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Substantial Further Dollar Decline Needed to Restore Balance to World Economy

November 30, 2004

Contact:    C. Fred Bergsten    (202) 328-9000
    John Williamson    (202) 328-9000

Washington, DC—The dollar needs to decline by another 15 percent or so to cut the US current account deficit to a sustainable level and thereby protect the US and world econ-omies from the risk of severe disruption. Most of this further adjustment should take place against Asian currencies, which will require China to revalue its exchange rate against the dollar by about 20 percent. These are among the main conclusions of Dollar Adjustment: How Far? Against What? edited by C. Fred Bergsten and John Williamson for the Institute for International Economics.

The average exchange rate of the dollar has fallen by about 15 percent since the beginning of 2002 (table 1). This has achieved about half the correction needed to cut in half the US external deficit, now running well above $600 billion (5.5 percent of GDP) and rising rapidly, and thus to stabilize the ratio of US foreign debt ($2.5 trillion at the end of 2003) to GDP. Most of the dollar decline to date has occurred against the euro and other currencies that are floating freely. China, Japan, and other Asian countries have intervened massively in the exchange markets to block or limit their participation in the international adjustment process and must cease doing so to permit its second leg to take place in a constructive manner.

The decline of the dollar has been quite orderly to date and world economic growth has remained brisk. Another six months or so of realignment at the recent pace could complete the process satisfactorily. There is a significant risk, however, that the currency movements could accelerate sharply and produce a hard landing for the US and world economies, with interest rates rising sharply in the United States and growth abroad dampened by precipitate reductions in trade surpluses as other currencies rise in value.

Hence the exchange rate movements need to be complemented by two major policy changes. The United States must enact a credible program to reduce its budget deficit, increasing its national savings rate and thus reducing its need for foreign capital as well as restoring confidence in its economic management and long-term growth prospects. The surplus countries, in both Europe and Asia, must expand domestic demand (through expansionary monetary and fiscal policies along with needed structural reforms) to offset the reductions in their trade surplus.

The main conclusions of the new Institute volume are as follows:

  • The Chinese renminbi needs a substantial appreciation, on the order of 15 to 20 percent, on both internal and external grounds. Such an appreciation would help China achieve its stated goal of curbing the overheating of its economy by reducing demand for exports, cutting prices of imports, and checking the large inflows of speculative capital that could again produce rapid expansion of the money supply.
  • Given the weaknesses in a number of Chinese banks, it would not be wise to seek such a result by liberalizing the capital account and floating the renminbi as recommended by the US government and the IMF. A far better policy would be to implement a one-off revaluation, followed by the adoption of limited flexibility (wide margins and a basket peg) that would enable China to learn to float.
  • A number of other Asian economies, most of which have currencies that ostensibly float but whose authorities are fearful of losing too much competitiveness vis-à-vis China, should permit their exchange rates to appreciate more (although in most cases by somewhat less).
  • These revaluations of other Asian currencies would enable Japan to allow the yen to appreciate further against the dollar without the large effective appreciation that would occur if the yen were to rise alone, thus mitigating any risk that Japan’s economic recovery would be jeopardized.
  • The euro may overshoot against the dollar because the dollar will need a period on the weak side to compensate for its years of acute overvaluation. It would therefore be inappropriate, as well as almost certainly futile, to try to stem a moderate further rise in the euro at this time.
  • Other Anglo-Saxon currencies (the pound, Canadian dollar, Australian dollar, New Zealand dollar) have already appreciated substantially. As with the euro, however, a period of overshooting may need to occur.
  • The currencies of other emerging markets (Latin America, South Africa) have
    already strengthened against the dollar but will need to move further against the dollar—though not necessarily in effective terms—if and when Asia appreciates.

The new book is divided into three main sections. Following an overview of the volume by
C. Fred Bergsten and John Williamson, the first part examines models of equilibrium exchange rates. The second part looks at the impact of dollar adjustment on various countries and regions: Michael Mussa examines the impact on the world as a whole, Martin Baily and Robert Lawrence look at the impact on US manufacturing, Paul Masson considers the impact on Canada, Takatoshi Ito analyzes the position of Japan and Morris Goldstein assesses the situation of China.

The third part of the book contains two papers that explore new approaches to analyzing the impact of intervention in the currency markets. Chris Kubelec concludes that there is strong evidence that intervention can be successful in helping to curb misalignments. Marcel Fratzscher argues that intervention actually offers two policy instruments: “oral intervention” (jawboning) as well as purchases and sales in the foreign exchange market. He shows that the United States and the ECB have largely abandoned the latter in favor of the former and that both have had measurable, if not always reliable, effects in the past.

About the Authors

C. Fred Bergsten has been the director of the Institute for International Economics since its creation in 1981. He is also chairman of the "Shadow G-8," which advises the G-8 countries on their annual summit meetings. He was chairman of the Competitiveness Policy Council, which was created by Congress, throughout its existence from 1991 to 1995 and chairman of the APEC Eminent Persons Group throughout its existence from 1993 to 1995. He was assistant secretary for international affairs of the US Treasury (1977–81); assistant for international economic affairs to Dr. Henry Kissinger at the National Security Council (1969–71); and a senior fellow at the Brookings Institution (1972–76), the Carnegie Endowment for International Peace (1981), and the Council on Foreign Relations (1967–68). He is the author, coauthor, or editor of 34 books on a wide range of international economic issues, including The United States and the World Economy: Foreign Economic Policy for the Next Decade (2004), Dollar Overvaluation and the World Economy (2003), No More Bashing: Building a New Japan-United States Economic Relationship (2001), Global Economic Leadership and the Group of Seven (1996), and The Dilemmas of the Dollar
(2d ed, 1996).

John Williamson , senior fellow since 1981, was a professor of economics at Pontifícia Universidade Católica do Rio de Janeiro (1978–81), University of Warwick (1970–77), Massachusetts Institute of Technology (1967, 1980), University of York (1963–68), and Princeton University (1962–63). He also served as adviser to the International Monetary Fund (1972–74), economic consultant to the UK Treasury (1968–70), and senior economist for the South Asia Region of the World Bank (1996–99) while on leave from the Institute. He is author, coauthor, or editor of numerous studies on international monetary and development issues, including After the Washington Consensus: Restarting Growth and Reform in Latin America (2003), Dollar Overvaluation and the World Economy (2003), Delivering on Debt Relief: From IMF Gold to a New Aid Architecture (2002), Exchange Rate Regimes for Emerging Markets: Reviving the Intermediate Option (2000), The Crawling Band as an Exchange Rate Regime: Lessons from Chile, Colombia, and Israel (1996), What Role for Currency Boards? (1995), Estimating Equilibrium Exchange Rates (1994), and The Political Economy of Policy Reform (1994).

About the Institute

The Institute for International Economics, whose director is C. Fred Bergsten, is the only major research center in the United States that is devoted to global economic policy issues. The Institute's staff of about 50 focuses on macroeconomic topics, international money and finance, trade and related social issues, and international investment, and covers all key regions—especially Europe, Asia, and Latin America. The Institute averages one or more publications per month; holds one or more meetings, seminars, or conferences almost every week; and is widely tapped over its popular Web site.

Dollar Adjustment: How Far? Against What?
C. Fred Bergsten and John Williamson, eds.
November 2004 • 300 pp. • $21.56
ISBN paper 0-88132-378-0