by Arvind Subramanian, Peterson Institute for International Economics
Op-ed in the Financial Times
April 20, 2010
© Financial Times
Necessary adjustments in global imbalances are under way. China's current account surplus is down from a peak of 11 percent to about 6 percent in 2009, while the US current account deficit is well down from its peak of 6 percent. Estimates of future surpluses in China are being revised down. Yet the contours of the next imbalance are becoming clear and China's exchange rate is central.
Essentially, the tidal force of capital flows to emerging economies faces only partially flexible currencies. The wave is being caused by a number of factors that have sharply increased returns to capital in emerging markets relative to those in advanced economies.
The biggest factor is the contrasting performance of emerging economies, especially in Asia, which are roaring back while advanced economies, notably in Europe, are growing anemically. As a result, the size of these flows is likely to surpass precrisis levels.
With these economies at different stages of cyclical recovery, monetary policy stances are also in contrast. With inflation still quiescent, monetary authorities in advanced economies are likely to withdraw policy support only gradually. In emerging economies authorities have started to tighten monetary policies to head off incipient inflationary pressures (China, India, and Indonesia) or they are unwinding the earlier monetary accommodation as growth returns. Thus, substantial interest rate differentials in favor of emerging economies are becoming a reality, further pushing capital from advanced to emerging economies. Problems in Greece and consequential contagion in Europe might only aggravate capital flows to emerging economies.
How have emerging economies responded? Essentially through massive accumulation of foreign exchange reserves, the pace of which resembles the precrisis period. It is not that emerging economies have not let their currencies appreciate in response to flows; rather, upward currency flexibility has been limited. The irony is that this policy choice worsens the imbalance. The more inflexible exchange rates are, the greater the pull for capital flows because of the one-way bet that is created by policy.
How can this imbalance be resolved? To the extent that some flows are unavoidable and even desirable, emerging economies have to be ultra-vigilant in preventing overheating of goods and asset prices. Here there is reason for optimism. Especially in Asia the lessons from the late-1990s crisis and the recent one have been etched in the collective DNA. The 1990s crisis taught them what not to do, while the financial crisis affirmed the prudent choices made in the intervening years.
But emerging economies will want to moderate inflows of capital both for macroprudential reasons and to avoid becoming uncompetitive due to rising currency values. What should they do? The only two real options are capital controls and currency appreciation. But what is becoming clear is that the landscape is rife with beggar-thy-neighbor possibilities. For example, if some countries restrict capital, there is the risk that capital gets diverted to others, increasing pressure on them. And competitive nonappreciation—the revealed preference of many emerging economies given that their main trade competitor, China, has a fixed exchange rate—imposes large systemic costs of global overheating and excess liquidity creation as reserves pile up around the world.
The policy lesson is clear: the need for coordination among emerging economies on managing capital flows and exchange rates. Key to facilitating this is China's exchange rate policy. It is welcome that China has signaled that the renminbi will be more flexible, but its policy of gradualism risks being overtaken by events. Given the scale of capital flows, a small move by China will probably only elicit a small move by other countries, especially in Asia. Given expectations about the magnitude of its eventual appreciation, the one-way bet will remain largely intact, with not much dampening effect on flows.
Rectifying the new imbalance will require an even more ambitious move by China. With that in place other emerging economies can then allow more flexibility in their currencies. De facto policy coordination is possible and China moving soon and substantially can help bring that about.
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