The Global Think Tank - Click here to learn more...

Currency Wars

Uri Dadush, Vera Eidelman Carnegie Report, September 2011 Comments

Currency Wars In September 2010, Brazilian Finance Minister Guido Mantega shocked the world by launching the opening salvo in what he called a “currency war.” Mantega claimed that emerging markets were being squeezed by a combination of a depreciating U.S. dollar and an undervalued Chinese renminbi (RMB).

Only weeks later, French President Nicolas Sarkozy placed reform of the international monetary system atop the G20 agenda under France’s chairmanship, prompting the International Monetary Fund (IMF) and other organizations to launch a host of events and studies on the issue. Meanwhile, Congress renewed its bid for legislation to brand China as a currency manipulator, while China, Brazil, and other countries condemned the United States for its quantitative easing policies, claiming that their real purpose was to devalue the dollar.

Over the ten months that followed the ostensible eruption of the “currency wars,” Carnegie economists wrote a series of short articles, collected in this report, to address three questions: What is the nature of the problem that Mantega first brought to the world’s attention? What caused it? And, finally, what can be done about it?

The central message that emerges here is that the international monetary system performed well during an extraordinarily tumultuous time and does not need a major overhaul. The real cause of currency tensions lies in misguided domestic policies and the disequilibrium caused by the crisis in the reserve currency countries. One very important contributing factor is Chinese exceptionalism. China, the world’s largest exporter, is the only major trading nation to maintain a pegged and nonconvertible currency, and also remains almost entirely insulated from global financial markets. This situation requires reforms in China.

The implication is that reformers should focus on putting the reserve currency countries back on an even keel and on making China less exceptional. But, in fact, only incremental changes are needed in the international monetary system. In short, the rules of the game do not need a big change; rather, the big players need to raise their game. Until they do, no conceivable reform of the rules can provide stability.

We explore each of these ideas in the following articles, focusing on the performance of the international monetary system during the crisis in Part I, the tensions arising from the disequilibrium in the core countries in Part II, and the needed policy changes in Part III. A brief summary of each section follows.

Part I: The International Monetary System and the Financial Crisis

In contrast to its predecessors—the gold and dollar standards—the current international monetary system has served the global economy well, even in the most difficult of times. During the Great Recession—the worst downturn in seventy years—the system exhibited great flexibility and resilience. Countries with flexible exchange rates, which account for 80 percent of global gross domestic product (GDP), used them to good effect as shock absorbers. Several countries with pegged rates switched to more flexible regimes during the crisis and some switched back again when confidence returned. These changes were nearly always orderly, with most currencies following a common path against the dollar, which retained its safe-haven status despite the fact that the United States was at the epicenter of the crisis: Currencies depreciated against the dollar during the worst of the crisis and then appreciated again once it ended. Though some currencies saw large real appreciation, most remained in line with fundamentals; misalignments occurred in only a few instances, usually related to the dysfunctional institutional set-up of the eurozone monetary union. Overall, the global economy avoided the balance of payments crises and protectionist responses that characterized previous episodes of acute economic turmoil.

For these reasons, it is difficult to conclude that today’s exchange rate system is fundamentally flawed. At the same time, a number of undesirable developments and responses have occurred in the aftermath of the Great Recession: some developing countries have excessive reserves; several countries have reluctantly resorted to capital controls; a few countries, including Brazil, Switzerland, and Japan, have seen very large exchange rate appreciations; the eurozone is in deep crisis; and fear persists that global imbalances may widen again as the recovery progresses.

Part II: Tensions in the Core Countries

The roots of these problems, however, lie not in inadequate international exchange-rate arrangements, but in the fact that countries and regions holding the main reserve currencies—the United States, the eurozone, Japan, and the United Kingdom—are severely off balance: their output gap (actual versus potential GDP) is large, unemployment is high, public debt is soaring, monetary policy remains extremely loose, and divergences in economic performance and fiscal management within Europe have placed the survival of the euro itself in question. Not surprisingly, doubts about the soundness of these economies have big repercussions: No one welcomes currency appreciation when demand is weak and uncertainty reigns; nervousness about exchange-rate levels and competitiveness, and hot money flowing into emerging markets, are two of the most severe manifestations of the turmoil. At the same time, China’s extraordinary advances in world markets have compounded these fears, as perceptions that the remninbi is undervalued are widespread, and China’s capital controls have kept out inflows that are flooding other, much smaller developing economies.

Part III: Policy Challenges

In response to the sharp domestic imbalances that were the main cause and are now also the effect of the financial crisis that engulfed them, the reserve currency economies—beginning with the United States and the eurozone—are scrambling to find an international fix to their problems. It is often easier to place the focus on reducing “global” imbalances or on reform of the international monetary system than to recognize that the politically thorny solutions to their problems lie at home.

The United States’ fundamental problem is not a loss of competitiveness, and it will not be corrected by dollar devaluation—nor, as is more politically correct in Washington these days, by demands that China and other countries allow their currencies to appreciate. Instead, the United States must find ways to durably raise its household savings rate and reduce its budget deficit.

The eurozone must move faster toward fiscal and labor market integration in support of its single currency, while the countries in its periphery must accelerate their structural reforms and budget consolidation if they are to regain access to the government debt markets.

China cannot aspire to be both the world’s largest trading nation and largest economy while conducting itself as if it were an outsider to the international monetary system. It must move faster on the far-reaching reforms required to internationalize its currency, open its capital markets, and make the RMB more flexible.

All of these moves are necessary not only to ease currency tensions—which may be alleviated naturally as the reserve currency economies regain their footing and as the RMB plays an increasingly important role in international transactions—but also, and more important, to restore the health of the advanced economies and to make China’s growth more balanced and sustainable.

Meanwhile, any efforts to reform the international monetary system should recognize the resilience that the system exhibited during the crisis, and that the changes needed are incremental rather than revolutionary. These changes include encouraging more exchange-rate flexibility where appropriate, increasing the diversity of reserve holdings, and further expanding IMF resources and the organization’s surveillance role. While these improvements will make the international exchange rate system work more smoothly and help alleviate currency tensions, they are of secondary importance to the reforms needed in the major countries.

 

Comments

 
  • Report Abuse
Source: carnegieendowment.org/publications/index.cfm?fa=view&id=45559
Featured Event
Tuesday, June 7, 2011 Washington, D.C.

Power Implications of the 21st Century Economy

Within a generation, developing countries will likely account for six of the world’s seven largest economies and dominate world trade. How will this affect international relations and governance in the context of globalization?

Resources
More Related Events
Related Publications
 

Carnegie Resources

Quotes on Carnegie - Praise for the Global Think Tank
“[Carnegie is]…one of the centers of gravity of thinking about national security matters in our country.” – General Martin Dempsey, Chairman of the Joint Chiefs of Staff
“Carnegie remains a first-rate source of policy analysis and practical guidance on all the major international issues and I rely on the advice and counsel of many Carnegie scholars.” – John McCain, U.S. Senator
“The Carnegie Endowment has been a training ground for many of the all-stars in the State Department….” – Madeleine Albright, Former Secretary of State
“I appreciate its work in the area of peace.” – Kofi Annan, Former Secretary-General of the United Nations
“I cannot think of a better alignment of communication, information, and getting people together.” – Eric Schmidt, Executive Chairman of Google
“The Carnegie Endowment for International Peace is the #3 think tank in the world.” University of Pennsylvania 2011 Global Think Tank Rankings
“[T]his great vision of becoming a global think tank [is] badly needed in an interconnected world.” – Nicholas Burns, Undersecretary of State for Political Affairs
“One of the most globally trusted talking-shops.” The Economist
“The Carnegie Endowment for International Peace is the #3 think tank in the United States.” University of Pennsylvania 2011 Global Think Tank Rankings
“It is truly a global think tank…completely and appropriately reflective of the nature of the challenges that we face today.” – John Kerry, U.S. Senator
“A force for global peace and security for 100 years.” – John Brennan, Homeland Security Advisor
“An excellent institution that does important work to help establish stronger international laws and organizations.” – His Royal Highness Prince Turki Al-Faisal
“The Carnegie Moscow Center is the top think tank in Central and Eastern Europe.” University of Pennsylvania 2011 Global Think Tank Rankings
“The Carnegie Endowment…has for a century been dedicated to understanding and preventing war and its myriad causes.” – Robert Gates, U.S. Secretary of Defense
“The Carnegie Endowment is known on both sides of the aisle with great deal of respect for your active international engagement….” – Michael Turner, U.S. Congressman
“[This event is]… a testament to the success that you’ve had in transforming Carnegie… into a truly global think tank.” – Leon Panetta, U.S. Secretary of Defense
“The Carnegie Middle East Center is the top think tank in the Middle East and North Africa.” University of Pennsylvania 2011 Global Think Tank Rankings

From Carnegie's Global Network

The Syrian Opposition Needs a Political Strategy

Yezid Sayigh
Friday, May 11, 2012

The Syrian opposition will fail to bring about change unless it develops a clear transition plan and a credible political strategy for winning over key sectors in Syria.

Upcoming S&ED to be First Formal U.S.-China Dialogue Since “Pivot to Asia”

Paul Haenle, Chen Qi
Wednesday, March 28, 2012

The Strategic and Economic Dialogue, scheduled to be held in May 2012, will mark the first formal U.S.-China bilateral dialogue since the United States announced its strategic pivot to the Asia-Pacific region last year.

The EU’s Plan B for Ukraine

Olga Shumylo-Tapiola
Monday, May 14, 2012

Ukraine Relations between Ukraine and the EU have reached their lowest point yet. It could be time for the EU to come up with a new plan.

The No-Show

Dmitri Trenin
Friday, May 11, 2012

Putin Putin’s surprising decision to skip the G8 summit means that he is putting the stability of his power structure above his diplomatic engagements abroad.

Connect with Carnegie

Stay in the Know

Sign up for Carnegie announcements and publications—including Carnegie This Week—by filling out the form below. Note—fields marked with an asterisk (*) are required.

Personal Information
 
 
 
1779 Massachusetts Ave. NW Washington, DC 20036-2103 Phone: 202 483 7600 Fax: 202 483 1840