MARKETS were greatly excited by Alan Greenspan’s musings on the US trade deficit and the dollar last Friday. The idea that market forces were “poised” to stabilise and ultimately to decrease the US trade deficit was hailed as an oracular revelation by the other central bankers and finance ministers assembled at Gordon Brown’s pre-G7 conference in London on Friday. But the Fed Chairman’s pronouncement raised questions that were more important than the one it apparently addressed.
Of course, the US deficit will start to narrow at some point. But the important issue is what will be the impact on the rest of the world economy when the current account deficit begins to “improve”.
The word “improve” belongs inside inverted commas, because a narrowing of the US current account will be anything but good news for other countries, or for the world economy. Mr Greenspan showed with his usual meticulous statistical detail where the pain would be felt if nothing happens to shift the current trends.
The Fed’s main reason for expecting an improvement in the US trade figures is that the squeeze in European exporters’ profit margins has reached its limiting point. Until a year ago European exporters were able to hold their dollar prices at the cost of roughly two-thirds their US profits, according to the Fed’s estimates. But after the recent euro appreciation, European exporters’ margins were now “minimal” and they were starting to give up market share. Chinese exporters, by contrast, “do not have to address this issue” and other Asian countries have suffered only a modest currency effect. Europe, in other words, will remain the fall-guy for the dollar’s depreciation, until the Asian currencies rise.
But a generalised Asian revaluation, led by Japan and China, looks less likely after this weekend’s G7 meeting. The Japanese have parried criticisms of their currency intervention in three ways. First, they have argued that the Japanese economy is still in a delicate convalescence and has to be supported with a competitive exchange rate, although Japan’s real exchange rate is only about 7 per cent below the long-term average it has enjoyed for 20 years (see charts). Secondly, Japan’s private investors are buying dollars and euros so that Japan’s efforts to hold down the yen do not show up as official intervention. Finally, the absence of Japanese intervention and the weakness of its economy have deflected attention to China.
But China has three arguments of its own for avoiding revaluation. First, the economic figures offer no support for the claim that its currency is undervalued. The real exchange rate is near its long-term average (see chart) and China’s current account surplus this year will be $20 billion or 2 per cent of GDP.
This small number suggests that China is not a significant factor in global trade imbalances. Secondly, China sees no case for a one-off revaluation. If there is to be a change in regime, it should be a move towards floating rates. But a floating currency requires a market-based banking reform and this is still far from complete.
Thirdly, a Chinese revaluation would have no perceptible impact on the US trade imbalance because Chinese wages are so far below America’s. A stronger RMB would be hugely beneficial to poor Asian countries. And it is to help these smaller economies that China may be persuaded to shift its currency. But a Chinese revaluation would be as little help to Europe as to the US.
What, then, could Europe do to protect itself in the face of a narrowing US deficit, especially with both Japan and China refusing to budge? The obvious answer would be to stimulate domestic demand by cutting interest rates and taxes. But the sado-monetarism of the ECB rules this out.
A second-best approach, if Europe refuses to make up for flagging US sales by stimulating its domestic expansion, would be to share the burden of adjustment with another part of the world. If China and Japan refuse to oblige, then maybe Europe should direct attention to their Asian neighbours: Korea, Taiwan, Malaysia, Hong Kong and Singapore. Between them, these countries export twice as much as China. Their combined current account surplus of $120 billion is six times China’s and, at 7 per cent of GDP, it is far bigger in relation to their economies than Japan’s. The national surpluses range from 3 per cent in Korea to 7 per cent in Taiwan, 12 per cent in Malaysia and 22 per cent in Singapore. These are still relatively poor countries, with fairly young populations and large needs for infrastructure. They should not be lending surplus savings to rich countries.
Moreover, the economic and technological advances in Korea, Taiwan and even Malaysia, have made these countries direct competitors to US and European exporters. In terms of real GDP per capita and economy-wide productivity, Singapore and Taiwan are now on a par with Italy, while Korea is almost equal to Spain. Yet Singapore’s hourly labour costs are 35 per cent of Italy’s and Taiwan’s are 28 per cent. Korea’s labour costs are 65 per cent of those in Spain.
Such figures suggest that revaluations in the Asian NIEs could do much more to level the world’s competitive landscape than any currency adjustments in China.
Turning from theories to practicalities, both financial and political conditions may be developing for a shift in focus from China and Japan to the Asian NIEs. Politically, Korea, Taiwan and the other NIEs have been able to avoid G7 pressure to revalue their currencies. But as it becomes clearer that China wants to stick with its dollar peg, while Japan can use market forces to avoid a substantial revaluation, US and European exporters may start to pay more attention to the competitive pressures they face from smaller Asian economies.
At the same time currency investors may direct more of their firepower at other potential targets. And speculative attacks on smaller Asian currencies could prove much more successful in forcing policy changes than the sporadic inflows into Japan and China. The Chinese can resist speculation forever because of their closed financial system. The Bank of Japan can also defy the markets by simply printing all the yen the speculators can buy. But smaller economies could not emulate a Japanese-style policy of unlimited intervention, since this would cause massive disruptions in their domestic banking systems.
The smaller Asian economies could fight off currency inflows by closing down their economies and reverting to exchange controls. But such action to hold down currencies would play into the hands of Western protectionist lobbies, which have long accused Asian governments of unfairly manipulating their currencies to put their US and European competitors out of business. In the end, currency revaluations might be the least unattractive option for the Asian economies — and if the smaller Asian countries allowed their currencies to float more freely, Japan and China could hardly claim that they were too weak to do the same.
Stronger currencies would stimulate domestic demand and consumer spending in Asia, while giving US exporters greater scope for growth. The US trade deficit would start shrinking without pushing Europe towards bankruptcy — and the global economy could continue to enjoy expansion for many years ahead. Is this just wishful thinking? Perhaps, but Mr Greenspan said on Friday that “the flexibility of the US economic system should facilitate adjustment to smaller deficits without significant reductions in economic activity”. He should have added that flexibility in the smaller Asian economies could do the same for the rest of the world.
