Efficient markets and exchange rates

Preference for market-determined exchange rates is not backed by evidence

After agreeing to a trade truce with China (“The global political economy”, April 21) on his recent visit to Europe for a Group of Seven summit meeting, US President Donald Trump opened another front in his global trade war: This time the enemy is Germany. (Incidentally, the truce with China has nothing to do with that country having agreed to register “Trump” as a brand name earning royalties for several high-priced goods and services to be sold in China, soon after Trump’s meeting with Chinese President Xi Jinping.) But this apart, Trump is right on one point: The US’ external trade deficit leads to lower domestic growth, output and employment. The other side is that surely one of the more important reasons underlying the deficit is an overvalued dollar whose exchange rate is market-determined and there are no capital controls. Eswar Prasad would approve of these policies (see “Prospect of China’s domination”, June 1) — and, by implication, its consequences in terms of growth and employment?

The origin of this preference for market-determined exchange rates and a liberal capital account is in the theory of market efficiency — that market-determined asset prices reflect all fundamentals, and allocate capital in such a way as to maximise returns. This is an integral part of the laissez faire ideology propagated by the so-called Chicago school of freshwater economists, founded by Milton Friedman. Empirical evidence does not support the theory as economists such as Robert Shiller, Stephen Golub, James Tobin and others have proved. Tobin had also proposed a tax on short-term, cross-border capital flows to curb the volatility of exchange rates. Powerful lobbies of banks, who make a lot of money from currency trading, made sure it went nowhere. 

Leaving aside technicalities, there are many examples of asset prices having nothing to do with fundamentals: From the tulip bulb mania in Amsterdam in the 17th century to Bitcoin, the artificial computer-created “crypto-currency” today. The latter has no intrinsic value, but the price more than doubled last year, and is up another 150 per cent so far this year (It is around $3,000, and the market capitalisation of the asset is close to $50 billion!) Gold is of course an age-old example. Tobin has argued that it derives value “almost wholly from guesses about the opinions of future speculations”. Keynes described man’s fascination with gold as a “barbaric relic of human irrationality”. As for allocative efficiency of markets, he saw little evidence that “investment policies which are most profitable” are socially desirable. This is surely true of exchange rates the role of which as a speculative asset now overshadows the original purpose as a means of exchange.
  

Another point I had made in last week’s article was Martin Jacques’ prophecy that China’s impact on the world will not be limited to the economy, but encompass ideology and culture as well; it may end the era of global dominance of the West. This possibility has become stronger after Trump withdrew from the Paris agreement on climate change to which most of the rest of the world subscribes. On climate issues, global leadership seems to be passing to Europe and China. On the question of a liberal capital account, both Paris and Berlin are far less enamoured of finance capital than London and Washington. With China joining them as a co-leader of the global economy, will capital controls and managed exchange rates once again become the norm?

To be sure, China’s rise in the global economy is unlikely to be in a straight line. There are two major question marks:

—The outsized banking sector with assets almost 300 per cent of gross domestic product and a huge shadow banking sector selling all kinds of investment products. Are there large, hidden problems in the asset quality?

—The pace of Chinese companies taking over businesses abroad reminds one of a similar spree by Japanese companies in the 1980s. Have Chinese entrepreneurs learnt from their Japanese counterparts’ experience then?

Tailpiece: Last week, one day after the media reported the debt servicing problems of Reliance Communications, a major international rating company downgraded its rating on the company. Surely, rating should be a leading, not lagging, indicator of a borrower’s financial health? Last week, the same agency was fined €1.24 million by the European Securities and Market Regulator for breach of regulations. Sadly, our policymakers plead with such companies, which so liberally distributed the coveted AAA ratings on thousands of mortgage-backed securities almost until the bubble burst in 2007, to improve India’s ratings.

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