All eyes are on foreign exchange on the eve of another G-7 meeting of finance ministers and central bankers. Fixation on the Chinese currency remains intense from the American side, and the Europeans are increasingly concerned about the weakness of the Japanese yen. In my view, these concerns are misplaced. In a world where the main misalignments are on the saving-investment axis, currency solutions are not the remedy. This timeworn fixation on foreign exchange markets detracts from the heavy lifting of structural change that is required to meet the competitive challenges of globalisation head-on.
How the Chinese currency became politicised
The politicization of the Chinese currency issue has been a hallmark of the US-China debate of the past several years. The “logic” is straight-forward: Most US workers are feeling enormous pressures on job and income security – labour’s share of national income is back to historical lows and the gap between the rich and everyone else is getting larger and larger. Meanwhile, the United States is now suffering from the mother of all trade deficits – an external imbalance that hit about 7% of GDP in 2006.
The key presumptive link in this equation is that workers and their elected representatives have concluded that this ever-widening trade deficit is the source of labour’s deepening sense of angst. The smoking gun comes in the form of a Chinese bilateral deficit that now accounts for 29% of America’s total multilateral trade gap – easily the largest portion of the US external shortfall. Washington views China as the culprit to all that ails the American worker. It then follows that an adjustment of an undervalued renminbi is the fix that can assuage the pain.
Why Europe is complaining about the yen
Europe’s yen complaint is of a different ilk. Currently at 157, the euro-yen cross rate has strengthened dramatically in recent years – now up over 75% from the all-time low in October 2000 to the strongest level in 8 1/2 years. For a European economy that is still lacking in vigorous support from internal demand – especially private consumption – any currency-related pressures on external demand are viewed with great concern. That’s especially the case with a still high – albeit declining – pan-regional unemployment rate of 7.6% and a persistence of relatively stagnant real wages.
However, unlike the US with its massive trade deficit, Europe’s overall external position is nearly in balance – a current account deficit that our estimates put at -0.3% of GDP in 2006-07. But here’s the rub for Europe: Despite a nice cyclical pop of 2.7% real GDP growth in 2006, Europe still views itself as a 2 to 2.25% grower – in essence, lacking the vigor to provide much further relief for pressures bearing down on labour. For such a sluggishly growing European economy, any currency-related pressures on its external sources of growth are a much bigger deal than is the case for the US, which enjoys much more solid support from internal consumption. The recent weakness of the yen is perceived as a growing threat in that context.
Exactly which problems would a currency ‘fix” solve?
The question for G-7 policy makers is whether a currency “fix” – namely, pushing for a stronger RMB and yen – is in the world’s best interest. This is an interesting intellectual debate but probably misses the subtext of the real hand-wringing – whether currency realignments will temper the domestic political concerns now evident in the US and Europe. The answer, in my view, is an unequivocal no. In the case of the US, the outsize bilateral imbalance is a symptom of a much bigger problem – an unprecedented shortfall of domestic saving that drove the net national saving rate to historical lows of just 1% over the past three years.
For an economy like the US, where the political constituency for rapid economic growth is very powerful, saving shortfalls create an inherent bias toward chronic trade deficits. America is left with no choice other than to import surplus saving from abroad in order to fuel its appetite for growth. The only way to get that foreign capital is to run large current account and trade deficits. The distribution of those deficits then follows along the lines of comparative advantage. China fits all too nicely into that equation – both as a supplier of surplus saving and as a source of low-cost, increasingly high-quality goods. I do not believe a stronger RMB will force Americans to save more. The best Washington can hope for if it relies on such a “remedy” is to shift the China piece of the US multilateral imbalance somewhere else – most likely to a higher-cost producer, which would be the functional equivalent of a tax hike on the American consumer.
The Chinese currency and US trade problems
There’s another element of the “RMB fix” that bears noting insofar as the US is concerned. America’s trade problem is one of excess imports – not insufficient exports. As of 4Q06, goods imports were running 73% higher than goods exports. The import surge, in my view, is very much an outgrowth of an extraordinary period of excess personal consumption – with the consumer spending share of US GDP rising to 70% over the past five years from an average of 65% over the 1975 to 2000 period. With labour income growth unusually weak over the current economic recovery cycle – private sector compensation tracking over $425 billion (in real terms) below the norm of previous cycles – US consumers have drawn increasingly from the wealth effects of asset appreciation to finance both consumption and saving. With the income-based saving rate falling into negative territory for the first time since the early 1930s, the excess consumption and the outsize import surge it has spawned is a major source of America’s macro saving imbalance. I do not believe that a stronger RMB-dollar cross rate will temper this imbalance in any way whatsoever.
The excesses of asset-driven consumption are best addressed through asset markets themselves – a development that now seems to be under way as the US property bubble bursts. Moreover, given the sheer size of the imbalance between imports and exports, an equilibrating realignment of the dollar would be so huge that it would be politically unacceptable to the rest of the world – not just the Chinese but also the Europeans, the Japanese, and America’s other Asian trading partners.
A yen realignment will have little impact on European growth
Nor should Europe count on a realignment of the yen to underwrite its growth imperatives. In large part, that’s because Japan is far from Europe’s major trading partner. As of 3Q06, Japan accounted for just 2.5% of total pan-European merchandise exports – well below shares going to the United States (14%), OPEC (5.3%), China (3.9%), and Latin America (3.9%). The same is true on the import side of Europe’s trade equation. Japanese-made products account for just 4% of total European merchandise imports – well behind shares coming from China (10%), the US (9%), OPEC (8.9%), and Latin America (4.7%). Yes, the euro has, indeed, borne the brunt of the yen’s recent weakness. And, yes, Germany and Japan compete aggressively in several export markets. But given Japan’s relatively small share of overall European trade flows, it is by no means clear that a strengthening of the yen would have a material impact on European economic growth. Eric Chaney’s estimates suggest that a 20% appreciation in the broad yen index would add just 0.2% to pan-European GDP growth. In short, Europe’s yen fixation appears overblown.
The G-7 doesn’t have much to do these days. The glory days of the Plaza and Louvre Accords of the 1980s are long gone. After last May’s highly celebrated recognition of the perils of global imbalances, the G-7 has retreated back into its ever-hardening shell of irrelevance. Traditionally, this gathering of the world’s Wise Men has been an important signalling mechanism for currency markets. And currencies, of course, have long been – and still are – a hot-button in political circles. Those concerns are heating up again – especially in the US with respect to the Chinese RMB and now in Europe with respect to the Japanese yen.
The communiqué from this weekend’s gathering in Essen, Germany will undoubtedly have some carefully worded, yet oblique, references to perceptions of certain “misaligned” currencies. Financial markets could well take these references seriously for a few trading days – or possibly longer – insofar as yen and RMB spot rates are concerned. But in a global economy beset by major saving imbalances and structural competitive issues, the impacts of a politically expedient currency fix are likely to ring increasingly hollow. The world needs to do a much better job in coming to grips with the stresses and strains of globalisation.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum