Cause for alarm?
Kenneth Rogoff welcomed the fall in the dollar during 2002-2003 as a broadly healthy development but warned that the adjustment so far has not been enough to put the current account deficit on a path toward sustainability. On the basis of present trends, he saw the United States on course to increase its net external liabilities to around 40 percent of GDP within the next few years. Rogoff expressed concern over what he termed unprecedented levels of external debt for such a large industrial country. Only a number of emerging market economies and some smaller industrial countries have reached comparable debt ratios.
Although a reversal was not necessarily imminent, Rogoff and Ted Truman argued that this external imbalance could not be sustained. In Truman’s view, an eventual further dollar depreciation of some 30 percent in effective terms is needed to return the U.S. current account deficit to a sustainable range. But, as Rogoff noted, short-term movements in the exchange rate are essentially impossible to forecast, and a depreciation scenario could easily take three to five years to fully play out.
The AEI seminar featured presentations by Yusuke Horiguchi (Institute of International Finance), Mickey Levy (Bank of America), Adam Posen (Institute for International Economics), Kenneth Rogoff (IMF), Michael Rosenberg (Deutsche Bank), Vincent Truglia (Moody’s), and Ted Truman (Institute for International Economics), as well as closing remarks by Allan Meltzer (AEI).
Even a rapid depreciation need not necessarily be catastrophic. During the late 1980s, for example, when the trade-weighted dollar fell by more than 40 percent over a relatively short period, the problems proved manageable. But this time, Rogoff warned, with the United States reaching record net external debt levels, the global economy could be drifting into uncharted waters, and the risks, especially to financial markets, should not be underestimated. In his view, it was of particular concern that the U.S. current account deficit increasingly reflected low saving (in part because of the dramatic shift of the U.S. budget into deficit) rather than high investment, as it did through most of the 1990s.
Or maybe not?
By contrast, Mickey Levy and Vincent Truglia attached a low probability to any large exchange rate adjustment. Their presentations emphasized the lackluster domestic demand of U.S. trading partners as the main factor behind the large trade deficit. At the same time, the relative weakness of the European and Japanese economies implies that the United States remains by far the most attractive destination for foreign capital, offering higher risk-adjusted returns than the rest of the world. Levy likened the current phase of technological progress to the expansion of the U.S. rail network in the nineteenth century, which was also financed to a large extent by foreign investment.
Levy and Truglia put the onus on U.S. trade partners to raise growth and attract international investment capital. In their view, the difficulties in these economies have little to do with exchange rates and a good deal to do with their failure to tackle longstanding structural weaknesses. When pressed, Levy acknowledged that Europe had recently made some progress, which is reflected in the moderate strengthening of the euro and some private capital outflows from the United States. However, this served only to show that the exchange rate reacted quickly once the market sensed a change in underlying fundamentals, which in his view illustrated that the euro area and Japan needed to boost growth rather than focus on particular exchange rate levels.
If the euro strengthens
Other discussants also called for an acceleration of structural reforms in Europe, if only to cope with the consequences of an exchange rate appreciation. With Asian countries generally reluctant to tolerate a strengthening of their currencies, Truman and Michael Rosenberg expected the euro to absorb a considerable share of any future exchange rate adjustment. The euro area accounts for about 25 percent of U.S. trade (excluding oil). However, with even larger financial links, Truman suggested that a dollar depreciation vis-à-vis the euro would account for around 40-50 percent of any future decline in the U.S. Federal Reserve’s nominal exchange rate index. Both he and Rosenberg suggested that the euro could appreciate to $1.50—a level consistent with past exchange rate cycles.
Truman estimated that a strengthening of the euro to such a level could cut GDP growth in the euro zone by up to 1-2 percentage points over two years. He was pessimistic about the scope for policy measures to respond to such a major shock. Besides further monetary easing, which could help reduce interest rate differentials, he thought intervention was likely to prove only marginally effective. Truman maintained that European policymakers had so far been “largely in denial” about the potential impact of the exchange rate on the European Union’s trade position, which left them with few options for softening the blow.
Meanwhile, in Asia…
As for Asian countries, some participants questioned the wisdom of their accumulating large foreign exchange reserves, notwithstanding recent successes in preventing currency appreciation. Asian central banks have acquired large amounts of U.S. treasury securities over the past year, amounting to more than $100 billion since early 2002. The bulk of these assets is held by Japan, whose recovery remains largely dependent on export growth, and China, which has acquired dollars to maintain the renminbi’s peg to the dollar. Smaller Asian economies have also maintained their close currency relationships with the dollar, and Rogoff pointed out that there was no obvious limit to the quantity of reserves a country could accumulate. However, most participants agreed that the rising cost of reserve holdings, as well as increasing political pressure from the United States and Europe, would eventually force most of these countries to rethink their policies.
Against this view, Yusuke Horiguchi argued that criticism of Asian exchange rate policies was misplaced—at least as far as Europe was concerned. In his view, the adjustment burden on Europe is independent of whether Asian currencies appreciate or not. Rogoff said that there had been few cases where governments decided to unilaterally initiate a substantial appreciation of their currency; he cited Italy in 1926 (40 percent) and Japan in 1971 (17 percent) as rare exceptions. On the basis of historical experience, he argued that current account adjustments eventually involved both an adjustment in the exchange rate and a narrowing of relative growth rate differentials.
Michael Rosenberg supported this view. He expected the Japanese yen to be the first currency to appreciate during a “second wave” of dollar weakness, and others, including China’s, to follow in later stages. Allan Meltzer and Adam Posen pointed out that this step would require difficult political decisions by Japan, partly because it conflicts with Japanese attempts to establish greater exchange rate coordination with Southeast Asian economies. Posen suggested, however, that the scope for yen appreciation was limited by the continued need for monetary easing and the weakness of the domestic economy.
Most participants also agreed that any decision about the Chinese currency peg had to be viewed largely in domestic policy terms, notwithstanding calls by U.S. and Japanese manufacturers to allow the renminbi to appreciate. For Truglia and Meltzer, the renminbi exchange rate reflected China’s long-standing desire to acquire sufficient reserves to withstand economic shocks, such as those that hit Mexico and the Asian crisis countries in the 1990s. While this objective has largely been achieved, the country is now reluctant to face a possible appreciation, given deflationary pressures both in its domestic economy and in Hong Kong SAR.
Of course, Posen said, a change in Chinese exchange rate policy need not necessarily lead to an appreciation, particularly if it is accompanied by a relaxation of capital controls that allows some pent-up savings to exit in search of higher returns. He and Truglia pointed out that China’s overall foreign trade was broadly balanced, that Chinese exporters were not competing directly with high-end U.S. manufacturing companies, and that China already had a saving rate of close to 50 percent. Any exchange rate move would hardly be large enough to offset extremely low labor costs, so it is unlikely that Chinese trade flows would be significantly affected. Echoing this view, Rogoff expressed support for the current level of the renminbi but called for a more flexible exchange rate regime.
Photo credits: Denio Zara, Padraic Hughes, and Michael Spilotro for the IMF, pages 233, 237, 242, and 246-248; Jeff Haynes for AFP, pages 233-236; and Andrew Rose, page 244.
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