Asian Production Networks: China's Exchange Rate Policies Could Hamper Their Growth

Oct.21.09 | About: iShares Asia (AIA)

by Brian Hoyt

There is an interesting article in Econbrowser by Willem Thorbecke of the Asian Development Bank, which looks at East Asian Production Networks, Global Imbalances, and Exchange Rate Coordination.

Thorbecke highlights the important relationship between exchange rates and production chains in East Asia, arguing for increased policy coordination between the two. The paper presents both good news and bad news regarding East Asia's crisis recovery. First, the good news:

Signs are emerging that East Asian production networks are reviving. Imports for processing and processed exports both collapsed earlier this year. Since then, however, imports for processing have recovered 85 percent of their losses and processed exports 75 percent. Thus trade within East Asian production networks is recovering.

However, currency markets may put an end to this growth. More specifically, China's crisis-inspired dollar peg may hamper this recovery by introducing excessive volatility to East Asia's production networks:

Exchange rate arrangements within the region may not allow this revival to be sustained. While many Asian countries have adopted greater exchange rate flexibility, China has returned to a de facto dollar peg. This implies that exchange rates between Asian countries have become very volatile...In a recent survey found that exchange rate stability between Asian currencies is essential for the uninterrupted flow of parts and components within regional production networks.

In addition, since Asian economies do not only cooperate within production networks but also compete in third markets, China's exchange rate peg puts pressure on other countries in the region to prevent their exchange rates from appreciating. If the renminbi is kept fixed, it becomes much harder for the huge surpluses generated within East Asian production networks to lead to a generalized appreciation of Asian currencies.

Asian production networks are highly dependent on exports to the US, Europe and Japan. The crisis has hampered the demand coming from these countries, which has led to a breakdown in East Asian industrial production, creating massive unemployment.

China has held down the value of the renminbi in order to increase its own industrial competitiveness and mitigate unemployment. This has adverse consequences not only for China's neighbors, but for China itself. Quite simply, by pegging the renminbi to the weakening dollar, China has introduced a short-term solution (boost exports via a cheaper currency) to a long term problem (global imbalances, weak domestic demand, and exchange rate-induced competitiveness).

Thorbecke calls for greater monetary coordination within the region in order to address the problems associated with Asia's export-led growth models:

A good policy mix for Asia would thus involve relatively stable intra-regional exchange rates that could appreciate together in response to regional trade surpluses combined with more spending on human capital. Stable exchange rates would help to strengthen regional production networks. Joint appreciations would prevent unpleasant outcomes such as beggar-thy-neighbor policies and excessive reserve accumulation while also reducing global imbalances and encouraging production for domestic markets.

Spending on human capital would facilitate technology transfer by allowing firms in developing Asia to become more involved in the engineering and design aspects of production. If Asian countries could climb the value chain in this way and focus on knowledge-intensive activities rather than assembly operations, not only would living standards in developing Asia rise but the region could become an engine of growth for the rest of the world

There is a certain irony that China has been the most vocal Asian critic of dollar depreciation, yet it is one of the few Asian countries whose currency has not absorbed any of the recent dollar weakness. It is hard not to see a contradiction: a weaker dollar is exactly what the US needs in order to produce a sustainable recovery, which will in turn help restore faith in the fiscal health of the American government, which will thus bring credibility to the health of the dollar. Ben Bernanke hinted at this on Monday in San Francisco.

The issue of reserve accumulation is becoming a serious concern (see Monday's post). The IMF is now looking for strategies to weaken the case for hording reserves. Deputy Managing Director John Lipsky said Monday:

We are exploring the possibility of improving our existing facilities or adding other insurance-like facilities that will give our members greater confidence that they don't need to self-insure by building up [foreign] reserves.

The easiest way to stop the trend of stockpiling reserves would be to simply allow the market to determine exchange rates. As Thorbecke's paper concludes, attempting to halt this process can be bad for your neighbors, bad for the global economy, and may even be bad for your own country.