11

Currency WarsCurrency Wars

Jeffrey FrankelJeffrey FrankelHarpel Professor of Capital Formation & Growth,Harpel Professor of Capital Formation & Growth,

Harvard University Harvard University

American Enterprise Institute, March 18, 2013American Enterprise Institute, March 18, 2013

Is “currency wars” just a catchy phrase?Is “currency wars” just a catchy phrase?

It is another way of saying “competitive It is another way of saying “competitive devaluation,”devaluation,”

• a kind of beggar-thy-neighbor policya kind of beggar-thy-neighbor policy to use language of the 1930s, to use language of the 1930s, one motive at Bretton Woods one motive at Bretton Woods

for fixed exchange rates; for fixed exchange rates;

• or “manipulating exchange rates…or “manipulating exchange rates…to gain an unfair competitive advantage over to gain an unfair competitive advantage over other members…” other members…”

to quote from IMF Article IV(1)iii.to quote from IMF Article IV(1)iii.

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The phrase has The phrase has been applied been applied to the Fed’s QE.to the Fed’s QE.

But it does not in truth fit well.But it does not in truth fit well.• A key point often missed: A key point often missed:

even the direction of the effect of one even the direction of the effect of one country’s monetary expansion on the trade country’s monetary expansion on the trade balance is ambiguous: balance is ambiguous:

• the expenditure-increasing effect the expenditure-increasing effect when the expanding country expands when the expanding country expands counteracts the expenditure-switching counteracts the expenditure-switching effect when the exchange rate responds.effect when the exchange rate responds. 33

National authorities will & should pursue economic National authorities will & should pursue economic policies in their own countries’ interests.policies in their own countries’ interests.

At times cooperation is fruitful, At times cooperation is fruitful, • whether by norms, whether by norms, • multilateral meetings like the G20, multilateral meetings like the G20, • or formal institutions: WTO & IMF.or formal institutions: WTO & IMF.

• But there is little point in trying to establish But there is little point in trying to establish international cooperation if the nature international cooperation if the nature of the spillover effects is not relatively clear and of the spillover effects is not relatively clear and agreed upon. agreed upon.

Pollution & tariffs, for example, Pollution & tariffs, for example, are negative externalities, not positive. are negative externalities, not positive.

It is not clear, with monetary policy.It is not clear, with monetary policy.44

If US unemployment is high & inflation low, If US unemployment is high & inflation low, the Fed will naturally choose the Fed will naturally choose an easy monetary policy (low an easy monetary policy (low ii). ).

If the macroeconomic situation If the macroeconomic situation is the reverse in Brazil, its central bank is the reverse in Brazil, its central bank will naturally choose a tight monetary policy will naturally choose a tight monetary policy (high (high ii ).).

Also naturally, capital will flow from the US Also naturally, capital will flow from the US to Brazil and will in turn appreciate the Real.to Brazil and will in turn appreciate the Real.

But that is the beauty of floating rates. But that is the beauty of floating rates. 55

Brazil’s inflation has been highBrazil’s inflation has been highso a strong currency should helpso a strong currency should help..

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The exchange rate movement will shift The exchange rate movement will shift demand toward exporters in the US and away demand toward exporters in the US and away from those in Brazil, other things equal. from those in Brazil, other things equal.

But such “casualties of war” are not even But such “casualties of war” are not even unexpected collateral damage; unexpected collateral damage;

they are the point they are the point of the two chosen of the two chosen monetary policies:monetary policies: If the goal is to stimulate demand for US goods If the goal is to stimulate demand for US goods

& cool off demand for Brazilian goods, & cool off demand for Brazilian goods, why shouldn’t the exporters in both countries why shouldn’t the exporters in both countries share in that process, via net foreign demandshare in that process, via net foreign demand

alongside construction & the other sectors alongside construction & the other sectors that are sensitive to that are sensitive to ii via domestic demand? via domestic demand?

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More of a problem arises if one of the countries More of a problem arises if one of the countries had been targeting or fixing the exchange rate. had been targeting or fixing the exchange rate.

• It won’t necessarily want to abandon It won’t necessarily want to abandon a proven exchange rate regime a proven exchange rate regime at the first sign of trouble.at the first sign of trouble.

• Capital controls & sterilization of reserve Capital controls & sterilization of reserve flows might help delay the adjustment, flows might help delay the adjustment,

• but a persistent capital flow will eventually but a persistent capital flow will eventually force the country either to allow its exchange force the country either to allow its exchange rate to adjust or its money supply. rate to adjust or its money supply.

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In the case of China, 2004-2011,this meant a In the case of China, 2004-2011,this meant a choice between allowing some appreciation of choice between allowing some appreciation of the RMB and an increase in the money supply.the RMB and an increase in the money supply. They did some of both They did some of both

but more of the latter than the former: but more of the latter than the former: the monetary inflow eventually turned the monetary inflow eventually turned

inflationary, as expected: in 2008 & 2011.inflationary, as expected: in 2008 & 2011.

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True, an impressively wide array True, an impressively wide array of countries prefer weaker currencies of countries prefer weaker currencies to stronger ones, as a means to improve to stronger ones, as a means to improve their trade balances. their trade balances.

• True, too, not all can depreciate at once, True, too, not all can depreciate at once, nor improve their TB at the same time.nor improve their TB at the same time.

• This does not mean that they are guilty This does not mean that they are guilty of violating agreements or norms,of violating agreements or norms,

especially if they have not devalued but merely especially if they have not devalued but merely stuck with a pre-existing exchange rate regime: stuck with a pre-existing exchange rate regime:

• float, fixed, or band. float, fixed, or band.

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Uncoordinated monetary expansion does not Uncoordinated monetary expansion does not even necessarily leave the world in a worse even necessarily leave the world in a worse

equilibrium. It might just give the world what it equilibrium. It might just give the world what it needs. needs.

Eichengreen & Sachs Eichengreen & Sachs (1985, 86) (1985, 86) for the 1930s for the 1930s argue the opposite of the conventional wisdomargue the opposite of the conventional wisdom

• re beggar-thy-neighbor competitive devaluations. re beggar-thy-neighbor competitive devaluations. To the extent that each country devalued against gold, To the extent that each country devalued against gold,

even though they could not all succeed in improving even though they could not all succeed in improving their trade balance, their trade balance, they raised the price of gold & thereby increased the they raised the price of gold & thereby increased the value of the global money supply, value of the global money supply,

which is what a world in Depression needed.which is what a world in Depression needed.

• The same may apply today The same may apply today Eichengreen Eichengreen (2013).(2013).

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The accusation is especially misplaced The accusation is especially misplaced against a country like the USagainst a country like the US

• which was the target of the phrase’s which was the target of the phrase’s original coiner, Guido Mantega.original coiner, Guido Mantega.

• The US authorities have not intervened in The US authorities have not intervened in the fx market nor talked down the $. the fx market nor talked down the $.

• $-depreciation is probably not at the top $-depreciation is probably not at the top of the list of the effects that the FOMC of the list of the effects that the FOMC has in mind when deciding QE. has in mind when deciding QE.

EE1212

Yes, the usual channel of transmission, via Yes, the usual channel of transmission, via short-term interest rates, is all-but-endedshort-term interest rates, is all-but-ended

by the Zero Lower Bound.by the Zero Lower Bound.

But, aside from depreciation, But, aside from depreciation, that still leaves effects via:that still leaves effects via:• longer term and private bonds, longer term and private bonds, • the credit channel, the credit channel, • expectations regarding inflation, expectations regarding inflation, • equity prices, equity prices, • And real estate prices.And real estate prices.

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Japan comes a little closer,Japan comes a little closer,

in that:in that:

• Japan went back to buying $ in Sept. 2010;Japan went back to buying $ in Sept. 2010;

and some members of the new Abe and some members of the new Abe government in 2013 were initially foolish government in 2013 were initially foolish enough to mention ¥ depreciation explicitly. enough to mention ¥ depreciation explicitly.

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China of course intervened heavily.China of course intervened heavily.

The RMB was undervalued The RMB was undervalued by most measures by most measures from 2004 to 2009 from 2004 to 2009 (less so, by 2012).(less so, by 2012).

• But countries have a right to opt for a fixed But countries have a right to opt for a fixed exchange rate regime.exchange rate regime.

• China was continuing a regime China was continuing a regime that had previously been in place, that had previously been in place,

which does not sound like “manipulation.”which does not sound like “manipulation.”1515

Appreciation was probablyAppreciation was probablyin China’s interest.in China’s interest.

And it was reasonable And it was reasonable for others to propose that China for others to propose that China allow appreciation as part of a deal voluntarily allow appreciation as part of a deal voluntarily agreed among sovereign states agreed among sovereign states

• in exchange, for example, for the US fiscal reform. in exchange, for example, for the US fiscal reform.

But this is different from charging Beijing with But this is different from charging Beijing with having violated international norms having violated international norms or rules and from threatening retaliation.or rules and from threatening retaliation.

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Also, China has adjusted much of the way, since 2009.Also, China has adjusted much of the way, since 2009.

Appreciation versus the US $, 2005-12Appreciation versus the US $, 2005-12

0.9

1.0

1.1

1.2

1.3

1.4

1.5

2005 2006 2007 2008 2009 2010 2011

CNY/USD,2005M06=1

nominal

real

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Indeed, very few of the countries accused of Indeed, very few of the countries accused of participating in the currency wars have undertaken participating in the currency wars have undertaken

discrete devaluations in recent years or acted to discrete devaluations in recent years or acted to weaken their currencies weaken their currencies by switching exchange by switching exchange rate regimesrate regimes. These are the sort of deliberate . These are the sort of deliberate

policy changes connoted by a phrase like policy changes connoted by a phrase like “manipulation” “manipulation”

Switzerland perhaps comes the closest. Switzerland perhaps comes the closest. But the Swiss franc was so “overvalued”, But the Swiss franc was so “overvalued”,

even at the new rate set Sept. 2011, that the even at the new rate set Sept. 2011, that the SNB cannot really be accused SNB cannot really be accused of unfair undervaluation.of unfair undervaluation.

ConclusionConclusion

The accusations fly in both directions.The accusations fly in both directions.• The US accuses China of unfairly The US accuses China of unfairly

manipulating its currency.manipulating its currency.• EM countries retaliate by accusing EM countries retaliate by accusing

the advanced countries of pursuing the advanced countries of pursuing a currency war.a currency war.

My view: In both directions, the charges My view: In both directions, the charges of wrong-doing are not merited. of wrong-doing are not merited.1919

2020

http://ksghome.harvard.edu/~jfrankel/index.htm

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Warning from Brazil’s Finance Warning from Brazil’s Finance

Minister Guido Mantega Minister Guido Mantega (9/27/2010)(9/27/2010):: “ “We’re in the midst of We’re in the midst of

an international currency war, an international currency war, a general weakening of currency. This threatens us a general weakening of currency. This threatens us because it takes away our competitiveness.”because it takes away our competitiveness.”

I.e., countries everywhere are trying I.e., countries everywhere are trying to push down the value of their currencies, to push down the value of their currencies, to gain exports & employment,to gain exports & employment,• a goal that is not globally consistenta goal that is not globally consistent..

Appendix I: Origin of Appendix I: Origin of “Currency Wars,” in 2010“Currency Wars,” in 2010

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Singapore took the renewed inflows Singapore took the renewed inflows heavily in the form of reserves,heavily in the form of reserves,

GS Global ECS Research

less-managed floating

(“more appreciation-friendly”) →

High EMP

Low EMP

↑ more-managedfloating

while India & Malaysia in 2010 took them while India & Malaysia in 2010 took them in the form of currency appreciation.in the form of currency appreciation.

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In Latin America, renewed inflows In Latin America, renewed inflows

less-managed floating (“more appreciation-friendly”)

more-managed floating

GS Global ECS Research

but as appreciation in Chile & Colombiabut as appreciation in Chile & Colombia. . were reflected mostly as reserve accumulation in Peru,were reflected mostly as reserve accumulation in Peru,

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Renewed flows to EMs in 2010-2013Renewed flows to EMs in 2010-2013were met with $ purchases in FX interventionwere met with $ purchases in FX intervention• Brazil, Brazil,

• Korea, Korea,

• Thailand, Thailand,

• Peru …Peru …

• By 2011, even Chile, the cleanest of the floaters, was By 2011, even Chile, the cleanest of the floaters, was intervening to dampen appreciation.intervening to dampen appreciation.

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Currency Wars,Currency Wars, continuedcontinued

China had long been intervening China had long been intervening to prevent the RMB from appreciating.to prevent the RMB from appreciating.

The U.S. tried to enlist help from countries like Brazil The U.S. tried to enlist help from countries like Brazil in pressuring China to abandon its undervaluation.in pressuring China to abandon its undervaluation.

The Brazilian Minister’s response: The Brazilian Minister’s response: The $ is as much a part of the problem as the RMB.The $ is as much a part of the problem as the RMB.• He was referring to QE2 that fall, which like any other He was referring to QE2 that fall, which like any other

monetary easing could be expected to depreciate the $.monetary easing could be expected to depreciate the $. More attacks on Fed action -- More attacks on Fed action --

• ChinaChina & & Germany: $ depreciation is a deliberate salvo in currency warsGermany: $ depreciation is a deliberate salvo in currency wars

• Sarah Palin, Rick PerrySarah Palin, Rick Perry & & John Taylor: QE2 “debauches the currency.”John Taylor: QE2 “debauches the currency.”

Appendix II: ChinaAppendix II: China

2626

2727

-1-.

50

.51

Lo

g o

f P

rice L

evel

-3 -2 -1 0 1 2Log of Real Per capita GDP (PPP)

coef = .23367193, (robust) se = .01978263, t = 11.81

Source: Arvind Subramanian, April 2010, “New PPP-Based Estimates of Renminbi Undervaluationand Policy Implications,” PB10-08, Peterson Institute for International Economics

Undervaluation of RMB in the regression estimated above = 26%.Estimated undervaluation averaging across four such estimates = 31%.

Compare to estimate for 2000 (Frankel 2005) = 36%.As recently as 2009 (Chang 2012) : 25% .

The Balassa-Samuelson Relationship2005

China Adjusts, 2009-12China Adjusts, 2009-12

Various key measures suggest that China has Various key measures suggest that China has achieved a substantial share of the needed achieved a substantial share of the needed trade adjustment since 2009:trade adjustment since 2009:

Its trade surplus peaked at $300 billion in Its trade surplus peaked at $300 billion in 2008, and has been declining since then. 2008, and has been declining since then.

Substantial real appreciation of the RMB has Substantial real appreciation of the RMB has brought it closer to equilibrium. brought it closer to equilibrium. • Some nominal appreciation +Some nominal appreciation +• Some inflation &, especially, wage increasesSome inflation &, especially, wage increases

China’s external balance has adjusted.China’s external balance has adjusted. China’s trade surplus is much smaller now.China’s trade surplus is much smaller now. Its overall balance of payments, too, Its overall balance of payments, too,

was negative some months in 2012 was negative some months in 2012

Adjustment of relative pricesAdjustment of relative prices

The famous “China price”:The famous “China price”:

• Ever since China rejoined the world economy Ever since China rejoined the world economy 3 decades ago, its trading partners have 3 decades ago, its trading partners have snapped up exports of manufacturing goods,snapped up exports of manufacturing goods,

• because low Chinese wages made them because low Chinese wages made them super-competitive on world markets. super-competitive on world markets.

But in recent years, relative prices have But in recent years, relative prices have partly adjustedpartly adjusted• following the laws of market economics. following the laws of market economics.

Adjustment of relative prices, Adjustment of relative prices, continuedcontinued

The change in relative prices is reflected The change in relative prices is reflected as real exchange rate appreciation. as real exchange rate appreciation.

• This comprises, in part, nominal appreciationThis comprises, in part, nominal appreciation

• and, in part, Chinese inflation.and, in part, Chinese inflation.

• The government would have been better advised The government would have been better advised to let more of the real appreciation take the form to let more of the real appreciation take the form of nominal appreciation ($ per RMB).of nominal appreciation ($ per RMB).

• But it didn’t, so it showed up as inflation instead. But it didn’t, so it showed up as inflation instead.

• See appreciation in chart below. See appreciation in chart below.

The natural adjustment process was delayed.The natural adjustment process was delayed. 11stst, because the authorities intervened to keep , because the authorities intervened to keep

the exchange virtually fixed against the dollar, the exchange virtually fixed against the dollar, in the years 1995-2005 and 2008-2010. in the years 1995-2005 and 2008-2010.

22ndnd, workers in China’s increasingly productive , workers in China’s increasingly productive coastal factories were not paid their full value. coastal factories were not paid their full value. • The economy has not completed its transition The economy has not completed its transition

from Mao to market, after all. from Mao to market, after all.

As a result of these two delaying mechanisms, As a result of these two delaying mechanisms, Chinese continued to undersell the world.Chinese continued to undersell the world.

But then two things happened.But then two things happened.

11stst, the yuan was finally allowed to appreciate , the yuan was finally allowed to appreciate against the $ during 2005-08 & 2010-11, against the $ during 2005-08 & 2010-11, by 25% cumulatively by 25% cumulatively

=17% + 8%.=17% + 8%.

22ndnd, and more importantly, , and more importantly, labor shortages began to appear => labor shortages began to appear => China’s workers at last began to win rapid wage hikes. China’s workers at last began to win rapid wage hikes. • Major cities raised their minimum wages Major cities raised their minimum wages

sharply over each of the last 3 years: sharply over each of the last 3 years: 22% on average in 2010 & 2011; 22% on average in 2010 & 2011; somewhat less in 2012, in response to slowing demand: somewhat less in 2012, in response to slowing demand:

• 8.6 % in Beijing, 13% in Shenzhen & Shanghai. 8.6 % in Beijing, 13% in Shenzhen & Shanghai.

Meanwhile another cost of business, Meanwhile another cost of business, land prices, rose even more rapidly. land prices, rose even more rapidly.

34

The RMB rose against the $ during 2006-08, returned to peg in mid-2008,

and then appreciated again in 2010-2011.

35

Overheating also shows up in rapid rise of land pricesOverheating also shows up in rapid rise of land prices

Real Beijing land prices

Real appreciationReal appreciation

The RMB’s real appreciation against the $The RMB’s real appreciation against the $from 2009 to 2012 has amounted to 12%, from 2009 to 2012 has amounted to 12%,

reducing the degree of undervaluation by roughly half,reducing the degree of undervaluation by roughly half, depending on whether one measures it against the $ depending on whether one measures it against the $

or against all currencies. or against all currencies.

In any case, China’s real exchange rate is already In any case, China’s real exchange rate is already closer to this measure of equilibrium than are most closer to this measure of equilibrium than are most countries’ exchange rates countries’ exchange rates (Cheung, Chinn & Fuji, 2010).(Cheung, Chinn & Fuji, 2010).

5 types of adjustment are gradually taking place 5 types of adjustment are gradually taking place in response to the new high level of costs in response to the new high level of costs

in the factories of China’s coastal provinces:in the factories of China’s coastal provinces:

11stst, some manufacturing is migrating inland, , some manufacturing is migrating inland, • where wages & land prices are still relatively low.where wages & land prices are still relatively low.

22ndnd, export operations are shifting, export operations are shifting to Vietnam or Bangla Desh to Vietnam or Bangla Desh • where wages are lower still. where wages are lower still.

33rdrd, Chinese companies are beginning to automate,, Chinese companies are beginning to automate, • substituting capital for labor.substituting capital for labor.

44thth, they are moving into more sophisticated products, , they are moving into more sophisticated products, • following the path blazed by Japan, Korea, & other Asian tigersfollowing the path blazed by Japan, Korea, & other Asian tigers

in the “flying geese” formation. in the “flying geese” formation.

55thth, multinational companies, multinational companies that had in the past that had in the past moved some stages of their production process to moved some stages of their production process to China, out of the US, or out of other high-wage China, out of the US, or out of other high-wage countries, countries, areare now moving backnow moving back. .

All five of these ways of reallocating All five of these ways of reallocating resources represent the economic resources represent the economic process operating as it should. process operating as it should.

None of this comes as news None of this comes as news to most observers of China. to most observers of China.

But many Western politicians are unable But many Western politicians are unable to let go of the syllogism that seemed to let go of the syllogism that seemed so unassailable just a decade ago:so unassailable just a decade ago:• (1) The Chinese have joined the world economy; (1) The Chinese have joined the world economy; • (2) their wages are $0.50 an hour; (2) their wages are $0.50 an hour; • (3) there are a billion of them, and so (3) there are a billion of them, and so • (4) their exports will rise without limit: (4) their exports will rise without limit:

“Chinese wages will never be bid up in line “Chinese wages will never be bid up in line with the usual textbook laws of economics with the usual textbook laws of economics because the supply labor is infinitely elastic.”because the supply labor is infinitely elastic.”

But it turns out that the laws of economics do But it turns out that the laws of economics do eventually apply after all -- even in China. eventually apply after all -- even in China.

Expansion of the services sector.Expansion of the services sector.

This 6th dimension of adjustment still lags behind,This 6th dimension of adjustment still lags behind,

despite the consensus in favor of it.despite the consensus in favor of it.

China has had great success in manufacturingChina has had great success in manufacturing• especially via exports.especially via exports.

Now it needs to help the other side of the economy Now it needs to help the other side of the economy catch up: services, via domestic demandcatch up: services, via domestic demand• Housing, retail, education, environmental quality,Housing, retail, education, environmental quality,• health care, pensions, social safety net.health care, pensions, social safety net.

Some of this could be done via government spendingSome of this could be done via government spending• as China did in 2009; but that was mostly heavy investment.as China did in 2009; but that was mostly heavy investment.