Caught Between a Greenback and Redback World

There are moments in history when the future is often clear, but its path is somewhat obscured. Such could be said about the early 21st century, a period of unprecedented globalization that raises serious questions concerning the world’s near-term economy and capital markets. Today, one could argue that the U.S. economy and its dollar – the greenback – most likely have peaked (or at a minimum, paused) in terms of global importance. The future leading economy, probably within a generation, should be China and its currency, the yuan - or what is now being called the “redback”.

How long it will take for the currently controlled redback to intertwine itself with the world is anyone’s guess, but in this transition period, we forget there are dozens of smaller countries that are also engaged in cross-border trade and investing. Compared to the quilt-like global economy of the 20th century – largely domestic systems with only modest cross-border flows of goods and capital - today’s international system resembles a tapestry: many national economies woven with commercial and financial threads of others. There’s evidence, however, that without better stewardship, the Neoliberal “capitalist peace” that the globalizing world has experienced since the late 1980’s may unravel. Foreign exchange (FX) rates form the basis of comparative advantage and free trade, and recent American fiscal and monetary policies, coupled with China’s Neomercantile posturing, have jostled many smaller countries caught in the economic superpower crossfire. Such American and Chinese stances recently prompted Brazilian Finance Minister Guido Mantega to warn of a “currency war” that could quickly turn into a global “trade war,”¹ something not seen in roughly a century.  True, the likelihood of this is small. However, there are telltale signs in the FX markets today that beg for greater multilateral economic coordination. 

The Curious Superfusion of the US and China

While few doubt the yuan will become one of the world’s dominant currencies, its internationalization process has been painfully slow, perplexing, and problematic – that is, to everyone but China. But it is America and China’s co-dependency – the economic and financial “superfusion”, as Zachary Karabel has labeled the relationship²—that is most intriguing given record trade deficits  and China holding a remarkable $1.7 trillion in U.S. government debt (down from its peak, see Exhibit 1). As Martin Wolf of the Financial Times has noted, “Never in human history can the government of one superpower have lent so much to that of another. It is difficult to envisage a robust configuration of the world economy without large net capital flows from the high-income countries to the rest.  Yet it is also hard to imagine that happening, on a sustainable basis, if the world’s biggest and most successful emerging economy is also its largest net exporter of capital.”³

Surely, even to laymen, the situation makes little sense. One would think a country with such low per capita income, over 1.3 billion people, and the fastest-growing large economy would have plenty of domestic investment possibilities. However, for nearly fifteen years, China has hoarded export earnings, swelling reserves from $75 billion to nearly $3 trillion. Instead of boosting imports, China – perhaps with fears from the Asian financial crises – contributed to a global savings glut by becoming one of the world’s largest buyers of U.S. government and agency bonds and maintained its firm U.S. dollar peg. Some suggest that this partially fueled the global financial crisis by curbing long-term U.S. interest rates, thereby stoking the borrowing frenzy for more than a decade,⁴ including the spendthrift Bush administrations that added nearly $3 trillion of national debt from 2001 to 2009, according to the Congressional Budget Office.

A Brief, Cautionary History

Financial leadership transitions with currency re-alignments are not uncommon in history, and they normally occur after a country runs into trouble. Up until World War I, the United Kingdom was one of the world's strongest economies, and the British pound was equal to roughly $5. However, by accumulating a huge amount of war debt - while the U.S. industrial base and economy roared forward - the British were forced to devalue several times (or the U.S. dollar, revalue)  to approximately $2.80. With the breakdown of Bretton Woods in 1971, the British pound has fluctuated between $1.20 and $2. This is what happens when a financial power with a reserve currency incurs massive overseas debt while lesser-developed economies rise in productivity and converge globally.

Japan, in its ascent to becoming a global economic power has seen its currency revalue in recent decades, similar to the dollar versus pound earlier in the 20th century. The yen lost value during and after World War II, and was fixed at ¥360 against the U.S. dollar by Bretton Woods. By 1971, however, it had become undervalued after two decades of productivity gains. Japanese goods were incredibly cheap, and imports were costing too much.  Japan’s current account balance rose from the deficits in the early 1960s to a surplus in 1971. The belief that the yen was undervalued motivated the United States and Europe to push the yen to ¥308 per $1. In 1971, the fixed rate system was scrapped, and the major nations of the world allowed their currencies to float.

In the 1970s, Japan grew concerned that a strong yen would hurt export growth. The government intervened heavily in FX markets (buying or selling dollars), even after the 1973 decision to allow the yen to float. Trade surpluses helped strengthen the yen to the mid ¥200s against the dollar by 1980. This continued and in 1985, key nations signed the now famous multilateral Plaza Accord to acknowledge that the Yen was undervalued. This agreement, coupled with shifting market supply and demand, led to a rapid rise in the value of the yen, now below ¥85 to the U.S. dollar.

Floating currency regimes tend to more honestly reflect value, but some stability is sacrificed in the process. In the 1990s, many developing countries, struggling with hyperinflation and monetary instability, pegged their currencies to the U.S. dollar in an attempt to gain better monetary control. While this policy helped to stabilize economies, over time the strengthening U.S. dollar meant that many countries—including Mexico, South Korea, Brazil, and Russia, among others—saw their trade competiveness erode. Large foreign debt loads forced countries to raise interest rates to attract capital, which ultimately depressed their local economies. The dam burst with Mexico in late 1994, several Asian countries in 1997, Russia in 1998, and Brazil in 1999. In the wake of these currency de-peggings and free floats, most developing countries reversed trade deficits and recorded record growth, trade surpluses, and accumulated combined hard currency reserves of $5+ trillion.⁵ China is the remaining large developing country that seemingly maintains a peg, although it purportedly dropped it in 2005 and reaffirmed this in June 2010.⁶

Even with currency free-floats and phenomenal trade successes, the International Monetary Fund (IMF) suggests that many EM currencies may still be theoretically undervalued (see Exhibit 2) based on Purchasing Power Parity, a useful though imperfect methodology.⁷ Over time in a free-float world, many should gain against the dollar, just as the dollar gained against the British pound and the Japanese yen gained against the dollar as trade and investment integration accelerated. Note that in the first decade of the new millennium, fast integrators like South Africa, South Korea and Turkey saw their currencies value rise move from roughly 30 percent to 67 on a GDP/PPP basis. Even with this strength, most major currencies still look expensive, which is also leading investors to cheaper emerging markets.

Not surprisingly, India and China, which still resist full, free conversions, have some of the theoretically cheapest currencies – with India’s actually much cheaper than China’s.⁸  Given the dramatic U.S. trade deficit with China – and high American unemployment since the credit crisis – Beijing’s  currency policy has become a nagging issue with U.S. government officials. Will the Chinese eventually allow the value gap to narrow by either market forces or government intervention? Only time will tell but the situation is more complex than it may appear. Like European countries trapped in the dollar-yen ranklings in the 1970’s and 1980’s, emerging markets are now caught between greenback and redback politics.

Casualties of the Crossfire

Pressed against the wall, the Obama administration has used the financial crisis to push policies that not only address America’s sluggish economy, but also China’s reluctance to relax the dollar-yuan peg: by lowering interest rates and launching Quantitative Easing (QE), the controversial strategy that creates money to purchase government debt when interest rates are near zero, with the hopes of stimulating more credit into the real U.S. economy. These policies inherently weaken the dollar and reverberate globally. De facto, the U.S. Treasury is encouraging investors to look outside the country for higher returns. Who knows whether this was the intended consequence, but it is a reality that many emerging markets – including China – must now confront.

The combination of low U.S. dollar interest rates (with comparable lows in the Euro and Japanese yen), Quantitative Easing, and the China peg has wreaked havoc for many developing countries trying to compete fairly in the world’s free trade and investment game. Money is gushing not only out of the U.S. but also Europe (with the Euro’s questionable future) and stagnant Japan, with investors looking for better short-term yields and long-term potential. For many, that means emerging markets. With growth rates expecting to top 6% for the next decade, these nations are natural targets for investment. Unfortunately, this capital diaspora has ill effects: upward pressure on exchange rates (making exports less competitive) and prices for food and energy. Such inflationary heat sometimes can often result in many forms of social unrest and political instability.⁹

In the wake of greenback-redback tensions, many governments in Latin America and Asia have begun to counter foreign exchange pressures and currency appreciation with their own policy tools. Brazil has seen its currency effectively double from the time former president Lula Da Silva won election in late 2002 through 2010. On a GDP/PPP basis, the Brazilian real has skyrocketed from roughly 50% near 93%, prompting Mantega to make his currency war statement. Anecdotally, The Economist noted that Big Macs in Brazil were the second most expensive in the world ($5.26, topped only by Switzerland’s $6.78), 40% more than in the U.S. ($3.71) as of late 2010.¹⁰ To stem the rise, the country enacted a tax on foreigners’ securities purchases (recently raised to 6%), hiked interest rates, launched measures to curb short-selling of dollars by onshore banks, as well as intervened in the currency markets.¹¹

Elsewhere in Latin America, many countries have mounted defensive measures including a massive Chilean $12 billion sterilization plan.¹² Both Colombia and Peru have also taxed interest payments to non-residents. In addition, Colombia is considering measures to require foreign investors to deposit 30% of the price of their financial investments in the country for a year at its central bank with no interest – all efforts to make the country (and currency) less attractive. And Colombia has also urged Ecopetrol, its state oil company, not to repatriate international profits to help relieve currency pressures.¹³

Beyond China, other Asian economies have taken steps to cool their currencies. Many central banks have routinely bought and sold U.S. dollars to add stability and curb appreciation. In Thailand, the government imposed a 15% withholding tax on capital gains and interest payments for sovereign and quasi-sovereign bonds. Moreover, Thailand removed limits on locals investing overseas and eased restrictions on lending to foreign borrowers in an effort to encourage outflows by domestic investors. Elsewhere, South Korea has re-imposed a 14% withholding tax on foreigners’ income from sovereign bonds, and Taiwan recently capped foreign holdings of its long-term bonds. Struggling with Mundell’s “Impossible Trinity”, government intervention and capital controls seem to be an unfortunate default policy for many, and even approved by the IMF.¹⁴

One less reported phenomenon adding to inflow pressures is the current composition of local emerging market bond benchmarks, which often skews institutional investor flows. This is particularly apparent in JP Morgan’s indices, some of the oldest and most frequently used institutional benchmarks. Depending on country-specific foreign investment limits, JP Morgan uses multiple variations of their indices, ranging from pure market capitalization-calculated versions to the most investable. While JP Morgan’s market capitalization index notes that China’s percentage is approximately 25% of all emerging markets, in the most investable, replicable (and therefore, followed) index, China’s weighting drops remarkably to less than 2%. The steep falloff is linked to Chinese barriers on foreign investing. In this light, it was interesting to note the recent comment made by the normally reserved Japanese Finance Minister Noda that it was “strange” for China to buy his government’s securities when Japan cannot do the same in China.¹⁵ But China is not alone in this phenomenon. India, too, has similar restrictions on foreigners: its local markets comprise nearly 16% of JP Morgan’s market capitalization index, but less than 2% of the investable index. The distortions created by these two countries – the two largest emerging bond markets - effectively multiply investor flows into other smaller countries, thereby adding undue pressure and volatility onto their currencies. Some, like Hungary, unfortunately see their index weights swell from only 2.2% of market capitalization to nearly 10% in JP Morgan’s investable index. In essence, China’s – as well as India’s – lack of open, fully convertible currencies and bond markets contributes to the distortions in foreign capital flows with more open economies – regardless of size – thereby penalizing them with unwanted spillover.

Can these currency woes turn into trade wars? Surely the public concerns of Brazil’s finance minister are being discussed privately in many central banks. Moreover, these issues certainly complicate the Doha round of World Trade Organization talks, those that began in November 2001 but are nowhere close to concluding with any multilateral agreement. One can only hope that the economic and financial realities will yield to some cooperative outcome. The last time the world witnessed such cross-border competition was approximately one hundred years ago, a period which some suggest fomented the two world wars.¹⁶

Who Will Lead, and Where to?

The United States helped pioneer the Neoliberal economic order after World War II and has been the global markets’ shepherd ever since. No other single nation has yet to emerge as a leader, and the new rising power – China – has made few statements and taken even fewer actions to indicate that it wants to assume such responsibility, or whether it even wants to support a Neoliberal system. Yet trillions in commerce and future prosperity are perilously at stake. Globalization’s promise has only been partly realized in the last decade or so, with far greater benefits potentially ahead. However, globalization cannot flourish without acknowledging the inevitable multi-polarity that is unfolding as we transition from the greenback-dominated era to one that includes more redbacks.

Our short but useful experience in the 21st century underscores globalization’s need for better balanced trade and investment flows.  Some suggest a new framework to limit exchange rate fluctuations from their theoretical equilibrium values through close cooperation between policy makers in both older industrial and emerging nations—something that has been the G-7’s domain but now requires much broader participation.  Perhaps the G-20, or a smaller subset of countries, could coordinate these needed protocols. This might also be developed in tandem with closing the Doha round of trade talks, since trade and currency are inherently linked.

With better multilateral arrangements, the U.S. government would also benefit by stimulating greater domestic savings, discouraging indiscriminate consumption,¹⁷ and launching policies to slow energy imports – huge departures from America’s recent “living large” past. China, for its part, could accelerate the opening of its currency and bond markets, which would be coordinated with comprehensive plans towards greater domestic consumption. To do so, China would have to willingly abandon a growth model in which government-influenced bank lending and a cheap pegged currency have been keys to success. A stronger redback might also lead to more balanced trade not only with the U.S., but also many other emerging markets. That would relieve a lot of the inflationary, currency and political pressures building globally.

One could see how multilateral agreements and national adjustments could lead to a new financial order with multiple reserve currencies. Barry Eichengreen has noted, “the more alternatives central banks and other international investors possess, the more pressure policymakers will feel to take the steps needed to maintain those investors' confidence”.¹⁸ Such a new, diversified system would hopefully alleviate the imbalances and prevent asset bubbles that unfortunately characterized the last decade. Indeed, many bullets need to be bitten, both home and abroad. For globalization’s continued success, the sooner the better.

Notes

1 Jonathan Wheatley and Joe Leahy, “Trade war looming, warns Brazil,” Financial Times, January 9, 2011.

2 See Karabel’s Superfusion: How China and America Became One Economy and Why the World's Prosperity Depends on It (Simon & Schuster, 2010).

3 Martin Wolf, “Currencies clash in new age of beggar-my-neighbor,” Financial Times, September 28, 2010.

4 “Beyond Bretton Woods 2,” The Economist, November 6, 2010.

5 The World Bank notes that hard currency reserves of emerging markets grew from approximately $600 billion at year-end 1996 to more than $5 trillion at year-end 2010. China holds some 60% of this total, but there have been sizable gains by countries from all regions globally.

6 Beijing’s announcement ahead of the Toronto G20 meeting in June 2010 noted a policy of linking the yuan to a basket of currencies, without identifying the composition of the basket. To be fair, the yuan has appreciated nearly 3% since the announcement, but the currency still looks undervalued. In fact, some analysts, including former head of the International Monetary Fund’s China division, Eswar Prasad, noted that the yuan could potentially devalue against the dollar, depending on the basket’s composition. See “China’s Hu Buys Time With Yuan Announcement”, Bloomberg News, June 21, 2010.

7 According to the World Bank, Purchasing power parity conversion factor is the number of units of a country's currency required to buy the same amounts of goods and services in the domestic market as U.S. dollar would buy in America. By dividing a country’s GDP by its theoretical Purchasing Power Parity, as defined by the World Bank, one would see most emerging market economies have currencies that are still significantly undervalued (ratios lower than 100 percent). Major currencies, using such analysis, are largely overvalued. There are many variations on such methodology, including The Economist’s Big Mac Index, and the Penn World Tables (PWT).

8 The fact that the U.S. only runs a modest trade deficit with India (less than $5 billion in 2009 and less than $10 billion in 2010) versus the large one with China ($225 billion 2009 and $252 billion in 2010) is probably why we hear few politicians accusing India of being a “currency manipulator”.

9 How quickly we forget the 2007-2008 foods riots when grain and soybean prices shot up. Indeed, some analysts suggest rising food prices to help stoke some of the recent social unrest in Tunisia and Egypt.

10 “The Big Mac index,” The Economist, October 16, 2010.

11 The central bank was reported in local press of launching nearly $1 billion in reverse currency swaps on January 14, 2011.

12 “Leaning Against Currency”, The Institute of International Finance, January 4, 2011.

13 “Waging the currency war,” The Economist, January 15, 2011.

14 Dani Rodrik lamented the IMF’s February 2010 decision to reverse its long-held position on resisting capital controls, saying they were “legitimate part” of policymakers’ toolkit. See Rodrik’s “The End of an Era in Finance”, Project Syndicate (http://www.project-syndicate.org/commentary/rodrik41/English)

15 “China’s reserves in need of a bigger boat,” The Economist, October 16, 2010.

16 Harold James of Princeton is perhaps the most notable scholar to chronicle the economic history leading to World Wars I and II. See his excellent book The End of Globalization: Lessons from the Great Depression (Harvard University Press, 2002).

17 Better progress indicators could also be used versus the traditionally dominant Gross Domestic Product (GDP) statistic which would also steer public policy decisions. As long as spending $50 on cigarettes and $50 on schoolbooks have equal value in GDP calculations, the quality of sustainable economic wellness will always be trumped naively by the pure quantity of economic activity.

18 Barry Eichengreen, “The Dollar Dollar Dilemma: The World’s Top Currency Faces Competition”, Foreign Affairs, Sept/Oct 2009.