The Hindu Business Line : After the battle in Iraq .... Is the war on Asian currencies right?

Given the US focus on Asian currencies, if the yen strength persists, the risk of a currency war rises, with pressure on China to do something. The Bank of Japan would be forced into aggressive intervention. Central banks would race to destroy the value of their currency. When currencies plummet, interest rates soar. Economic growth and equity risks would rise as also of trade protectionism and isolationism, says V. Anantha Nageswaran.

THE G-7 desire for flexible exchange rates or, more bluntly, the American preference for a weaker dollar, has set the cat among the pigeons. The dollar has fallen considerably against the yen. As of Friday, the yen was trading at around 108.50; not so long ago it was at 122. The currency has gained more than 10 per cent in a few weeks. It must be unnerving for Japan.

The world is fast approaching the stage when it has to face up to the consequences of what appears to be an inevitable dollar adjustment. The consequences are hard to predict with precision but surely cannot be ignored. There are clear short-term negatives in it for Asia and Europe. Costs to the rest of the world might hurt US growth itself thus nullifying the aim of seeking a weaker dollar.

Yours Truly, therefore, does not believe that a weak dollar ought to be the first line of attack in rebalancing global growth. The analysis that follows shows that the US current account deficit does not represent foreigners' affection for US assets, as some patriotic American commentary believes. It represents insatiable American consumption and American corporations cutting costs by locating production and other processes overseas.

A weak dollar would hurt them. Further, to the extent that the American appetite for foreign goods is price-insensitive, a weak dollar would merely raise inflation risk rather than quell the American appetite for imported goods.

The real solution lies in Americans raising their savings rather than resorting to bashing other currencies. Though this line of reasoning appears logical, preaching austerity is the last thing that a President seeking re-election would do. It is easier to blame foreigners for domestic problems. They do not vote in local elections. Hence, America would continue to push for a weak dollar. If it does so, then it is not clear that Asians should bear the bulk of the currency adjustment.

When the US dollar strengthened in the second half of the 1990s, the US economy was growing strongly and could absorb the currency strength. It was the buyer of first resort for Asians to export their way out of trouble in the aftermath of the crisis. However, problems began there. American consumers got addicted to cheaper imports. Thus, America's current account deficit is homegrown rather than reflecting the willingness of the rest of the world to hold American assets because returns in the US are more attractive than elsewhere. That might have been true in the 1990s when global and local American investors thought that American assets held the highest return potential. No matter that bulk of such returns was pro-forma, the world believed it to be real and pumped in foreign direct investment into the US. However, it belongs to history. Portfolio investment is now dominating the funding of the US current account deficit. The following chart makes the point clear.

Asia has no monopoly for a strong dollar

While Asia has stepped up its purchase of American long-term securities, it still covers roughly only little over one-third of foreign net purchase of all American securities.

(a) Overall, Asian share of net purchase of American securities has moved up from around 11.3 per cent in 1998 to around 35.6 per cent in 2003 (up to July).

(b) Interestingly, the Asian share of net foreign purchase of American Treasuries and Agency (government guaranteed corporations) bonds has declined from a peak of 76.6 per cent to around 50 per cent in 2003.

(c) Adding corporate debt to Treasuries and Agency debt does not change the picture much. Although Asian share has jumped from nearly 20 per cent in 1998, it has held steady at 35-36 per cent in the last three years. There is no evidence of stepped up purchases in recent months as alleged.

(d)Within Asia, Japan's holding of US Treasuries has jumped from $317.9 billion in December 2001 to $443.8 billion in end-July, 2003. That marks an increase of over 40 per cent.

(e) China's holding of US Treasuries has jumped by about 61 per cent from $78.6 billion to around $126.1 billion. However, in absolute terms, this dwarfs the increase in China's international reserves from $218 billion in end-2001 to over $350 billion at present.

(f) The biggest increase in holdings of US Treasury securities percentage terms is recorded by Great Britain. It has increased its holding from $45 billion (December 2001) to over $142 billion (July 2003). That is more than a three fold increase.

(g) If Asian central banks were the big buyers of US Treasuries, official holding as a share of overall foreign holding of US Treasuries must have increased recently. Such is not the case, however. Actually, it has declined from nearly 60 per cent (end-2001) to around 52 per cent by end-July 2003.

Consumption needs to be curtailed

What is clear from the above is that if the rest of the world were enamoured of returns in the US, the share of foreign direct investment in the overall investment would not have tumbled. Further, within portfolio investment, the share of equities would not have declined drastically either. All that the rest of the world is doing is to recycle the US dollars that they receive from American residents who either consume foreign goods or source from the rest of the world. The current account deficit thus does not reflect a capital account success story for America. It is excess consumption over domestic production. Hence, if Americans were to rely on currency weakness as a solution to their employment problems, it is a simplistic approach and one fraught with dangerous consequences.

Weak dollar could hurt Japan (and Europe) badly

Right now, much as the US thinks it needs a weaker dollar, neither Japan nor Europe nor other countries are in a position to take stronger currencies beyond a point. If the yen strengthens prematurely, that is, before a sustainable economic recovery takes hold) as it has done now, it is going to rule out precisely that outcome.

The Japanese economy is only exhibiting minimal signs of life. Much of the real growth has come from deflation. This is statistical growth and not `real' growth. When an economy is in deflation, it is wrong to focus on real growth rates. Nominal growth rates tell the real story. Both nominal private consumption spending and investment spending do not paint a rosy picture.

The story is not much different in Europe. Like Japan, Europe too does not have the advantage of using fiscal policy. Monetary policy is on hold and economic recovery appears to be patchy, at best.

Nor would it necessarily help America

American economic policy thus has to work on raising the long-run savings rate of the economy. Continued private and public profligacy would suck in capital from the rest of the world. Incentives for savings would naturally curtail consumption-led growth and drag down economic growth. Weak growth would naturally act to lower the dollar value and thus bring about global rebalancing.

To be sure, this is not a costless solution either. The crucial difference is that this solution places the primary adjustment burden on the American consumer and the residual on the rest of the world. Whereas, a weak dollar does the opposite. There is no moral or economic case for doing that. In both situations, the rest of the world would be hurt given that world growth has been overly dependent on American growth in recent years. Arguably, the second order effect coming from lower American growth through higher savings would be more tolerable for the rest of the world than the direct deflationary/contractionary impact of strong currencies. Admittedly, elaborate modelling might be required to prove this hypothesis.

More important, even from the American standpoint, it is not entirely clear that a weak dollar would achieve their objective of preserving growth much beyond the election year. Consider the scenario below.

But economic warfare is a possibility

Given the American focus on Asian currencies, if the recent yen strength persists direction, the risk of an all-out currency war increases, including tremendous pressure on the Chinese authorities to do something. The Bank of Japan would be forced to step in repeatedly and conduct aggressive unhedged currency intervention. The Bank of Japan governor had conceded that he is concerned about recent yen strength. What if they decide to announce an inflation target and pursue that now? They will have to increase liquidity to make the promise of reaching that inflation target sound credible. What happens to the yen then? Will America keep quiet or will Europe keep quiet?

Europeans would reluctantly have to join in the globalised and global movement to debase currencies. Each central bank would be competing with the other in the race to destroy the value of their currencies. Risk of trade protectionism and isolationism would rise. When currencies plummet, interest rates soar. Economic growth and equity risks would rise considerably in such an environment. At this stage, this scenario still has low probability but this probability has perhaps doubled over the weekend. Tendency to ignore possible larger outcomes with low probabilities has landed the world in trouble previously. History may yet repeat itself in 2004.

(The author is Director, Global Economics and Asset Allocation in Credit Suisse, Asia-Pacific. The views are personal. Address feedback to anantha@nageswaran.com)

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