Brian Fallow: Currency scrap yet to become a brawl

Currency wars is a phrase that has gained some currency of late. It is the kind of expression we journalists love, evoking conflict and carnage. But is it warranted?

Certainly there is an elevated level of bad temper between the world's two largest economies, the United States and China.

The US dollar has weakened markedly in recent weeks as expectations have hardened that the Federal Reserve is about to embark on another round of quantitative easing, printing money on a scale that will drive down the international value of the US dollar. (That indeed would be one of the objects of the exercise.)

It has automatically pushed up floating currencies, including ours, against the US dollar.

But the Chinese yuan, not so much.

Since the Chinese authorities announced last June that they would allow a gradual appreciation, it has risen only a little over 2 per cent against the US dollar, most of it in the last few weeks as a Congressional vote loomed.

In fact, thanks to its "crawling peg" to the US dollar the yuan actually fell on a trade-weighted basis last month.

This has led to mounting frustration in Washington.

Faced with an unemployment rate close to 10 per cent, the US House of Representatives late last month passed, by a large majority, a bill that would allow "fundamental exchange rate misalignments" to be treated as export subsidies which could be met by countervailing duties.

This was clearly a shot across China's bow. Beijing responded by slapping a steep tariff on US poultry and issuing dire warnings about the consequences to bilateral trade relations.

But it is not yet US law. It would have to pass the Senate and be signed off by President Barack Obama.

The Bank of Japan, meanwhile, faced with the combination of a weak economy and a rising exchange rate has intervened in the foreign exchange market for the first time in six years.

And Brazil has increased a tax it imposes on capital inflows, which have surged as investors seek out better opportunities than the struggling economies of the OECD can provide, pushing up the Brazilian real in the process.

Underlying this is the bind Western economies find themselves in. They are starved of demand and the conventional policy options for stimulating demand - cutting interest rates and ramping up Government deficits - are out of ammunition.

Hence the attraction of devaluation, aimed at enabling an export-led recovery.

But it is a mathematical impossibility for everyone's currency to depreciate at the same time. And someone has to buy all those extra exports.

At this point all eyes swivel towards Asia in general and China in particular.

When, people ask, will the Chinese authorities recognise that their manufacturers do not need the artificial support of an undervalued exchange rate to be globally competitive? Surely low wages, good infrastructure and all the economies of scale anyone could wish for are advantage enough.

Paul Krugman, a Nobel laureate economist, minces no words: "In effect, China is taxing imports while subsidising exports, feeding a huge trade surplus. And in a depressed world economy any country running an artificial trade surplus is depriving other nations of much-needed sales and jobs."

Not only that. The vast foreign reserves, some US$2.5 trillion ($3.3 trillion), built up as China has prevented its trade surpluses from driving its exchange rate higher, represent the fruits of Chinese labours which those who earned them are not allowed to enjoy.

China's leaders have acknowledged the need for its economy to rebalance, that its growth has been top-heavy in investment spending and net exports and light on consumption.

But they are wary of abrupt change.

Premier Wen Jiabao said last week that many Chinese exporters "have profit margins of only 2 to 3 per cent, 5 per cent at most. Should the yuan appreciate by 20 to 40 per cent, as demanded by some people, a large number of Chinese export enterprises will go bankrupt, the workers will lose their jobs and the migrant workers will have to go back to the rural land, making it hard for society to remain stable."

With China having contributed half the growth in the global economy last year, a crisis there would be "disastrous for the world", he said.

Such comments make it clear that next month's G20 summit is unlikely to result in a consensus on how, and how quickly, to unwind the big imbalances confronting the global economy.

In economies like ours the process of rebalancing - more investment, less consumption; more saving, less borrowing; more exporting, less importing and so on - will not be swift or easy. The reverse process in China is also a formidable challenge and likely to be a long-drawn-out one.

Before concluding that things are set to get really ugly between the United States and China it is worth remembering that theirs is a multi-dimensional relationship where constructive relations on a range of issues like climate change and North Korea are needed.

Even on the trade front, US multinationals have a large stake in China.

A colleague recently bought an Apple product online. It arrived a few days later from the factory, in China.

Apple is of course a US company, and it is a fair bet some of the componentry in the device was made in Taiwan. Her purchase supports livelihoods in several countries.

In light of that sort of intricate interconnectivity in today's global economy, slipping back into the kind of protectionism which helped render the 1930s so miserable - and the 1940s so bloody - is surely out of the question.

In the meantime what can the New Zealand authorities do to mitigate the effects of turbulence in the foreign exchange markets?

Not much.

The Reserve Bank's mandate to intervene in the market is carefully circumscribed.

The New Zealand dollar has to be exceptionally high (or low) and at levels not justified by economic fundamentals.

The intervention also has to be consistent with what the bank is doing with interest rate policy.

Compared with its level a year ago (to take an arbitrary point of comparison) the dollar is 2.3 per cent higher against the US dollar but just 0.7 per cent higher on a trade-weighted index and 6 per cent lower against the Australian dollar.

Over the same period export commodity prices have risen nearly 25 per cent and are only marginally below a 24-year high.

So it is hard to argue the exchange rate is exceptionally or unjustifiably high.

And for the Reserve Bank to sell kiwi dollars on the scale needed to move the exchange rate materially would constitute an easing in monetary policy which would be at odds with the tightening bias it has with respect to the official cash rate.