Guard against neo-mercantilism

If the IMF cannot be persuaded to enforce the 'scarce' currency clause on China and Germany, unilateral trade actions by the US would be justified

During the past two decades, China and Germany have followed neo-mercantilist policies through “exchange rate protection”. This involves maintaining an undervalued real exchange rate to generate a trade surplus, by indirectly subsidising exports and taxing imports (see Corden: Economic Policy, Exchange Rates, And the International System ps.37-38, 94-95). These trade surpluses, particularly of China, have been a concern in the US, just as those of Japan were in the 1980s. These were tackled by negotiating voluntary export restraints’ (VERs), by which Japanese exporters of cars and semi-conductors agreed to limit their exports to the US to a given quota. This implied that the implicit tariff embedded in the export quota (raising the price to US consumers) was collected by the exporters and not the US. This entailed a double welfare loss for US consumers: Through the raised price of the import, and the loss of the implicit tariff revenue to foreigners. From the 1990s onwards, the US has attempted to tackle the burgeoning Chinese current account surpluses by judgments of the US Treasury Secretary on whether China was manipulating its nominal exchange rate. To date China has been exonerated of such manipulation.

This is inappropriate as can be seen through the Australian model of the balance of payments. This was outlined for the Indian context in Lal, Bery and Pant: “The Real Exchange rate, Fiscal Deficits and Capital Flows — India: 1981-2000,” EPW, November 23, 2003, and “Erratum and Addendum,” EPW, April 16, 2005. In this model which integrates both real and monetary aspects for a small open economy, the crucial relative price is the real exchange rate (er): The ratio of the price of the non-traded good Pn (determined by domestic demand and supply) and that of the traded good Pt (determined by the world price P* and the nominal exchange rate (e*)). [So, er= Pn/e*Pt].

Illustration: Binay Sinha

It can be shown that, with a fixed nominal exchange rate, and fiscal cum monetary policy maintaining internal balance by equating domestic expenditure (E) with domestic output (Y), endogenous changes in the real exchange rate through a rise/fall in the price of the non-traded good will maintain external balance with no trade surplus or deficit. In a fully floating exchange rate regime changes in the nominal exchange rate can provide the needed change in the real exchange rate, without any change in the non-traded good’s price.

For exchange rate protection to generate a current account surplus, the real exchange rate will need to depreciate, and domestic expenditure would need to be less than domestic output (E<Y). This will lead from standard national income accounting to savings (S) being greater than investment (I): (S>I), and exports (X) being greater than imports (M): (X>M). This is how the “savings glut” and “global imbalances” of continuing international concern have arisen. In a fixed exchange rate system, the reduction in domestic expenditure will create an excess supply of the non-traded good and lead to its price to fall, and thence to the depreciation of the real exchange rate. This shows that attempts to look at “currency manipulation” by just looking at the nominal exchange rate are inappropriate. What is needed is an estimate of the contingent real exchange rate and to see its deviation from the equilibrium real exchange rate which maintains internal and external balance. There are few attempts to estimate real exchange rates because it requires price data on a myriad of goods (including those which are made non-traded by import quotas and tariffs) to estimate the price of the composite non-traded good (Pn). The alternative of using the real effective exchange (ep) which is reported by the IMF and the RBI as a proxy for (er) is also inappropriate, being based on purchasing power parity (ep), corrects the nominal exchange rate e* for the difference between the domestic and foreign price levels. But, as a proxy for the real exchange rate it is vitiated by the fact of only being equivalent (to er) if there are no non-traded goods in the economy! (see Lal, Bery, Pant, op. cit.)

This implies that the only way to judge if a country is engaging in exchange rate protection is to see if it is running consistent multilateral trade surpluses over a period of time. The table shows the current account balances of China and Germany since 2007. Clearly, both are indulging in real exchange rate protection.

But, as we saw, a complementary policy to generate trade surpluses from a depreciated real exchange rate is a deflationary macroeconomic policy keeping domestic expenditure (E) less than output (Y). This was also the worry the Bretton Woods architects faced about the balance of payments adjustment process they had endorsed in the adjustable peg currency system. Whereas countries with chronic current account deficits were required to maintain internal and external balance through macroeconomic policies of disabsorption, and expenditure switching through exchange rate depreciation, no such obligation was placed on current account surplus countries. The most egregious example of the consequences of this asymmetry was the treatment of the Club Med countries by Germany in the eurozone, when it entered the euro at a depreciated rate providing it exchange rate protection, whilst bullying deficit countries to deal with their debt and balance of payments crises with massive deflations — most notably in Greece.

This lacuna in the asymmetric adjustment burden of deficit countries when surplus countries failed to boost domestic demand was filled by the IMF’s article 7, the “scarce currency clause” (see my column “Global financial crisis II — Is protection next?” December 30, 2008). This allows deficit countries to restrict imports from a surplus country whose currency is declared “scarce” by the IMF, whilst maintaining unrestricted trade with everyone else (see Roy Harrod: The Dollar, p. 109).

The scarce currency clause has not so far been invoked, as during the post-war dollar shortage it would have been churlish for the deficit countries of Europe to have the dollar declared “scarce”, given the munificence of the US Marshall Plan in reviving their economies. When the US became a debtor in the 1960s, it did not want to penalise its “surplus” allies in the Cold War. Whilst since the opening up of China in the 1980s the US turned a blind eye to Chinese mercantilism, as it hoped that as China became rich it would also become a liberal democratic liberal country. This hope has been shattered, with China showing its true colours under President Xi, as an unreconstructed Leninist state using authoritarian state capitalism to challenge US global hegemony. As I argued in my March column, Chinese surpluses are now being used to create vassal states in a new Chinese “empire”.

President Trump seems to have understood the Chinese challenge. But, his trade strategy in dealing with the Chinese dragon would be greatly strengthened if he invoked the “scarce currency clause” to legalise his Chinese trade restrictions and allow them to become multilateral. Finally, to tackle the German surpluses the European Central Bank should be asked to adopt and enforce the IMF scarce currency clause. There have been various suggestions about alternatives to enforcing the “scarce” currency clause; surveyed in John Williamson: “Getting Surplus Countries to Adjust”, Policy Brief, PB11-01, Peterson Institute of International Economics, but they do not inspire much confidence. If the IMF cannot be persuaded to enforce the “scarce” currency clause on China and Germany, the Trump administration’s unilateral trade actions would be justified.