SERIOUS MONEY:THE G-20 leaders declared emphatically in April last year "we will not repeat the historic mistakes of protectionism of recent eras".

The lessons of history were clear and confidence was high there would be no repeat of the “beggar-thy-neighbour” policies that followed Britain’s decision to abandon the gold standard after the collapse of Austria’s largest bank, Creditanstalt, in the summer of 1931. Eighteen months after the G-20 communiqué, confidence looks fragile as concerns the world is on the verge of an all-out currency war continue to escalate.

Sluggish economic growth and extraordinarily accommodative monetary policy in the developed world has triggered a surge in capital flows seeking to exploit the structurally higher growth evident in the emerging world. The upward pressure on exchange rates has seen the currencies of several emerging countries experience significant appreciations vis-à-vis the dollar.

In response, Guido Mantega, Brazil’s finance minister, complained: “We’re in the midst of an international currency war. This threatens us because it takes away our competitiveness.”

Policymakers in the emerging world are struggling to cope with the policy “trilemma” that arises because macroeconomic policy can include at most two elements of the “inconsistent trinity” of policy goals – an independent monetary policy, a fixed exchange rate and free capital mobility. Attempts to limit currency appreciation in the face of strong capital inflows compromise monetary policy independence and a central bank’s ability to increase interest rates in response to intensifying inflationary pressures. In other words, policymakers would risk potentially unacceptable high levels of domestic inflation.

Alternatively, efforts to increase interest rates in response to domestic inflationary pressures would attract “hot money” flows that would not only place further upward pressure on the currency but could potentially overwhelm the absorption capacity of financial markets. This concern is acute given the ultra-accommodative monetary policy in the developed world. Again, in other words, policymakers would risk an unsustainable asset boom followed by a painful bust.

Policymakers in the emerging world have assessed the risks the macroeconomic trilemma poses and have postponed monetary tightening to keep “hot money” flows at bay. Their central banks have intervened to prevent excessive currency appreciation, but these actions have typically been sterilised to limit growth in the monetary aggregates. The use of capital controls has been restricted to raised taxes on money market instruments.

Thus, it is difficult to argue the emerging world is becoming more inward-looking, though that could change should further monetary easing in the developed world lead to a surge in “hot money” flows.

Meanwhile, sluggish growth and high unemployment in the developed world has contributed to intense criticism of China’s exchange rate policy. The Middle Kingdom announced during the summer that it intends to gradually relax the peg between the renminbi and the dollar, but the currency has since appreciated by little more than 2 per cent – a far cry from the 25-40 per cent required to silence its critics.

China’s exchange rate policy has been a matter of considerable political debate in the US. Indeed, the House of Representatives has passed legislation to punish China for failure to adopt greater exchange-rate flexibility.

The Americans believe Beijing’s policy is costing US jobs and that a realignment of exchange rates would foster export-led growth. This belief fails to account for the fact China’s emergence as the world’s manufacturing workshop has positioned it at the centre of a complex global supply chain. The country’s rise as an export platform has been accompanied by a surge in imports from its Asian neighbours, as it sources goods for further processing and eventual re-export to the developed world.

Furthermore, US exporters source competitively-priced components from the Middle Kingdom and retain the additional value added once the goods are sold in international markets. Thus, a significant appreciation of the renminbi would not work quite as neatly as envisioned. Indeed, such an action could depress growth throughout East Asia, and importantly, from a US perspective, result in the loss of American jobs.

The US needs to reverse its current account deficit if it is to register anything better than lacklustre growth through the middle of the decade, given the drag from household deleveraging and the absence of further fiscal stimulus.

It is widely believed the undervalued renminbi is the primary culprit, yet the US share of global exports declined by more than three percentage points since 2000, even though the exchange rate moved in America’s favour. Switzerland defended its market share over the period in spite of currency appreciation. The US simply does not produce what the rest of the world wants, and a currency war with China won’t resolve this.

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