The threat of a currency war between the US and China is one of the main concerns for the G20 ahead of this month’s meeting in Seoul. This column say that while policymakers appear to grasp some of the issues, they underestimate the impact of quantitative easing by large economies on exchange rates worldwide.
The headlines shout “currency wars”. The US believes China engages in “currency manipulation”. The authorities hesitate to declare this to the US Congress, and the Secretary of the Treasury says “competitive non-appreciation” instead. China accuses the US of excessively loose monetary policy, flooding the world with liquidity. There is some truth in both charges, but some exaggeration.
This is one of the key issues facing the G20. Exchange-rate pressures, global imbalances and rebalancing, spillovers and the desirability of policy coordination – these are at the centre of the economic interdependence between the developed and emerging market countries. All this is in the context of weak US and European recoveries from the Great Recession, the risk of deflation, and the likelihood of more quantitative easing (QE) by major central banks. Domestic issues and inability to get direct action on exchange rates has led the US to propose internationally agreed targets for current-account imbalances. The wheel goes round – these proposals bear some resemblance to those of Keynes at Bretton Woods, which the US then opposed.
Need for an analytic framework
Policies such as these cannot be properly assessed without an analytic framework. In the current discussion, the furthest this has gone is evocation of the “trilemma”: the impossibility of simultaneously maintaining open capital markets, nominal exchange-rate stability, and monetary policy autonomy. (We hear little of the “inconsistent quartet”, which adds trade openness to these three – but protectionism is indeed a potential weapon in the currency wars, and we must not disregard that threat.)
While policymakers in both developed economies and emerging markets are aware of this trilemma, they are not fully conscious of the international repercussions of QE by the largest economies when they are at the zero lower bound for interest rates. This column will explore these issues.
The US dollar has already experienced a real effective exchange-rate depreciation of over 10% since early 2009, almost bringing it back to the low of early 2008. The Federal Reserve Bank of St. Louis has calculated that much of this is due to QE — the Fed’s $1.725 trillion asset purchases resulted in a 6.5% depreciation of the dollar (Neely 2010). The Bank of England has estimated that its QE resulted in a 4% depreciation of sterling (Joyce et al. 2010). So domestic QE does seem to have substantial international implications.
But the communiqué of 23 October 2010 by G20 finance ministers from their meeting in Gyeongju, while condemning “competitive devaluations”, avoids direct discussion of this spillover of monetary policy – which some might reasonably call a “competitive devaluation”: To quote the communiqué:
“Specifically, we will… continue with monetary policy which is appropriate to achieve price stability… move towards more market determined exchange rate systems that reflect underlying economic fundamentals and refrain from competitive devaluation of currencies. Advanced economies, including those with reserve currencies, will be vigilant against excess volatility and disorderly movements in exchange rates…”
This suggests that as long as QE does not lead to “disorderly” exchange rate changes, the monetary authorities can ignore its international effects. We shall examine whether this view is justified.