Mercantilist Exchange Rate Policies In East Asia

The United States is headed for a record current account deficit this year of over $400 billion, or more than 4 percent of GDP, and the IMF projects a similar deficit next year. One consequence of this long-standing external deficit is that the United States has shifted from a net creditor nation of $300 billion in the mid-1980s to a net debtor approaching $2 trillion this year.

Those of us concerned about this negative external course of events need to look at the principal causes of the deficit, and there are three of them. One is cyclical patterns in the growth of national economies. The financial crises in Asia and elsewhere in 1997-1998 reduced U.S. exports and thus increased the trade deficit, but now stronger economic growth in Asia, Europe, and Latin America has greatly diminished the cyclical factor. The second cause of the deficit is the low level of U.S. domestic savings, which can be addressed through fiscal, regulatory, and other measures to induce greater savings and less consumption. In any event, such actions can be taken by the United States alone.

The third cause, addressed here, relates to what our trading partners do, and in particular the practice of some foreign central banks to buy large amounts of dollars so as to keep their exchange rates below market-determined levels and thus to maintain larger than market-oriented trade surpluses. The mirror image, of course, is a stronger dollar and a larger U.S. trade deficit. I refer to this practice as a mercantilist exchange rate policy.

There have been three recent phases of this mercantilist policy. From 1989 to 1996, dollar holdings of foreign central banks more than doubled from $432 billion to $947 billion, and the $515 billion increase amounted to 90 percent of the U.S. current account deficits during those years. In other words, 90 percent of the dollars accumulating abroad from the external deficit, which otherwise would have exerted downward pressure on the dollar exchange rate, were taken off the market through foreign central bank purchases. And this, in turn, led to a substantially larger U.S. trade deficit.

The second phase of 1997-1998 was a hiatus in official dollar purchases because of the Asian and other financial crises. Speculative currency flight into the United States resulted in a stronger dollar than even the most dedicated mercantilist could desire.

We are now in the third, post-financial crisis phase, and official dollar purchases have resumed with a vengeance, particularly in East Asia. As shown in the table, East Asian trading partners, during the most recent 12 months of available data, increased foreign exchange reserves by $187 billion, led by Japan, South Korea, Taiwan, and China. At the same time, all were running current account surpluses which totaled $215 billion. In effect, 87 percent of foreign exchange inflow from the current account surpluses was taken off the market through central bank purchases, with the result of lower exchange rates and larger trade surpluses.

The dollar share of the $187 billion was probably about 80-90 percent, although the actual figures are kept secret. This means that 80-90 percent of the impact of lower valued Asian currencies translated into a stronger than market-oriented dollar.

These are the facts, but what should be the policy response? The IMF Articles of Agreement state that members shall "avoid manipulating exchange rates to gain an unfair competitive advantage," and surveillance criteria include "protracted large scale intervention in one direction in the exchange market." Surely the protracted large scale purchase of dollars in recent years by some Asian trading partners would meet this criterion. Indeed, since they are also running current account surpluses, the presumption in most cases is that the currency is under rather than overvalued, and that, if anything, central banks should be selling rather than buying dollars.

U.S. policy, as stipulated in the Omnibus Trade and Competitiveness Act of 1988, requires semiannual reports by the Secretary of the Treasury as to whether other nations "manipulate exchange rates to gain unfair competitive advantage in international trade." In all subsequent reports, however, only brief comment has been made about a few trading partners, and Japan, the most evident currency manipulator, has never been mentioned at all.

There is thus a policy framework in place for curtailing mercantilist-oriented exchange rate policies, but it has been a dormant framework, and the time has come to activate it. Views vary widely in the United States as to whether the overall trade deficit is good or bad for U.S. interests, but there should at least be broad agreement that other governments should not be manipulating their exchange rates to create a larger U.S. trade deficit than would otherwise prevail.

The next opportunities for the United States to take some initiative in this area are the IMF annual meeting in September and the Asia Pacific Economic Cooperation (APEC) summit meeting in November. Secretaries of the Treasury Robert Rubin and Lawrence Summers have stated that the current large U.S. trade deficit is "unsustainable." This implies that something should be done to reduce it, and one way to start is by adopting tighter disciplines on mercantilist exchange rate policies abroad, particularly in East Asia.