Calls for government co-ordination of exchange rates to manage global imbalances are misguided. For a lesson in how exchange rate intervention can wreak monetary havoc, just look to the Plaza and Louvre agreements.
The Group of Five industrialised nations – the US, UK, Japan, Germany and France – met in New York in 1985 to agree on collective action to lower the value of the dollar. China was not a factor as its foreign exchange reserves were only $12.7bn and its overall current account was roughly in balance. The G5 nations’ intervention in the foreign exchange markets, plus changes in fiscal policies, did help to bring down the value of the dollar. But two years later the US current account deficit reached a peak of 3.4 per cent of gross domestic product, prompting the G6 (the G5 plus Canada) to meet again in Paris to reverse course.
Worse, after the 1987 accord, the Bank of Japan bought dollars and allowed the monetary base to grow rapidly, creating the bubble economy of the late 1980s. The bubble burst in 1990 after the BoJ sharply cut money growth in mid-1989.
The countries that suffered the most from the Asian financial crisis that followed were those that had mistaken monetary policy. As John Greenwood, chief economist for Invesco Asia, observed: “The general lesson is that to control money and credit growth within reasonable ranges that are compatible with low inflation in the longer run, the external value of the currency must be free to adjust – especially upwards.”
Today, there are other factors that make an exchange rate accord even less likely to succeed. The US current account deficit has risen to more than 6 per cent of GDP. China is now the world’s third largest trading nation. And Asian central banks play an important role in financing the US budget deficit. A new Plaza-Louvre accord would require a much larger group to reach agreement – the Group of 20 – without any credible enforcement mechanism.
A negotiated approach to resolving trade imbalances presumes that “experts” know the relevant market-clearing exchange rates and that governments can agree to enforce them – neither of which has proven to be true. Financial markets are much more complex now than in the 1980s and private capital flows swamp official flows. Any exchange rate that was fundamentally misaligned would eventually be attacked and governments would be ill-equipped to prevent it. Moreover, the longer adjustment was delayed, the higher the cost in terms of resource misallocation.
Rather than a new Plaza-Louvre type agreement, an alternative approach to correcting global imbalances would be to have monetary authorities agree on common principles and objectives. The aim would be to establish credibility by having central banks commit to long-run price stability.
Hans Genberg, executive director for research at the Hong Kong Monetary Authority, has suggested creating a “zone of monetary stability” in east Asia. The key step would be to agree on a credible inflation target regime.
To be consistent with capital freedom, central banks would not intervene to peg exchange rates. The information contained in flexible rates would be useful in the conduct of monetary policy and some monetary authorities may choose to follow the Singaporean model by using the exchange rate as an operating target. Hong Kong would maintain its currency board and have a hard peg to the dollar.
With regional price stability and financial integration, interest rates would converge and exchange rates would be less volatile. Though a common currency may evolve – either for the region or more likely for a smaller bloc of countries – it is not necessary to realise those benefits.
China needs an independent central bank to stabilise the growth of nominal income and prevent inflation. Relaxing capital controls would take pressure off the yuan/dollar exchange rate while interest rate liberalisation would allow a more efficient allocation of capital.
The problem is to get China to adopt liberal economic principles when its political regime is illiberal. For the US to threaten China with protectionist measures for not adopting liberal principles is counterproductive. Carrying out that threat would make both China and the US less liberal.