Currency manipulations and their ramifications

Frankfurt (Apr 6)   For many years the United States has viewed its emerging challenger China with particular suspicion in respect of its seemingly manipulated and undervalued currency, provoking American trade deficits and flooding the global market with cheap goods.

Then for a while it seemed that this "mercantilist" strategy, of outbidding rivals in international trade and therefore acquiring wealth with which to acquire overseas stakes in those self-same countries, had outstayed its welcome. China allowed the yuan to escalate by modest degrees to reflect economic realities.

Recently that strategic shift has been modified again, as occasional bouts of currency depreciation have been promoted to burn speculators exercising the lucrative "carry trade" of borrowing funds to leverage the returns on what was a one-way street. Introducing two-way traffic is meant to work as a calming influence, given that the Chinese dragon has been snorting flames of discomfort from the difficulties of an overblown credit system.

This episode, reflecting an underlying condition quite threatening to the global economy, only highlights the perils of building castles of non-market behaviour, each designed to protect against the effects of previous creations.

Europe is an even plainer example just now, with the Eurozone chronically crippled by the inability of its constituent members to adjust exchange rates to cope with their relative states of over- and under-competitiveness. This malady is thoroughly locked in, to the point that desperate commentators are imploring the dominant force, Germany , to recycle its wealth among those falling by the wayside.

Concerted effort

Since the only way now for those suffering, peripheral countries to reduce relative prices and wages compared to the comfortable core is by austerity — which is likely to be thwarted by the impact thereof on their already dire debt dynamics — cheerleaders for the European project are pleading that the European Central Bank must flood the region with cash in a concerted effort to float all boats.

As opposed to fixing the basic fault-line in this morass, undoing the euro itself, that idea comes across as tantamount to rearranging the chairs on the Titanic. Whether Germany , on the bridge of the vessel, indulges that behaviour, will depend on its assessment of the damage if this proud ocean liner pummels into another life-wrecking iceberg of financial crisis.

It makes you wonder why any bloc would consider following Europe's example, except where politics overrides sensible economics. More pertinently here, it raises the matter of policies over exchange rates, and how to guide or peg them, if at all.

Monetary union of some sort in the GCC has been in the offing for some time, and much discussed, and that's an issue beyond simply the consequences of exchange misalignment, bearing in mind that some of the Gulf currencies (viewing the surpluses of its larger members) are considered very undervalued.

In the absence of the naturally corrective, equilibrating mechanism of the exchange rate according to market forces, it is not only the trade surplus that will persist.

Trade imbalance

Apart from the cementing of a competitive advantage in terms of the balance of payments (leading to the accumulation of foreign asset reserves), there is a counterpart disadvantage in terms of control over the domestic economy.

If the exchange rate does not appreciate as it logically should, then not only will an exaggerated trade imbalance arise — contributing to the lopsidedness and vulnerability of the world economy -- but the suppressed currency will not be able to rise to counteract any tendency to rising inflation.

The apportionment of jobs, investments, living standards and general economic trends will be misaligned, depending on how governments further intervene in an attempt to offset their effects — and prices specifically will get out of kilter.

Indeed, in the case of the Gulf states, that problem is amplified by the dollar peg, keeping interest rates excessively low relative to the internal economy, a condition exaggerated further by the fact that hydrocarbon-based export revenues largely accrue to governments which tend substantially to spend the proceeds, subject to provisioning for and by sovereign wealth funds.

Implied stability

Thus, monetary policy is hampered, and fiscal settings may act in a pro-cyclical way rather than the counter-cyclical way that might reasonably be advised.

Of course, there are well-rehearsed reasons why such circumstances prevail, centring on the implied stability, especially in an uncertain world, of anchoring to the US dollar.

Yet it means the burden increases on so-called direct actions as the solution for managing the economy, rather than the conventional, indirect means (i.e. appropriate monetary and fiscal levers) that may accompany a freely fluctuating currency.

Such applications are known, in the jargon, as macro-prudential measures, and their relevance is coming to the fore again as the pace of pick-up increases in the Gulf economy. They may indeed have to do some pretty heavy-lifting in the contest for policy control.