By Aoyu Bai
In desperate hopes of reviving their economies, the world is playing a zero-sum game of currency devaluations.
Slowly the world is becoming a less welcoming place. As if to ready the public for the advent of another Cold War, a remake of the propaganda film Red Dawn was due to be released this November, this time featuring the cruel Chinese army invading and enslaving innocent American middle class families in the heartland. Luckily, MGM’s financial woes put the film in an Inception-style limbo. Far-right leaders from all over the world gathered in Japan this summer in what appeared to be an internationalization of the anti-globalization movement. Too often in history do nations turn on each other during difficult times, and during this economic downturn, they have begun an offensive of a different kind.
Bringing Economies Back from the Brink
Traditionally, there are two ways for the government to get its economy out of a recession. It can use monetary policy to lower interest rates to encourage lending, or use fiscal policy in the form of government spending to boost aggregate demand. But in a period filled with rock-bottom interest rates and record government debt, countries have creatively figured out a third way: reducing the value of their currency. This way, domestic producers flourish in foreign markets, as their exports are now cheaper to purchase. At the same time, imports become more expensive relative to domestically produced goods which gives domestic producers another advantage. So far, China, US, Japan, Brazil, South Korea, and Switzerland have all been in the news for government interventions in their currencies.
China has been the prominent case. By purchasing US debt, China supports the value of the dollar while its own currency, the yuan, stays low. Despite past speculations of yuan appreciation, most still believe that it is undervalued. There are also rigid controls on investments in the yuan, preventing foreign investors from pouring in capital which would force the yuan up. Unable to invest in fast-growing China, investors look to other emerging markets to invest their money, increasing pressure on their currencies to rise as well, and thereby compelling them to devalue their currencies. This month, Chinese Prime Minister Wen Jiabao announced plans to purchase Greek bonds in a show of confidence in Greece’s future. However, it will also help push the value of the yuan down relative to the euro.
The declining value of the US dollar is old news as well. After two wars and a financial crisis, America’s debt, accumulated over decades, has made many lose faith in its currency. Another prospective round of quantitative easing will push down the dollar even further, while pushing gold to new heights.
China has such a history of facing Western criticisms that defending itself has become a natural reflex. Amidst the controversy, Wen hit back, saying that letting the yuan appreciate would cut the razor-thin margins of Chinese export firms, create rampant unemployment for migrant workers, and cause massive social unrest. The Chinese government is weary of public discontent that will certainly arise if it is seen as bowing to US pressure to appreciate the yuan while hurting migrant workers who barely make a living churning out goods for Americans. While the average American increasingly fears the assertiveness of the Chinese government, the average Chinese is increasingly frustrated at their government’s inability to defend its national interests.
While China defends its currency policies, the US has always been on the offensive. Convinced that a low yuan subsidizes Chinese exports, the US Congress has repeatedly made loud political gestures and protectionist threats. Lately, the House of Representatives Ways and Means Committee backed the Currency Reform for Fair Trade Act, letting the US government estimate the extent of a country’s currency undervaluation to calculate countervailing duties against its exports.
With the spectre of midterm elections, US politicians are more desperate than ever to find a scapegoat for its sagging economy. Up until now, most of the hawkish moves were made by the Senate and House. As a large group of decision makers, an individual Senator or Representative can be seen as standing up to a country many Americans have begun to fear. But the negative consequences of protectionism will be divided over 100 Senators and hundreds more Representatives. There are many political points to be gained and virtually nothing to lose. The White House has found itself acting as the voice of reason. While bowing to the angers of the legislature, it is much more moderate on the international stage. Neither Obama nor Geitner wants to be blamed for a trade war with China as a result of discriminatory tariffs. But in an election season in which the Democrats are expected to suffer massive losses, the White House wants to do its part to appease public anger. Somehow, in the eyes of the American voter, Obama’s defense of free trade makes him a socialist.
At the same time, smaller players have also entered the game. Brazil, another emerging economy recently doubled a tax on foreign purchases of its bonds to reduce capital inflows that would pressure the real upwards. In September, the Bank of Japan sold the yen against the dollar in desperate hopes of propping up its declining export sector. However, most of the effects of this intervention have been neutralized by the market. Similarly, the Swiss National Bank made large purchases of euros this year, though it was mostly ineffective in preventing the appreciation of the Swiss franc. Indonesia, which has seen inflows due to high interest rates and strong economic growth, moved to purchase dollars, though the rupiah did not decline significantly either. South Korea’s move to depreciate the won will put it in an awkward position as it hosts the next G20 meeting in Seoul. The Bank of Thailand and the Reserve Bank of India have also indicated desires to intervene in the foreign exchange market.
Using exchange rates as a tactic to boost the economy is counterproductive, if not out-right dangerous. The foreign exchange market is a zero-sum game that can be best explained using the Nash Equilibrium. When one country devalues against another, it gains through the boost in exports and increased dominance in its domestic market due to the increase in prices of foreign producers. The other country loses for the same reasons. Therefore there is incentive for both countries to devalue, which results in the competitive depreciation of both currencies. But since the exchange rates are ratios, mutual depreciation accomplishes nothing but inflation and economic instability.
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The International Monetary Fund tried to broker a deal, though it had the same effectiveness the United Nations would in preventing a real war between China and the United States. Managing Director Dominique Strauss-Kahn suggested a moderate proposal for the yuan to appreciate slowly as a result of increased Chinese consumer demand. But with China and the US having the same clout in the IMF as they do being the permanent members of the Security Council in the UN, neither is likely to listen.
A Better Way Forward
China needs to let its currency appreciate to give its middle class a much needed boost in purchasing power. Instead of shoring up its foreign reserves, it should spend more to alleviate the sufferings of its poor, which still consists of a large portion of the population. Healthcare, welfare, education, and pensions are much more productive ways to invest money. It is about time China spends its surpluses feeding its poor instead of America’s rich. Its firms need to move away from low-cost exports up the value chain eventually. Now they have a good reason to do so.
At the same time, the US needs to accept that China’s currency is not the source of its entire deficit. If cheap Chinese goods are gone, cheap goods from other low-cost countries such as Vietnam will simply take their place. The problem of America’s trade deficit lies in its addiction to debt. The US cannot have it both ways. It needs China buying its debt if it wants to keep its spending streak, yet it also wants an appreciation of the yuan, which devalues China’s holdings. Massive spending in essential areas such as defense, healthcare, and social security needs to be reviewed. Eventually, America needs its own David Cameron to tell people they cannot live beyond their means.
All of political gesturing distracts from the fact that the successes of globalization all open economies into a symbiotic bond. Free trade has allowed a developed nation such as America prosper from foreign labour while allowing developing nations such as China grow from foreign demand and investment. All the successes of free trade resulted from nations combining their competitive advantages to create more wealth. While this symbiotic bond allowed each country to amplify their economic growth, it is during the darkest of times when they need each other more than ever.
Disclosure: No positions in stocks mentioned