The Spectre of Competitive Devaluations

Could China lead Asia and the world into a currency-driven spiral of protectionism? That may seem an extreme notion at a time when some Asian countries, not least Indonesia, are worried about their currency falling too far against the US dollar, in the process generating inflation and raising concerns about financial sector stability.

But no less an authority than the usually soothing, uncontroversial Asian Development Bank last week noted that Asian central banks had been buying dollars again. Countries needed “to avoid unnecessary and excessive interventions in the currency markets, especially to depreciate domestic currencies,” the bank said in a news release.

According to Lee Jong-wha, head of the ADB’s office of regional economic integration, they were being pushed towards devaluations to support ailing exporters. Japan, Korea and Taiwan have all shown collapses of more than 20 percent in exports, and even China is now in negative export territory.

But using devaluation to try to offset these problems is not only likely to enrage the US, which sees currency realignment as essential for restoration of global trade equilibrium, but could spark competitive devaluations among east Asian countries. They are supposed to be cooperating to stabilize trade, keep markets open and, through the Chiang Mai initiative and ASEAN+3 cooperation, avoid massive swings in the values of their currencies and otherwise help each other counter financial instability.

As it is, the four key currencies of northeast Asia have all been headed in different directions. The yen has risen 16 percent against the dollar over the past three months, the Korean won fallen by 17 percent, the Chinese yuan by 0.5 percent and the Taiwan dollar by 1.5 percent. The latter three were down by larger amounts in early December before regaining some ground. Although the fall in the won far exceeded anything the government might have wanted, there remains a suspicion that Korea would have tried harder to stem the fall – which amounts to 30 percent in a year – had it not sort to gain some competitive advantage vis-à-vis its neighbors.

Overall falls in the currencies of Indonesia and the other energy and commodity-exporting countries of southeast Asia have mostly been bigger, but that at least is understandable given the very sharp deterioration in their terms of trade due to the collapse of raw material prices and the exodus of foreign capital from stock markets in the wake of the western flight to liquidity.

No such terms of trade excuse exists for declines in values of northeast Asian manufactured-exporters who are gaining almost as much from improvement via the collapse in oil and other commodity prices as they have lost in export volumes. It is quite likely that the export collapse will look less alarming by early 2009, although commodity prices look likely to remain depressed well into next year. Though consumer demand will be down in the developed world, the off-the-cliff fall in October of manufactured exports was due to de-stocking and financial disorder as much as to a consumption collapse.

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In any event, payments equilibrium requires that outsize east Asian surpluses diminish drastically, which in the case of Japan and Taiwan suggests they should have trade deficits – but not current account deficits due to their large investment incomes - and that China and Korea move to trade balance.

China is likely to be the key to how the rest of east Asia reacts. While the yen is floating freely much to the discomfort of Japan’s exporters, China’s policy towards its currency is opaque. It is not clear whether the small decline against the dollar was simply to keep its trade-weighted exchange rate stable at a time when the US currency was appreciating as the financial crisis created an artificial shortage of dollars, or if it was a deliberate attempt to ease pressure on exporters, already reeling from rising labor costs and falling foreign demand.

Now China faces the likelihood of large-scale capital outflow as expectations of further rises in the yuan evaporate and hot money exits as fast as the official restrictions permit. That has probably begun to happen. Foreign reserves contracted marginally in October despite continuing current account and direct investment surpluses. Given that at US$1.9 trillion the reserves were far too big for comfort, and indeed contributed to China’s asset bubble, a large outflow should not be viewed with alarm. But it could easily be used by Beijing as a reason to allow currency depreciation on the grounds that this was a response to the market. A rapid reversal of the money inflows of the previous two years could also complicate China’s efforts to boost domestic demand.

Any significant appreciation against the dollar while China continues to run a huge trade surplus with the US would likely spark pressure in a Democratic Congress in Washington for retaliation – pressure that can only increase during 2009 as few are forecasting any US recovery until 2010.

Meanwhile smaller Asian economies could well decide to follow whatever currency path China takes. Malaysia, Taiwan, Thailand and Singapore all in practice give much weight to China as they attempt flexible management of their floating currencies, with varying degrees of success.

In theory the huge volume of intra-regional trade derived from multi-country manufacturing systems should act both as a barrier to protectionism and reason to avoid competitive devaluations. But given the depth of the demand collapse, pressures for short-term national measures to prop up employment and overstretched companies could easily overwhelm long term interests in free trade and regional integration.