Op-ed in the Financial Times
March 4, 2005
© Financial Times
Proponents of what is called the "revived Bretton Woods system" of semi-fixed exchange rates argue that we need not worry about the sustainability of either the large US current account deficit or the undervalued exchange rates of a group of Asian economies. In their view, the US and the Asian economies have entered into an implicit contract that can comfortably carry on for another decade or two, with significant benefits to both parties.
The United States gains stable, low-cost funding for its large current account deficit. Without big purchases of US Treasury securities by Asian governments, US interest rates would be higher and financing of the US external deficit less secure, perhaps inducing a more painful and chaotic adjustment to the US savings-investment imbalance. Asian countries also welcome foreign direct investment, permitting US companies to use low-cost Asian labor.
From the perspective of the Asian countries, their prolonged, large-scale exchange market intervention limits or even prevents the rise in the value of their currencies against the US dollar. The undervaluation of their currencies, in turn, is said to underpin an export-led development strategy generating sufficient economic and employment growth to maintain social stability.
Inward FDI is claimed to contribute to building a world-class capital stock that would otherwise be unattainable due to the inefficiencies and distortions in the domestic financial system. And US investors provide Asian countries with an ally in keeping US markets open to their exports. China plays a central role in the revived Bretton Woods system. It is Asia's largest exporter, its largest source of surplus labor, and in 2003 was the world's largest recipient of FDI. It has been one of the two largest official sources of financing for the US current account deficit over the past two years. In addition, the US has been China's largest export market for a decade.
However, the case for this system is undermined by Chinese reality. First, it suggests that China should focus exclusively on undervaluing its exchange rate in relation to the dollar. But more than half of China's exports go to markets other than the US or to countries with currencies not pegged to the dollar. Second, the exchange rate that matters most to China—the real, trade-weighted exchange rate—appreciated by nearly 30 percent between 1994 and early 2002, followed by a depreciation of about 10 percent by end-2004. Apparently, keeping the real, trade-weighted exchange rate undervalued has not been an integral part of China's development strategy. Third, their argument about a large, efficient FDI-financed capital stock ignores the fact that foreign investment in China has funded under 5 percent of fixed asset investment over the past few years—far too small a share to offset the misallocation of investment financed through China's weak domestic banking system. Without the capital stock argument, the revived Bretton Woods system is just another ill-informed employment-oriented case for exchange rate undervaluation. Fourth, the approach underestimates the costs of sterilization, particularly those associated with financial repression.
If, as seems likely, both the US current account deficit and China's reserve accumulation, currently $610 billion, (£318 billion), become much larger, these sterilization costs will rise. Finally, not only have profits of direct investors in China been modest but US companies investing in China sell mainly on the domestic market and do little exporting back to the United States. It is Taiwanese and Hong Kong investors that are most dependent on exports to the United States. But they do not lobby to keep the US market open to goods produced in China. Thus, the true political economy of China's trade and investment is widely at odds with the revived Bretton Woods view.
The revived Bretton Woods system sets out a faulty development strategy for China. Rather than seeking to promote an enclave economy based on an undervalued exchange rate and on domestic financial repression, China must expedite financial reform, particularly in banking, liberalize interest rates, and reduce reliance on administrative controls and guidance. It must move toward greater flexibility in the exchange rate over the medium term, including an immediate 15 to 25 percent appreciation of the renminbi relative to a currency basket. These policies will promote domestic financial stability and more balanced employment growth, improve the allocation of investment and the management of the economy, and help ensure continued access for China's exports.
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