating currencies and the exchange rate is “market-determined”. No wonder German authorities have described the accusation as “absurd”. The Japanese are more polite, at least in public. As for China, the yuan’s exchange rate is actively managed by the authorities. In fact, the yuan has been appreciated significantly against the dollar over the last decade. A couple of years back the country changed its policy and linked the exchange rate to a basket of currencies. Since then, the currency has fallen against the dollar, but that is more a reflection of the dollar’s appreciation against practically every currency. China’s external surplus has come down sharply as the country refocuses from exports to domestic consumption and investment.

While on the subject, it is worth emphasising that there is a difference between “managed” and “manipulated” exchange rates. While both involve active intervention in the market to target the exchange rate, “managed” is not synonymous with “manipulated”. As Joseph Gagnon argued in a 2012 paper: “Currency manipulation occurs when a government buys or sells foreign currency to push the exchange rate of its currency away from its equilibrium value or to prevent the exchange rate from moving towards its equilibrium value. The equilibrium value of a currency is that which is sustainable over the long run… An exchange rate is sustainable if the current account balance is not generating an explosive path for net foreign assets relative to both domestic and foreign wealth. Sustainability generally implies a small value of the current account balance, but fast-growing economies can maintain moderate current account deficits as long as the associated liabilities do not grow faster than their economic output.”

To be sure, it is not as if only Trump is ignorant of the issues in exchange rates and their impact. Even the “Free exchange” columnist made some strange arguments in The Economist dated February 11. One claim is that most governments “managed their exchange rates using massive piles of foreign exchange reserves”. The reality is that the “massive piles” are built by buying dollars in the market to stem currency appreciation — or to depreciate it. And reserves need to be used to halt currency depreciation. Another strange argument in the same column is that the “flow of investment income allows America to run persistent current account deficits, to buy more than it produces year after year, decade after decade”. Surely, investment income is included in current account numbers and does not compensate for the deficit? Again, “an overvalued currency and persistent trade deficit are fine for America’s consumers, but painful for its producers”. True, but they are also painful for the workers employed in the tradeables sector. It is also claimed that “the current account gap is a product of underlying financial flows”. It is more correct to say that capital flows are increasingly determining the exchange rates and it is the overvaluation that leads to a gap between external income and expenditure. What is needed is controls on capital flows so that the external account remains in reasonable balance on both flow and stock basis. But nobody talks about this.

The author is chairman, A V Rajwade & Co Pvt Ltd; avrajwade@gmail.com