| By Henry C.K. Liu|
February 14, 2007
For decades, the
Section 3004 of Public Law 100-418 (22 U.S.C. 5304) requires, inter alia, the Secretary of the Treasury to analyze twice-yearly the exchange rate policies of foreign countries, in consultation with the International Monetary Fund (IMF), and to consider whether countries manipulate the rate of exchange between their currency and the dollar for purposes of preventing effective balance of payments adjustment or gaining unfair competitive advantage in international trade. Section 3004 further requires that if the Secretary considers such manipulation occurring in countries, such as Japan and China, that (1) have material global current account surpluses; and (2) have significant bilateral trade surpluses with the US, the Secretary of the Treasury shall take action to initiate negotiations with such foreign countries on an expedited basis, in the IMF or bilaterally, for the purpose of ensuring that such countries regularly and promptly adjust the rate of exchange between their currencies and the dollar to permit effective balance of payment adjustments and to eliminate any unfair advantage.
Section 3005 (22 U.S.C. 5305) requires, inter alia, the Secretary of the Treasury to provide each six months a report on international economic policy, including exchange rate policy. The reports are to contain the results of negotiations conducted pursuant to Section 3004. Each of these reports bears the title, Report to Congress on International Economic and Exchange Rate Policies.
Unfortunately, the underlying implication of the law assumes erroneously that current account surpluses can be by itself evidence of currency manipulation by the surplus country. In fact, as trade imbalances are the structural effects of fundamentals in the terms of trade, attempts to correct them with exchange rate adjustments are by definition currency manipulation.
Exchange rate policies cannot be substitutes for structural economic adjustments necessary for mutually beneficial trade between two economies. Nor can exchange rate policies be substitutes for sound domestic monetary or economic policy. When two economies of uneven stages of development trade, a trade surplus in favor of the less-developed economy is natural and just, until the less-developed economy catches up with the more-developed one, otherwise it would be imperialistic exploitation, not trade.
A Protectionist Nation in Free Trade Clothing
That the US, by its unilateral trade policies, has really been a nation of protectionists in free trader clothing is again highlighted by the Senate Committee on Banking, Housing, and Urban Affair hearing on January 31, 2007, headed by its new chairman Senator Christopher J. Dodd (Democrat- Connecticut) whose party won control of the Congress in the 2006 mid-term elections. The hearing was on the Treasury Department’s Report to Congress on International Economic and Exchange Rate Policy and the US-China Strategic Economic Dialogue. Hank Paulson, the 74th Treasury Secretary of the nation and the newly installed current Secretary in the Bush administration, was the lead witness.
The target of the hearing is
The twice-yearly high-level US-China Strategic Economic Dialogue is a brain child of the new Treasury secretary. The first meeting, headed on the US side by Secretary Paulson, with the participation of Federal Reserve Board Chairman Ben Bernanke and several other cabinet secretaries, and on the China side by State Counselor Wu Yi, supported by Chinese counterparts of US officials, was held in Beijing last December, with the second meeting scheduled to take place in Washington in May.
The Senate Banking Committee, pursuant to statute, twice-yearly receives exchange rate reports from the Treasury, taking testimony from the sitting Treasury Secretary, and exercises oversight on government exchange rate policy which has become of critical concern for US businesses and workers who seek “a level playing field” to compete in global markets. The Treasury Report is the only report to the Congress that directly addresses international economics, exchange rate policy, and currency manipulation by other national governments. Testimony from the Treasury Secretary to Congress, if requested, is required by law.
In his opening statement as Committee Chairman at the hearing, Senator Dodd expressed dissatisfaction with
Yet the Democrat senator is only half right. While US workers have lost jobs, the
A Selective Level Playing Field
Cross-border wage arbitrage is a subset of financial arbitrage in which investments are made in low-cost countries to produce goods for sale in high income countries. Interest rate arbitrage is another subset in which funds are borrowed in low-interest currencies to lend in high-interest currencies, a routine transaction known as “carry trade” in international banking parlance. The complaints about cross-border wage arbitrage by the
What Senator Dodd leaves unspoken is that the old slogan “what’s good for General Motors is good for
Outside of slavery, capital and labor have a symbiotic relationship similar to a marriage. In
National Security Trumps Free Trade
Senator Dodd also raised nationalistic concerns by pointing out that more than one million jobs outsourced have been in critical defense-related industries, dislocating the
The military required not just exotic special magnets. It required also mundane “dual-use” items such as uniform and boots which are mostly made in
Exchange Rates are determined by Exchange Rate Policies, not by markets
Reflecting popular misconception, the Senate Banking Committee focused its hearing on exchange rate policy with a flawed assumption that market-determined exchange rates would solve the problem of
For the global marketplace to be truly free and fair, all currencies must be equally subject to the impartial discipline of market forces. Yet despite neo-liberal rhetoric, no government today or even in history, particularly the
The differences among the exchange rate policies of different governments reflect the differences in each country’s economic, financial and monetary conditions as well as political ideology, social structure and societal values, but all governments manipulate the currency market to sustain the exchange rates of their currencies at levels best suited to their separate national needs.
History of Exchange Rates and Currency Stabilization
After WWII, as the
The idea of the need for international cooperation in trade and for a new “gold exchange standard” which would make wider use of gold by supplementing it with an anchor currency that would be readily convertible into gold had been developed in the 1920 international conference in Genoa, Italy, but the participating governments failed to reach agreement on account not all were ready to accept British sterling hegemony. This idea was incorporated two and a half decades later into the Bretton Woods regime with a gold-backed dollar replacing the British pound. The challenge was to devise an operative international finance architecture out of fiat currencies anchored to a gold-backed dollar to accommodate post-war international trade.
One crucial difference between the
The IMF, dominated by US voting power, closely followed the US/White plan for a contributory fund, although it was slightly larger, at $8.8 billion ($77 billion in 2004 dollar or $463 billion in relative share of GDP), of which the USA put in $2.75 billion ($24 billion in 2004 dollar or $145 billion in relative share of GDP), and the UK contributed $1.3 billion. Exchange rates could fluctuate 1% on either side of a par value with the dollar. The fund was designed to provide members with a cushion of credit to give them the confidence to abandon exchange and trade controls while keeping their exchange rate stable in relation to the dollars. It did not deal with how the transition from war through reconstruction to recovery was to be achieved, but certainly not by cross-border finance. The IMF was specifically not to lend for relief or reconstruction arising from the war. Article XIV allowed members to keep exchange controls for three to five years, after which they had to report annually on why controls still remained. This left open the absolute deadline for abandoning exchange controls or trade restrictions, and in fact they were not abandoned for current account purposes until 1958. The
In addition, the US/White plan contemplated the forbiddance of exchange rate intervention, an important feature for the US, whereas the British/Keynes plan did not put much emphasis on limits on exchange rate intervention and even advocated the use of capital controls for the weaker economies, of which Britain expected to become one in the course of the war.
China not a Currency Manipulator
The Treasury’s Report on International Economic and Exchange Rate Policy, required by law to examine whether any US trading partners are manipulating their currencies to gain unfair trade advantage, has determined in its 2006 findings that China does not so manipulate its currency. Still, congressional and media allegations persist that China’s continued resistance to US calls to allow its currency to rise in order to reduce trade imbalances with the US has distorting effects on global markets and detrimental effects on US companies and workers. Such allegations are misplaced, not supported by either fact or theory. The distortions have been created by US trade and monetary policies and their effects on the exchange value of the dollar, rather than by China which has pegged its RMB yuan to the dollar at 8.28 yuan to a dollar within a narrow band of 0.03% for a decade, from 1995-2005, at times above and at other times below market trends.
Manipulation involves willful, proactive volatile changes to profit from temporary technical market trends against market fundamentals. A stable exchange rate cannot be labeled as manipulative any more than a driver traveling at constant legal speed for long periods apace with the police car next to it can suddenly be accused of speeding merely because the police car slows down from loss of power.
Senator Dodd cites anonymous “credible analysts” who allegedly identify the undervaluation of the RMB by 15 to 40 percent as “a very significant cause” of the loss of jobs in the
But the Dodd Committee needs to understand that such a cure would be worse than the malady, as it will cause dollar inflation to skyrocket in the import-dependant
At both the House Ways and Means Committee and the Senate Finance Committee February 6 hearings on the Bush Administration’s $2.9 trillion fiscal 2008 budget, Paulson again asserted that the US has reached a “crossover” point in its trade with China, with exports to China rising at a faster rate than imports from China. China trade has remained a sensitive topic with Congressional members who, face with pressured from constituents over jobs lost to outsourcing overseas, are pushing Paulson for action to force China to revalue its currency. Yet the only sustainable way to increase
Paulson defends the Yen and criticizes the Yuan
Testifying before the all powerful House Ways and Means Committee, Paulson defended the recent fall of the Japanese yen against the euro, claiming the US Treasury saw no evidence that Japanese authorities have intervened in currency markets since 2004 to manipulate the value of the yen. European officials have been unhappy about the weak yen because it makes EU exports more expensive and less competitive in
The fact remains that the exchange rates of a currency is fundamentally affected by the interest rate set by its central bank. Whether such intervention is manipulation is a matter of perspective.
European ministers, particularly German Finance Minister Peer Steinbrueck, are of the opinion that the Japanese yen is undervalued as a result of Japanese monetary policy and want the problem discussed at the next G7 gathering on February 9. The mismatch between EU and Japanese monetary policies is caused by
<>A currency peg with another currency is a unilateral regime. It does not require permission from the government of the pegged currency. A currency peg is not sacred or inviolable, nor is it a free lunch for the economy that adopts it. Any currency peg can broken by the market if the government that adopts it is unwilling or unable to bear the cost of sustaining it, as has happened to many currencies around the world, including the British pound’s peg to the German deutschmark which was broken by hedge fund speculator George Soros in 1992 with a spectacular profit of over $2 billion in a matter of days, draining the exchange reserves of the Bank of England and precipitating a collapse of Europe’s Exchange Rate Mechanism (ERM).
The ERM was a multilateral fixed-exchange-rate regime adopted in March 1979 as part of the European Monetary System (EMS), to reduce exchange rate volatility and to achieve monetary stability in
During the 23 months of ERM membership, from October 1990 to September 1992,
The British government of John Major sought to balance political and macroeconomic considerations, only to fail in its effort to support the unsupportable to prevent a devaluation of a freely traded pound by market forces. If the
Withdrawing from the ERM released the
The appropriate exchange rate of currencies at any particular time is that which enables their economies to combine full employment of productive resources, including labor, with a simultaneous balance-of-payment equilibrium. An excessively high exchange rate causes trade deficits and domestic unemployment, while a low one generates an excessive buildup of foreign-currency reserves and stimulates domestic inflationary pressures that lead to a bubble economy. Thus every nation with a freely convertible currency must retain the ability to adjust the external values of its currency in this unregulated global financial market and an international financial architecture based on dollar hegemony. To be fixated on a fixed exchange rate within rigid limits is to court economic disaster in the current international finance architecture of freely convertible currencies. This is the lesson why
The ERM was a transitional regime whose problems were finally removed once the EU moved toward a single currency in the form of the euro. Still, the anti-inflation bias of the European Central Bank continues to create conflict with monetary policy needs of national economies within euroland. The current dispute surrounding the exchange rate of the yen to the euro is the result of interest rate disparity between the two currencies, ictated by separate domestic monetary needs, not by market fundamenatls.
In a fast-changing economic environment of unregulated global markets, the value of the exchange rate that facilitates full employment and a foreign trade balance will frequently fluctuate. Speculative volatility must be countered and the exchange rate managed by the national bank to prevent disruption in the domestic economy and in external trade. However, this does not imply fixed, unchangeable bands as under the ERM. The optimum strategy for cooperation between national central banks on exchange rates requires a combination of maximum short-term stability with maximum long-term flexibility, the opposite of the effects of fixed exchange rates.
Since, under ERM,
The reunification of Germany cracked open the structural flaw in the Exchange Rate Mechanism because massive capital injection from West to East Germany had produced inflationary pressure in the newly unified in German economy, leading to preemptive increases of interest rates by the Bundesbank. At the same time, other economies in
Along with the European Currency Unit (ECU, the forerunner of the euro), the ERM was one of the foundation stones of economic and monetary union in
In 1992, the ERM was torn apart when a number of currencies could not keep within these limits without collapsing their economies. On Wednesday, September 16, a culmination of factors led
In order to curb German inflation, an increase in German interest rates was necessary, but if the Bundesbank were completely independent of German political-economic interests as a dominant regional central bank, it would not have adopted this policy, as there were cries from all over
This was the fundamental problem with the ERM—fixed exchange rates conflicted with the interest-rate levels needed by different economic conditions in separate member economies. The British interest rate pegged to that set by the Bundesbank was crippling the British economy because the
Today, the foreign exchange value of the Japanese yen has been pushed down by low yen interest rates which the Bank of Japan has been forced to maintain to keep the Japanese economy from falling into deeper recession.
The Pro and Con of Full Convertibility<>
The key distinction between the Japanese yen and the Chinese yuan is the degree of convertibility. EU officials point to low yen interest rates as the cause of the yen being undervalued and the
It is true that the RMB’s limited convertibility allows
For economies where the currencies are freely convertible, the cost can be massive attacks on their currencies by speculators, such as hedge funds, that would quickly drain the government’s foreign exchange reserves and cause a collapse in the economy’s debt market. For economies that practice exchange and capital control, the penalty would be a drain in foreign reserves and a reduction in trade in the case of a deficit. In the case of a trade surplus, the penalty would be a drain of domestic currency capital into growing foreign exchange reserves.
For a limited convertibility currency, the cost of a fixed exchange rate is absorbed internally within the domestic economy. On the other hand, a freely-convertible currency with a fixed exchange rate is mixing gasoline with fire as the British pound demonstrated in 1992. Yet a freely convertible currency with a low interest rate policy designed to stimulate the domestic economy will enhance a nation’s foreign trade competitiveness. For the case of US-China trade, a freely convertible RMB with a low interest policy will exacerbate US-China trade imbalance further against the
In that sense, to say that a currency not freely convertible and tied to a fixed exchange rate pegged to the dollar is unresponsive to market forces, let alone market manipulation, betrays a lack of understanding of how international trade is financed and intermediated in the global economy. Currency pegs are not immune to market forces; they only transmit the effects of market forces through difference economic channels. All governments participate in money markets to carry out monetary policy, buying and selling government securities to implement their interest rate policies, and in currency markets to sustain the desired levels of exchange rate. Nowadays most central banks are not even dominant market participants, having been edged out of center stage by hedge funds as major players that regularly move markets with notional values in hundreds of trillions of dollars.
US is the Head of the Currency Manipulation Snake<>
Fundamentally, a currency peg is merely a different path to the same monetary objective as the setting of the Fed Funds rate, with the Fed Open Market Committee buying and selling government securities to maintain an announced interest rate target. As the dollar is the key reserve currency in world trade and finance, the
For decades, beginning with a collapse of budgetary and monetary discipline during the Vietnam War, the US had been manipulating the exchange rate of the dollar downwards, a fact obscured in the last decade by the emergence of dollar hegemony, a regime introduced by Clinton Administration Treasury Secretary Robert Rubin to finance the US trade deficit with its capital account surplus to deliver borrowed prosperity to the US through a global debt bubble fed by the US Federal Reserve’s dollar printing frenzy.
Thus it is irony bordering on disingenuousness when Federal Reserve Chairman Ben Bernanke, in China as part of the US-China Strategic Economic Dialogue delegation led by Secretary Paulson, voiced concern for the allegedly undesirable distortions that result from an “effective subsidy that an undervalued currency provides for Chinese firms that focus on exporting.” For decades, the real market distortion has come from the Fed’s interest rate policy, liquidity bias and inflation targeting. By law, the Fed is obliged to support the Treasury’s strong dollar policy in defiance of market forces as a matter of national security. And a strong dollar policy is a professed example of currency manipulation.
Dollar interest rates have been lower than euro interest rates and higher than yen interest rates because of differing economic conditions and national phobia regarding inflation at home. The US Treasury, while maintaining a strong dollar policy, has indicated that the dollar should be freer to find its own level. Since most Asian currencies except the Japanese yen are pegged to the dollar, the only currencies affected by a fall in the dollar will be the yen, the euro and currencies linked to it, British sterling and the Swiss franc, causing a technical movement away from the dollar until the US brings its twin deficits under control. Until then the yen and the euro will bear the brunt of the weakening of the dollar, but not evenly, with the yen falling against the euro while rising against the dollar.
The High Cost of Bringing the
If history is any guide, the
Volcker’s triumph over domestic inflation was bought with the destabilization of the international financial system, where
On the eve of the meeting of the Group of Seven (G7: the US, Japan, Germany, France, Italy, Britain and Canada) on February 10 in Essen, Germany, the dollar traded at 121.6 yen and 0.7689 euro (or $1.30 to a euro). While 120 yen to the dollar is where the
There is visible evidence that the volatility in exchange rates among major currencies has been caused by hedge fund arbitrage. Contrary to rationalization offered by apologists of the positive role of hedge funds in stabilizing and enhancing efficiency in the market, hedge funds have repeatedly shown themselves as a destabilizing and volatility-generating force that threaten the global financial system. In this context of the obvious dangers of unregulated currency markets, it is hypercritical for the world’s rich nations to urge
The G7 powers also addressed the recent slide in the Japanese yen by urging financial markets to take account of Japan’s strengthening economy in an attempt to convince currency speculators of the need for caution on carry trades where investors borrow massively in low-yield currencies such as the yen to invest elsewhere for bigger returns, something that is compounding recent yen weakness. G7 guidance to markets on the ultra-sensitive matter of exchange rates was almost identical to what they said an earlier meeting in September 2006 in Singapore that failed to stem a slide in the yen. G7 governments are the equivalent of permissive parent warning the youngsters on the danger of drugs while they themselves indulge in alcohol abuse with their addictive fixation on the fantasy merits of market fundamentalism.
US Treasury Secretary Henry Paulson dismissed the EU’s complaints on the yen, saying the Chinese yuan rather than the Japanese yen was the problem because the Chinese currency was controlled by the Chinese authorities and remained too weak, whereas
Foreign exchange was a hot topic at the latest G7 meeting in
The G7 also discussed potential risks from the burgeoning hedge fund industry, which is less regulated than banks and other financial institutions and geometrically higher leveraged. Loosely regulated hedge funds have become a powerful market force, initially catering to the risk appetite of the ultra-rich to profit from risk management needs of business but concern is mounting about their widespread proliferation to attract individuals and institutional investors who are attracted by the promised profit but not truly qualified to assume such risks. Instead of spreading risk throughout the financial system to prevent concentrated effects of singular defaults, hedge funds as an industry have become a prominent risk factor itself in catastrophic systemic failure.
Increasing links between hedge funds and commercial banks are also problematic, with banks lending to both sides of the same bet, profiting from handsome fees irrespective of the direction of the market but assuming exposure to counterparty risks in the event of default. Big money center banks are heavily trading credit derivatives that bet on the risk of bonds or loans default. Many investment banks have become de facto hedge funds with proprietary trading constituting the bulk of their profit.
Hedge Funds are the real Currency Manipulators
Hedge fund assets have doubled globally to more than $1.4 trillion in the last five years betting on notional values in the hundreds of trillion. The Bank of International Settlement (BIS) reports that the volumes outstanding of over-the-counter (OTC) derivatives expanded at a brisk pace in the first half of 2006. OTC contracts are traded directly between counterparties outside of exchanges which guarantee settlements for their members. Notional amounts of all types of OTC contracts stood at $370 trillion at the end of June, 24% higher than six months before. Growth was particularly strong in the credit segment, where the notional amounts of outstanding credit default swaps (CDS) increased by 46%. Rapid growth was also recorded in other market segments. Open positions in interest rate derivatives rose by 24%, while those in foreign exchange (FX) contracts expanded by 22%. Equity and commodity contracts grew at 17% and 18%, respectively. Gross market values, which measure the cost of replacing all existing contracts and thus represent a better measure of market risk at a given point in time than notional amounts, increased by 3% to $10 trillion at the end of June 2006.
The pace of trading on the international derivatives exchanges also quickened in the first quarter of 2006. Combined turnover measured in notional amounts of interest rate, equity index and currency contracts increased by one quarter to $429 trillion between January and March 2006. The combined notional value of all contracts comes to almost $800 trillion. Notional values are not the amount at risk, only the amount on which risk is calculated. But with a notional value of $800 trillion, a 1% shift in value will translate into a profit or loss of $8 trillion, 5.7 times the $1.4 trillion asset value of all hedge funds, or 61% of 2006 US GDP.
The derivative market has been described as a financial weapon of mass destruction. It makes the Chinese currency exchange rate issue seem like a small harmless firecracker.
US-China Trade Imbalance
The Senate Banking Committee also mistook the yuan/dollar peg as a significant contributor to record
Yet when China’s trade surplus with the US is viewed in the context of global trade data, leaving out oil, the collective trade surpluses of the oil-exporting countries having become larger than China’s surplus, Germany, Japan and the rest of non-China Asia have been the large trade surplus components as shares of the US trade deficit. In contrast, until two years ago,
While China has become the largest nominal surplus nation in the global trading system, having surpassed Japan, its foreign exchange reserves of over $1 trillion is an enormous drain of wealth from the yuan economy into the dollar economy, leaving China with the world’s largest poor population and a large growing economy with a capital shortage. Even if China should stop building up its dollar reserves, it only means some other country will add dollar reserves to make up the difference as long as dollar hegemony allow the US to finance its trade deficit with its capital account surplus. Under dollar hegemony, dollar reserves are created by
Wage Disparity and Trade Balance
Even a substantial increase in the exchange value of the Chinese currency will not reduce US-China trade imbalances if Chinese wages do not converge with US wages.
In fact, the yuan/dollar peg has a supportive effect on the
The dollar’s fall is not caused by the yuan being pegged to it. It is caused by the
While cross-border wage arbitrage causes the
Bilateral imbalance between the
The voice of free trade, economist C. Fred Bergsten of the Peterson Institute of International Economics, asserts that such global imbalances are unsustainable for both international financial and US domestic political reasons. On the international side, the
NBER declares Chinese Yuan not undervalue
National Bureau of Economic Research (NBER) Working Paper No. 12850 issued in January 2007 reports that relying upon conventional statistical methods of inference and a framework built around the relationship between relative price and relative output levels, once sampling uncertainty and serial correlation are accounted for, there is little statistical evidence that the RMB is undervalued.
NBER is a prestigious and highly respected private, nonprofit, nonpartisan research organization where Simon Kuznets’ pioneering work on national income accounting, Wesley Mitchell’s influential study of the business cycle, and Milton Friedman’s research on the demand for money and the determinants of consumer spending were among the early studies done. Sixteen of the 31 US Nobel Prize winners in Economics and six of the past Chairmen of the President's Council of Economic Advisers have been researchers at the NBER. The more than 600 professors of economics and business now teaching at universities around the country who are NBER researchers are the leading scholars in their fields.
Rising Chinese Currency will lead to US Inflation
Especially under the present circumstances of nearly zero structural unemployment (below 6%) and near full capacity utilization in the US, a rise in import prices caused by a fall of the dollar will sharply increase US inflation and thus interest rates, severely affecting the equity and housing markets and potentially triggering a recession. Inflation is caused by excess liquidity released by the
The most effective way to reduce the
Wave of Neo-Populism
In a wave of neo-populism, free trade is currently under review in US political debate for the uneven effect it has on the
The post WWII open global trading system had been first reversed by the Nixon Administration which imposed surcharges on imports and took the dollar off gold to achieve a cumulative devaluation of more than 20% in 1971, and by the Reagan Administration driving the dollar further down by more than 50% against the Japanese yen within two years and a smaller fall against the German mark via the Plaza Accord in 1985, with over $10 billion of central bank intervention in the market. The yen rose from 360 to the dollar in 1971 to top out at less than 80 to the dollar in April 1995. The result for
The Plaza Accord was openly government manipulation against market forces to correct the high exchange value of the dollar buoyant by Volcker’s victory over
With deep-seated anxieties over globalization surfacing in US political dialogue as the 2008 presidential election approaches, and the impasse at the Doha Round halting further trade liberalization around the world, the distressed global trade system can only be saved by restructuring the injurious terms of trade to provide a level playing field between global labor and global capital.
To restore global imbalance, the
China needs to wean itself from Export Addiction
On the other side,
State Council Development Research Centre, recently told the press that by 2020,
What is more fundamental is that China does not need foreign capital or foreign exchange reserves if it shifts its economy from export-dependency to accelerate domestic development financed by sovereign credit.
This article appeared in AToL
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