from Follow the Money

Surplus countries depreciating when they should be appreciating

April 17, 2008

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Most Asian currencies have depreciated significantly against Europe since 2003.

And don’t get me started about the Gulf. It remains wed to the depreciating dollar even as oil soars. Following the dollar as it fell from 0.85 or 0.9 to close to 1.60 against the euro as oil went from 20 to 115 doesn’t make economic sense. The Gulf’s currencies should be appreciating along with the price of their main export.

As a result, exchange rate moves, broadly speaking, haven’t helped to facilitate global adjustment. Don’t take my word. The IMF, in the WEO, comes to much the same conclusion:

“Bilateral and multilateral exchange rate movements since 2006 have born little semblance to the distribution of current account surpluses, in contrast to past episodes of dollar depreciation in the 1980s when the currencies of the major surplus countries all went through larger appreciations than other currencies. In the current episode, a number of countries with large current account surpluses have linked their currencies tightly to the dollar, thereby hindering adjustment. A continued mismatch in this regard could result in a reallocation of – rather than a reduction of – global imbalances.

The dollar has moved v Europe, but Europe isn’t the world’s big surplus region. Indeed, so long as the surplus countries link their currencies to the dollar, dollar weakness against the euro only pushes the currencies of big surplus countries down more. Visual evidence that surplus countries have tended to depreciate can be found here.

The IMF deserves a round of applause for its direct language -- and, for that matter, also having the courage to forecast a more prolonged US slump than the Fed formally expects.

My read of the WEO’s long-term balance of payments forecast is that the IMF is expecting more of a reallocation of the world’s imbalance than a reduction. To be sure, the IMF expects that a sustained US slump will help bring down the US deficit. Over time, however, the IMF expects the European Union’s deficit to rise. And once the oil shock wears off and the oil exporters surplus starts to fall, the IMF also expects a further rise in Chinas surplus, at least in dollar terms.

That is reasonable. China still hasn’t let its exchange rate adjust in nominal terms. The renminbi has been remarkably stable against a trade weighted basket of the currencies of China’s trading partners. Unless China wants to experience sustained inflation like the Gulf, it won’t experience a sustained real appreciation without a change in policy.

The failure of key exchange rates to adjust is one reason why I am a lot less confident than Dr. Johnson that the IMF’s multilateral consultation has identified the policies needed to reduce the long-term vulnerability associated with persistent imbalances. The Saudis made no commitment to allow exchange rate adjustment during this proces – and the IMF isn’t encouraging the GCC to move off the dollar either. If anything, the IMF is encouraging the Saudis to implement a fiscal contraction to avoid the inflation that is required to bring about real appreciation in the absence of nominal appreciation. That hardly is a policy that supports adjustment.

And other countries haven’t shown much willingness to change either. China has yet to allow a broad-based nominal RMB appreciation -- just look at the RMB v the euro. The US hasn’t exactly shown much commitment to reducing its fiscal deficit either, though in the case of the US, there is a plausible argument that circumstances have changed. The recession and all.

Update: I love Alphaville’s pithy summary of my post "Brad Setser isn’t appreciating the depreciating."   And I think Michael Pettis is right.  Asia’s enormous depreciation against Europe is just shifting the US deficit to Europe.  That seems to be what the IMF is forecasting as well.   Now that China trades more with Europe than the US, shouldn’t the euro-RMB get more attention than the dollar-RMB?

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