Finance Ministers of the G-20 group of nations met in Gyeongju, South Korea last weekend to arrive at an accord on how to deal with imbalances in the current accounts of the balance of payments, and on exchange rates. The discussions were a precursor to the meeting of the countries’ Presidents and Prime Ministers set to occur on November 11 – 12. A key item on the weekend agenda was the U.S. desire to have the member nations’ current account deficits and surpluses limited to 4% of GDP. A country with a bigger surplus (e.g., China) would have to let its currency appreciate sufficiently to encourage imports and domestic consumption, thereby bringing the surplus down to the 4% level.

That, in any case, was the theory. The U.S. delegation led by Treasury Secretary Timothy Geithner did not succeed in introducing the 4% figure explicitly, and the concluding statement by the Ministers gave no indication of how imbalances are to be corrected. And if China did not lower its current account surplus fast enough, for instance, there is no mechanism to force it to do so. The International Monetary Fund, which has historically used the carrot of additional credit, and the stick of a possible suspension of that assistance, to bring deficit countries into line, has little leverage to force countries to lower surpluses. Reminiscent of the Rodney King statement after the Los Angeles riots in 1992, the G-20 Finance Ministers seemed to be saying, “You know, can we all get along?”

G-20 and Avoidance of “Currency Manipulation”

The principal reason for the U.S. stance at the weekend meeting was the oft-repeated position in the U.S. Congress that China was manipulating the currency by keeping it undervalued through interventions in the foreign exchange market.  At the same time, repeated statements by various Federal Reserve governors that Quantitative Easing would be expanded as part of the decisions to be taken at their next meeting on November 2 and 3 has already weakened the dollar.

In other words, even though the U.S. is not intervening in foreign exchange markets to cause the dollar to depreciate, it achieves the same result by promising (threatening?) to increase the quantity of money in circulation! Rainer Bruderle, Germany’s Economy Minister, said as much when he pointed out that “excessive, permanent money creation, in my opinion, is an indirect manipulation of an exchange rate.”

A third form of influencing exchange rates has become increasingly evident in recent days. For the second time in less than a month, Brazil increased the tax on foreign investment in local fixed income securities, this time from 4% to 6%. Guido Mantega, Brazil’s Finance Minister, indicated that his government would carefully examine the impact of the recent moves before implementing additional measures. This could include, for example, a re-institution of an income tax on foreign investments that had previously been exempted. The intention is to slow capital inflows and forestall a further appreciation of the real. And in less than a week after the conclusion of the Gyeongju meeting intended to prevent “currency wars”, several G-20 Finance Ministers indicated that they would intervene in foreign exchange markets to prevent too sharp an acceleration of their currencies.  South African Finance Minister Pravin Gordhan’s statement that he would use a portion of the tax revenues to purchase foreign currencies resulted in a sharp depreciation of the rand Wednesday. Thailand, which has already cancelled a 15% tax exemption on foreign investments in domestic bonds, has indicated that it is continuing to watch capital inflows and will take any further action that may be necessary.

And emerging market leaders were not the only ones contemplating market interventions and new taxes to keep their currencies competitive. In addition to the criticism by Germany’s Mr. Bruderle, another European representative, Luxembourg Prime Minister Jean-Claude Junker, who is also Chairman of the Euro-area Finance Ministers, complained this week that the dollar is “undervalued” in its relationship with the euro. (Currency manipulation charges, anyone?)

Some Thoughts for G-20 Leaders Ahead of the Meeting Next Month

When G-20 leaders meet in Seoul next month to wrap up discussions, they will find that it is a brave new world when it comes to the post-2008 global financial system. Unlike in past crises when the United States and western Europe were in a strong financial situation while Latin America (1980’s), Russia (1998) or Asia (1997) faced funding difficulties, many of the emerging markets now have healthy banking systems, enjoy strong economic growth, and possess ample foreign exchange reserves. It is the developed countries which are struggling to revive growth after the recent crisis, and some of the countries (e.g., southern Europe) have weak banking systems to boot.

Even more significant, the International Monetary Fund has little ability to discipline the country with the largest current account and fiscal deficits, viz., the United States. With no credible global alternative to the dollar as the international reserve currency, neither the IMF nor the trading partners is in a position to threaten the United States with not accepting the dollar in exchange for goods and services. In theory, unlike Mexico in 1982 or Indonesia in 1997, there is no limit to the “seigniorage” that the United States can command through its right to issue a world currency.

It is such impotence on the part of the major current account surplus countries, notwithstanding their expanding economic growth and trade prowess, that makes restrictions on capital flows – through currency interventions, tariffs and new taxes – a growing global risk. The United States, for its part, cannot insist on deciding on the size of QE2 based purely on domestic considerations, accuse Chinese authorities of currency manipulation for defending an undervalued exchange rate, and expect other countries to provide a level playing field for its exports, all at the same time.

 

Komal S. Sri-Kumar

Chief Global Strategist

 

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