GLOBAL ECONOMY II: by Colin TeeseNews Weekly
Currency wars and the rise of China
, November 27, 2010
That the world is now caught in a currency crisis is part of the public record. That China is a contributing factor to the crisis is also beyond question.
China certainly is holding down the value of its currency in order to maintain a competitive edge over its rivals in export markets - though, if the Economist
journal is to be believed, less so than we all imagined.
China's behaviour is consistent with that of other emerging economic powers ever since advanced Western economies switched from fixed to floating exchange rates.
The US has succeeded in bringing pressure to bear on countries, notably Germany (before it joined the euro) and Japan, to desist from deliberately holding down the value of their currencies to boost exports. However, to date, the US has been unable to persuade China to desist.
It's debatable whether China's co-operation with the US on this matter would help rescue US manufacturing. Are US manufacturers waiting in the wings, as it were, to take up the slack and so generate new output, demand and employment inside the US? Almost certainly not. Such companies have long ago moved offshore or gone out of business. More likely, another low-cost Asian exporter would replace China in the US market.
China is, however, the world's fastest growing economic power and the nation with the world's biggest trade surplus. It has been very successful in exploiting and magnifying the distortions built into the West's trading and payments system associated with the switch to floating exchange rates.
Today, we have two trade and payments systems operating in parallel. One is a floating exchange-rate system which permits global market forces - including currency speculation - to set interest rates. The other, practised by China and other Asian exporting nations, is a system of government-instigated exchange-rate manipulation to control financial flows and hold down the value of currency to gain an export advantage.
Despite what we hear from the G20, it is not market forces that should set interest-rate relativities between trading partners, but export flows. Only in that way can exchange-rate relativities be kept in proper balance. Floating currencies can only work effectively if governments undertake not to interfere with exchange rate movements.
No such undertaking currently exists or seems likely - certainly not among the Asian countries. Most of the Asian economies, burnt by the 1997-98 financial crisis, which took place under a regime of floating exchange rates, won't easily be persuaded to float their currencies again.
China, in the context of the current currency war, has also been busy buying up currencies of export competitors (notably South Korea), partly with the intention of creating or maintaining its competitive advantage.
However, China did not initiate the currency war. That war has emerged as a result of the imbalances in the trading system developed over the past 30 years. We now have a world divided into saving and spending nations. That has allowed China to become the most successful surplus economy.
The British economic commentator Martin Wolf reminds us that China, as a consequence of these imbalances, now holds US$2.45 trillion dollars in currency reserves. This represents 30 per cent of the world's reserves and 50 per cent of China's annual output.
The imperfectly working trade and payments system that has been operating in the West over the past 30 years has made this possible. China could, and probably does argue, that it has done nothing more than exploit a system created by others.
It is doing no more than emulating the way powerful countries always behave. Again, to quote Martin Wolf: back in the 1970s, when Europe had concerns about the dollar, John Connally, the then US Treasury Secretary to President Nixon, was able to tell the Europeans, "The dollar is our currency, but your problem."
As part of its response to the present global financial crisis, the US Federal Reserve bank is pursuing a policy euphemistically called "quantitative easing". In reality, it is today's equivalent of printing money and putting it into circulation in the hope of generating domestic demand in the US.
Whatever else it does, this practice has the incidental effect of devaluing the US dollar. This, in turn, reduces the dollar value of US indebtedness to China.
It's not surprising that China sees a double benefit in using its vast holdings of US dollars to buy the South Korean currency. China thereby improves its competitive position as an exporter by increasing the exchange-rate value of South Korea's currency, and unloading some of its depreciating US dollars in the process.
All of these various actions are part of policy responses taken by countries in the wake of a damaging financial collapse and the consequent shrinking of global demand. Each of them is attempting to stimulate domestic demand in its national interest. But because world demand is not expanding, these policies impact adversely on other countries.
We have labelled them "beggar thy neighbour" policies. They are, however, nevertheless perfectly understandable - and inevitable - in present circumstances.
In the immediate post-World War II period, when the US was the dominant Western economy and was shepherding a recovering Free World in the direction of international cooperation, much time was spent creating a system that took beggar-thy-neighbour policies out of the trade and payments equation. That system, known as Bretton Woods and which was underwritten by the US, terminated 35 years ago.
China, in effect, has ridden to power on the back of the collapse of Bretton Woods. Before the 1980s, it scarcely counted in international power plays. James Wolfenson - an Australian who has held important positions in US financial circles, including a period as head of the World Bank - recently pointed out why the financial centre of gravity is shifting in the direction of Asia. Sixty years ago, Asia accounted for 1 per cent of world GDP; by 2040 it will be 60 per cent.
China is a dominant player in this shift. By 2050 it is expected to match the output of the US - though not, of course, in wealth per person.
Given these facts, and recognising that China holds 30 per cent of the world's currency reserves, it is fanciful to imagine that that the economic and political power relativities that preceded these developments can remain undisturbed.
We know China is investing much of its new-found wealth in mineral resources in many parts of the world - and wants more investment in Australia.
This new reality contains profound implications for Australia, both economic and political. It is by no means clear how well we understand them and are equipped to deal with them.
This fact is underlined by what has emerged during the recent visit to Australia of the US Secretary of State, Mrs Hillary Clinton.
How we handle the contradiction of our diverging economic and political interests has not yet been made clear.
A close alignment with the United States has been and certainly should continue to be our ongoing security priority. As part of this, we must hope that the US can and will maintain a presence in Asia.
Alliance with the US also conferred economic benefits, while the US was the dominant economic power. We were part of the West and as such our postwar economy grew within a flourishing trade and payments system underwritten by the US.
But the US is no longer the economic power it once was. The emergence of Asia, especially China, cannot be ignored. How much of what we had can be retained is as yet unclear. What we do know is that Australia is economically dependent on China as a buyer of our raw materials, and we must necessarily defer to them in ways that previously were unnecessary. We also know China is an emerging political force in our region.
What we don't know is to what extent the emerging political and economic strength of China can be accommodated by our important strategic ally, the United States.
All of this is made more difficult for us to reconcile because, despite rhetoric to the contrary, most of our policy formation is guided less by strategic considerations than by free-market economics.
To illustrate the point, our economic policy advisers insist that we treat China in the same way as any other foreign investor. However, it is possible, even likely, that some time soon this view could bring us into conflict with the United States.
Despite all the optimism of the past weeks, a power struggle between the US and China over primacy in Asia will necessarily be played out.
Hugh White, an influential defence commentator, believes that China will want at least equal status with the US as the power player in Asia. It is not clear that the US is ready for any such accommodation. And, if so, how will the resulting tensions be resolved? And what will be Australia's position?
There is much glib talk, at least from our side, about the importance of skilful diplomacy; but that alone won't solve genuine problems. We need only look at the Middle East and the problems between Israel and Palestine. No amount of diplomacy can fix those problems because there are fundamental issues at stake, and resolution requires one side or the other to make unilateral concessions.
The emerging problems between China and the US in Asia are quite likely to be characterised by the same difficulties. Australia, being the nation in Asia with the strongest strategic commitment to the US in matters of security but at the same time economically dependent on China, could be caught in the middle.
From this writer's point of view, if push comes to shove it would be folly for us not to keep faith with the US.
How that will be reconciled with our free-market commitments and with our wider economic dependence on China is hard to imagine.
But we had better begin to think about it rather than hoping that skilful diplomacy can rescue us.Colin Teese is a former deputy secretary of the Department of Trade.