The growing threat of trade and currency wars hung in the air at the IMF-World Bank Annual Meetings last weekend. The “global rebalancing” agenda—an initiative led by the United States and a few other countries to induce current account surplus economies to appreciate their currencies and import more goods and services—is having unintended but predictable consequences. The shared purpose that existed two years ago—when G20 economies partnered to stimulate global demand and rescue the financial system—has vanished, replaced by finger-pointing and admonitions.

In arguing so forcefully for “rebalancing,” the United States has always been on shaky ground. Here was the country responsible for the greatest consumption and construction binge in history declaring that things must change; that other countries should mend their ways, relying less on lending to the United States and more on their own spending; that U.S. exports would double in five years, and that the rest of the world’s currencies must appreciate to help out.

Meanwhile, the United States gave no signs of undertaking the painful long-term fiscal reforms—such as instituting consumption and gasoline taxes, ending the mortgage tax credit, and establishing a needs-tested Social Security system—needed to increase its dismal national savings rate. And the difficulties in the three other large trading blocs further complicated things: sovereign debt crisis in Europe; mixed signals from China about its currency flexibility; and Japan’s relapse into deflation.

Recent developments—including the recent U.S. House bill that threatens China with countervailing duties for holding down its currency, the vitriol about exchange rates in the op-ed pages, declarations by various finance ministers that they would not allow their currencies to become uncompetitive, and Japan’s return to intervention after a six-year hiatus—suggest things could turn much uglier.

What can be done to avoid a currency war, and mitigate the threat of eventual protectionism? To answer this question, we first review who has seen the largest appreciation since the outbreak of the crisis and why.

Few Countries Have Seen Large Appreciation

The effective nominal exchange rates of the four largest trading blocs have changed significantly since the outbreak of the financial crisis. The yen in Japan and the yuan in China have appreciated substantially—34 percent and 10 percent, respectively—from their 2006–2007 averages. The euro has changed little from pre-crisis levels, despite its weakness since the outbreak of the sovereign debt crisis.

And, frustratingly from the U.S. perspective, the dollar has depreciated only slightly, with devaluation in several U.S. trading partners offsetting the effect of the large yen and yuan appreciation.

Of the 40 largest economies, 25 have seen their currencies depreciate in nominal effective terms from pre-crisis levels. These include several countries that have vocalized the need to curb supposed appreciation, such as South Korea and India.


Only seven countries (including Japan and China) have seen their currencies appreciate by more than 10 percent since the start of the Great Recession. Of these, four countries—Japan, Switzerland, Israel, and China—have a significant current account surplus. And real exchange rates in the first three countries are roughly in line with their ten-year pre-crisis averages. In China, the real exchange rate has appreciated by 10 percent vis-à-vis its ten-year pre-crisis average.1

In the other three countries—Brazil, Colombia, and the Czech Republic—currency appreciation may be more problematic. Each of these countries has a modest current account deficit, and their real effective exchange rates have appreciated by 42 percent, 27 percent, and 36 percent, respectively, compared to their ten-year pre-crisis averages. Appreciation in these countries and in many other successful developing economies has been especially sharp in recent months.

However, some of this change is justified: Improved macro fundamentals, better governance, booming commodity exports, and recent oil and gas finds have made Brazil and Colombia more attractive to foreign investors, and the Czech Republic has been one of the more successful transition and EU-accession countries. Nevertheless, whether the large capital inflows into these countries will be sustained is unclear, since the surge in capital flows may only be beginning, and international interest rates will rise once the crisis abates.

The smaller countries play a significant role in trade, but will certainly not set the tone for international currency relations. Instead, the four large blocs will determine the behavior of smaller players through their management of currencies and relations with one another.

Maintaining the Peace

Notwithstanding calls for increased coordination, the current diverse constellation of currency regimes (pegged, managed, fully flexible, and so on) is unlikely to change. And so it should be, as regimes are shaped by national policy choices that reflect very diverse economic circumstances. In a previous Bulletin article, we argued that the present currency system—messy and arbitrary as it is—served the world economy well at a time of unprecedented turmoil. Countries with flexible currencies generally coped better than those with pegged currencies.

Going forward, the major economies should continue to freely float their currencies. In countries where exports represent only 10–15 percent of GDP, the alternative—dedicating monetary policy to stabilizing the currency instead of domestic activity—is unacceptable. Flexible currencies across the largest economies has been the norm since the Bretton Woods fixed exchange-rate system collapsed in 1973. The Plaza Accord of 1985—an agreement between the United States, Japan, West Germany, France and the UK to work together to bring down the value of the dollar against the yen and the deutsche mark—is held up as an example of international coordination precisely because it was such an important and temporary departure from unilateral action, and opinions about its effectiveness remain sharply divided.

Without putting exchange rates in a strait jacket, here is a set of steps that can both prod the global recovery and keep currency peace:

First, the focus of the G20, the IMF, and individual ministries of finance should shift away from “rebalancing,” which sounds and acts like a zero-sum game. Instead, the focus should be on stimulating domestic demand in individual countries in a sustainable way. The IMF can help advise countries on carrying out this agenda through its Article IV surveillance and other mechanisms. No one solution will work for all countries: some countries may still be able to push the demand accelerator, while others will have to press the brakes. In all cases, however, the discussion of currencies and external balances should be second to a sustainable growth agenda.

Second, advanced countries should beware of more quantitative easing to stimulate demand (never mind to engineer devaluation). Quantitative easing may or may not help stimulate demand at the margins, but it will certainly increase the incentives to engage in highly risky carry trades around the world, and push policy makers deeper into uncharted territory when they try to withdraw the already unprecedented buildup of liquidity. It will also compound the problems in emerging markets that are facing a surge of possibly temporary capital flows.

Third, emerging markets that are experiencing large inflows of foreign capital and appreciating currencies must decide how much of the capital inflow is justified by long-term fundamentals. In the presence of volatile and short-term inflows, sterilized currency intervention, reserve accumulation, and, as a last resort, taxes on capital inflows and other controls are justified.

Last but not least, the economies most responsible for the dynamics at play must respond appropriately:

The United States should cease pursuing what is increasingly perceived as a policy of currency depreciation vis-à-vis the rest of the world. With negative net exports representing less than 4 percent of U.S. GDP and domestic demand representing 104 percent, policies to stimulate demand should focus on the latter rather than the former. Against a background of slowing growth, the United States needs to resist an early withdrawal of stimulus, but must also reassure investors and trading partners by legislating reforms that reduce spending and increase taxes in the medium term.

In the Euro area, Germany and other core countries must stimulate domestic demand to support the adjustment in the debt-constrained European periphery. Failure to help the adjustment in competitiveness and fiscal balances in the periphery may one day threaten the survival of the Euro area as currently configured.

China has already contributed more to global rebalancing than any other country. Its domestic demand has increased by 41 percent since 2006–2007, its current account surplus has declined by 5 percent of GDP, and its real exchange rate has appreciated by more than that of any other large country compared to its ten-year pre-crisis average.


Domestic Demand and Current Account, 2010
  Domestic Demand, percent change from 2006-2007 Current Account Balance, percent of GDP Current Account Balance, percent change from 2006-2007
United States -0.8 -3.9 1.7
Japan -3.7 3.3 -1.1
Germany 2.8 4.9 -2.2
China 41.1 4.9 -5.1
Source: EIU.


But China can do more to correct distortions that impede the growth of its domestic consumption and the development of its backward regions. Gradually appreciating its exchange rate (aiming, say, for a 20 percent appreciation over three years, in line with progress in the pre-crisis period) will help both facilitate and accelerate this transition.

Japan has tried every expedient in the macroeconomic policy book for reigniting domestic demand, with little success. Given the size of the yen’s recent appreciation, Japan’s reluctance to see an even higher yen is understandable. The solution to its problems, however, lies not in a lower yen, but in breaking the political logjam so it can engage in far-reaching structural reforms and allow increased immigration to compensate for its declining labor force.


The G20 leaders need to return to the spirit of two years ago. They should encourage countries to refocus on domestic policies that will promote a sustainable economic recovery rather than obsessing over net exports, which have historically accounted for a tiny fraction of their demand growth. They should also recognize that currency shifts can have only a limited impact without corresponding changes in domestic demand, and are certainly not the solution to their collective problem.

Uri Dadush is the director of Carnegie’s International Economics Program. Vera Eidelman is the managing editor of the International Economic Bulletin.

1. And by 14 percent from its 30-year pre-crisis average, suggesting that this was not simply a normalization from previous devaluation.