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Monday, Mar 01, 2004

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Our currency, your problem

S. Venkitaramanan

IN THE midst of their preoccupation with "India Shining" and other main pre-poll distractions, the media have had little time to reflect on yet another meeting of the G-7 — of finance ministers and central bank chiefs held recently at Boca Raton, in Florida, US, to discuss the world's economic problems. Obviously, this time the conference includes only the members of the rich men's club — the US, the UK, Japan, Canada, Italy, Germany and France.

The Ministers of Finance reviewed the situation of the global economy and reiterated their earlier advice, proferred at their meeting held at Dubai in September 2003 to various countries to show more "flexibility in exchange rates". The Boca Raton meeting, however, yielded no fresh insights.

The problem continues to be one of the US' growing deficits and a falling dollar. The US is piqued that countries in Asia are adding to the problem by their interventionist policies, trying to keep their currencies weak or at the same level in relation to the dollar.

In China's case, the peg to the dollar has held for nearly a decade. The US wants China to revalue the renminbi — advice China is not heeding. Meanwhile, the dollar has declined nearly 50 per cent against the Euro since July 2001.

The decline of the greenback takes us back to an earlier era following the breakdown of the fixed parity regime of the 1970s and 1980s. The Bretton Woods agreement had introduced the regime of fixed exchange rates. The 1970s started with a change, when the US faced chronic deficits in addition to inflation, thanks to oil price rises.

The period was extensively covered by a remarkable book Changing Fortunes, by Paul Volcker, former Chairman, US Federal Reserve, and Toyo Gyoten, former Vice-Minister in Japan's Ministry of Finance. Both had played important roles in setting up the mechanism of consultation and coordination in the form of G-7 meetings. The book reminds us that the US obsession with other nations' exchange rate policies is not new.

At that time, the US's target of attack was primarily Japan, France and Germany. The US used to lecture these countries on the need to grow faster and have more open trading arrangements. Above all, its ire was directed against Japan's forex interventions, which were designed towards keeping the yen-dollar ratio such that yen was relatively low in relation to the dollar.

The belief at that time was that floating would solve the malaise. Unfortunately, it did not happen. The debate mainly centred on the extent of intervention by individual countries. "Floating" ceased to be purely market-determined, since the principal players apart from the markets were the central banks, which bought up surplus dollars.

The persistence of the "dollar" problem recalls an interesting statement by a US Secretary of the Treasury, Mr John Connolly. He told his fellow Ministers in 1971 that "the greenback was the US's currency; it was the world's problem".

The dollar and its problem have haunted the global economy since World War II. Immediately after the War, India faced the problem of dollar shortage. The US had a chronic trade surplus and the other countries were importing more from it than they exported. Then came the reversal with the US having a growing deficit.

The dollar started declining in value, but the US Administration was not too happy with it. It wanted the advantages of a weak dollar — higher exports — and at the same time the gains from a strong dollar — lower import prices and lower inflation. The 1970s and 1980s saw a number of attempts by the US Government to persuade other countries to modulate their currencies and economic policies to achieve these apparently conflicting objectives.

The present situation of the US current account deficit has attracted comments from various quarters. We have had occasion to review in this paper the perceptive comments of Mr Warren Buffet, on the continuing crisis that the US's profligacy imposes on the world and itself.

The strongest country of the world pleads with the erstwhile poor countries (China) and its past foe Japan to manage their exchange rates better. It is a sad commentary on how far the US's economic management has fallen so low that it has to plead with other countries to help it out of its misery!

It is fact that Asia's reserves are what are propping up the economy of the US. All observers agree on this, except perhaps the American administration, which sees the phenomenon from a Washington-centred point of view.

True, it has had some limited success in modifying other countries' policies mainly by threatening protectionist measures. Its "creditors" depend critically on its markets and cannot afford to alienate the powers of the US.

A perceptive observer has recently pointed out in this connection that the net upshot of recent currency interventions is that Japan has been experimenting with a rather "unorthodox" monetary policy, namely that of printing huge quantities of its own currency to support the fiscal deficit of another country, viz. the US. This is, indeed, an interesting variation of the Keynesian doctrine of printing one's own money to sustain the fisc of another.

This comment is based on the fact that since the beginning of 2003 Japan's central bank has obtained the approval of its Ministry of Finance to create 27000 billion Yen with a view to intervening in the currency market.

The reserves so gathered by Bank of Japan are invested in the US. In fact, this amounts to $250 billion — $2,000 per every single person in Japan. Globally, this amounts to $40 per every man, woman and child alive.

Japan has thus contributed by buying up dollars and investing in securities which have funded almost half of the US' $520-billion budget deficit this year. Interestingly, the amount of yen printed and converted into US dollars in the month of January 2004 alone was enough to finance 13 per cent of the US's fiscal deficit.

This is but part of the bonanza that the US' "profligacy" has earned from the rest of the world, particularly Asia. The total reserves of Asia's central banks — the big four — Japan, China, South Korea and Taiwan, have more than doubled over the past three years to $1.5 trillion, most of which is held in American Government securities.

This phenomenon also explains the relatively low interest rate environment obtaining in the US. This flood of Asian "dollars" helps the US bond market remain benign. The continuing flood of cheap imports also keeps inflation relatively low.

The net result is that the US Government is able to — apparently — defy the conventional laws of economics, which dictate that a high fiscal deficit leads to high cost of borrowing and to inflation. America's cost of capital is artificially kept low, thanks to Asian inflows. Ten-year treasuries are currently fetching a low 4.1 per cent.

This happy concatenation of circumstances cannot continue too long. It can break if the Asian economies start to ask for higher yields on their investments or their own investment opportunities begin to give higher returns.

This paradox has evoked an observer to remark that perhaps Mr Alan Greenspan has had one of his dream solutions come true. In mid-2003, the research analysts of US Fed produced a paper explaining that the Federal Reserve had not exhausted its options, "not run out of bullets" even though it had cut short-term interest rates to 1 per cent.

To reduce interest rates further would be infeasible. "The Fed could, however, implement what is essentially the classic textbook policy of dropping freshly printed money from a helicopter", if need be, to stimulate the economy.

This vision, says the observer, has come true. The helicopter is already in the air. It is, however, strangely not the stars and stripes — the US emblem — that emblazons the helicopter. It is rather the Rising Sun of Japan. The US economy is being virtually stimulated by the manna that falls from the Heavens, thanks to the Japanese Ministry of Finance the and Bank of Japan.

If a poor country were in the US' situation of rising fiscal deficit and current account gap, the International Monetary Fund would have strongly advised it to get its fiscal situation in balance, its currency devalued and its current account set right.

It is apposite to quote Mr Volcker in this context.

He says he was once told by the Finance Minister of a developing country that: "When the International Monetary Fund consults with a poor and weak country, the country falls in line. When it consults with a big country, the Fund falls in line. When the big countries are in conflict, the Fund gets out of the line of fire".

We have now the spectacle of the IMF getting out of the way of advising its creditor nations, which are in the pink of financial health, how to behave better.

Such is the law of the economic jungle, presided over by the new hegemon — the US, which uses its imperial power to hector various countries to follow its line of thinking rather than take the medicine it prescribes for others.

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