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Currencies: A Front Line for Global Balance

10-26 08:39 Caijing

Fluctuating currency values can make or break foreign exchange traders. On a far wider scale, they affect global economic balance.


By Andrew Shen

(Caijing Magazine) Anyone who has read the Chinese bestseller Currency Wars by Song Hongbing knows about the conspiracy theory that says currencies can be used as instruments of war. As one who witnessed the turmoil among Asian currencies during the 1998 Asian financial crisis, I can confirm that currency speculation can be highly profitable for some traders in over-the-counter and thinly regulated markets.

Even today, I would not encourage anyone to take up foreign exchange trading. Accumulator products that bet on currency volatility are famously called "I'll kill you later" with good reason: You might never have enough collateral to pay for margin calls, and your counter-party actually has the option to foreclose and crystallize your losses. Read contracts very carefully and make sure a contract seller discloses how much collateral you have to pay when prices hit certain levels.

As far as I am aware, no central bank has yet been able to launch regulatory cases against insider trading or market manipulation involving currencies. That's because currencies are traded in pairs. Unless both central banks and/or financial regulators overseeing a pair of traded currencies are willing to help with an investigation, it's unlikely that any investigation targeting market manipulation in this area would succeed.

However, the current financial crisis has convinced financial regulators around the world that naked short-selling during a crisis can have harmful effects, and that markets are not as innocent as free market fundamentalists claim.

The trouble with foreign exchange markets is that a mouse in a large market can be an elephant in a small market, so that a large speculator (or group of them) can move prices fairly quickly unless central banks supervising these markets are willing to cooperate to stop market manipulation activities. Until recently, major central banks tended to shun market intervention.

Yet the importance of currency values exceeds the forex trading sphere. I was reminded of this while returning from a think-tank conference in New Delhi recently, when it came to my attention that global imbalance is once again a hot topic. Some are again trying to blame Asia for saving too much money, claiming Asian saving habits caused the current crisis. It's the same excuse we hear when a banker blames his non-performing loans on depositors who save too much.

Anyone interested in the technical issues of global imbalance should read the famous debate between Stanford University Professor Ron McKinnon and Michael Mussa, former chief economist at the International Monetary Fund, published by the Bank of International Settlements Working Papers (http://www.bis.org/publ/work277.htm). McKinnon argued China should maintain stable exchange rates to anchor monetary policy while concentrating on fiscal policy to deal with its balance of payment surpluses. Mussa, on the other hand, argued that a revaluation of the yuan is necessary for an adjustment that steers the world away from global imbalance.

The debate turns on the question of whether the U.S. current account deficit is structural and can be resolved through devaluation. By definition, conventional economic theory assumes this means non-U.S. currencies should revaluate. Proponents of this line of thinking, therefore, think Asian currencies should be revalued significantly.

As Nomura Chief Economist Richard Koo argues quite convincingly in his new book The Holy Grail of Macroeconomics – Lessons from Japan's Great Recession, the Japanese crisis and the current crisis can be described as balance sheet recessions. The trouble with the flexible exchange rate argument is that the Japanese yen has revalued significantly, with hardly any effect on the U.S. current account deficit, implying there are structural reasons for the deficit that must be dealt with through fiscal and non-monetary policy measures.

This comes back to the Triffin Dilemma, which explains why a reserve currency country faces a conflict between its domestic monetary policy and global liquidity needs. If a reserve currency country tightens monetary policy, large capital inflows will negate monetary tightening policy moves. Raising interest rates will make exchange rates stronger and encourage more imports. It's a contradiction that says the stronger the dominant reserve currency, the stronger is global growth. But the larger the deficit, the less sustainable is the situation.

So in a globalized world of free-flowing capital, a reserve currency country's monetary policy is largely ineffective. When that country is unwilling to adopt a tight fiscal policy, a current account deficit is a consequence. So why should the blame fall on foreigners who have no say in a reserve currency country's policy decisions?

This is why Nobel laureate Robert Mundell and others have argued that we should have a single, global reserve currency to replace the current use of four, major reserve currencies in the SDR, in which with the U.S. dollar accounts for roughly 66 percent, euro 25 percent, pound 5 percent and yen 4 percent. A single, global reserve currency would mean the world would become one currency area. This would prevent nations from quarrelling about trade deficits, just as California does not fuss over a deficit or surplus with Texas.

However, since it is unlikely that any sovereign nation will be willing to cede power to a global central bank, a global financial regulator and a global taxation regime that taxes winners and compensates losers, that goal is many years away.

The current recession has already shrunk the U.S. current account deficit to 3 percent of GDP, but the funding requirements of the growing fiscal deficit are rising. This is where Koo's book is quite helpful in explaining how complicated the world has become, since the Japanese experience shows that a balance sheet recession throws conventional economic theory out the window.

I am convinced that conventional theory has put too much emphasis on the monetary and financial side of the analysis, and not enough on what is happening to the real, structural side of the world's economies.

Andrew Shen is a guest economist of Caijing and former Chairman of Hong Kong Securities and Futures Commission

Full article in Chinese: http://magazine.caijing.com.cn/2009-10-11/110278637.html

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