Global Realignment of Exchange Rates: East Asia's Dilemma
Eyd, Ali Al-, Barrell, Ray, Choy, Amanda, National Institute Economic Review
Over the past year East Asia has featured prominently in the international debate over the widening global economic imbalances. In particular, China has attracted much attention for the nature of its currency regime and its large trade surplus. Until recently, China pursued a strict policy of tightly fixing the value of the renminbi against the US dollar and, as a result, Chinese exports have remained highly competitive while the US current account position has deteriorated markedly. A substantial widening of China's trade surplus in the first half of this year has sparked a great deal of criticism from the US regarding China's exchange rate regime. Protectionist threats from the US and growing domestic imbalances in the Chinese economy have succeeded in prompting the Chinese authorities to reform their exchange rate regime. On 21 July, Chinese authorities announced the abandonment of the longstanding US dollar peg in favour of a managed system where the renminbi is fixed against a basket of currencies. The specifics of this new exchange rate regime provide ample scope for further renminbi appreciation; however, this will be an orderly and drawn-out process dictated by both economic and market conditions.
At first glance, economic and financial data appear to lend support to the common belief that East Asia has played a key role in contributing to the current imbalances between savings and investment in the world's largest economy. The rising trend in current account surplus and foreign exchange reserves in all of the major East Asian economies contrasts sharply with the deterioration in the external position of the US (chart 1). While some Asian currencies are beginning to appreciate, others remain firmly pegged to the US dollar and Asia as a whole has so far shared only minimally in the burden of currency realignment, since the dollar has weakened mostly against the euro and the pound sterling. (1)
Given the evidence described above, the question of interest becomes the following; will a one-off revaluation of the renminbi, as many in the US have called for, lead to a significant and sustained improvement in the US external imbalance? Our analysis below suggests that the answer to this question depends not only on the size of the revaluation, but also, and more importantly, on the nature and dynamics of the Chinese economy.
The Asian economic 'miracle' and its policy dilemma
The rising volume of complaints against East Asian economies has centred on the export-led development strategies adopted by these economies. The rapid economic growth in Asia since the 1980s, which some observers consider as an economic 'miracle', was really an expected outcome from following consciously similar economic strategies to those adopted by Japan and Europe in the postwar period. Many authors (e.g. Eichengreen, 1996) have characterised the centre of these strategies as a willingness to trade wage restraint and higher levels of consumption for higher investment and export growth rates that would generate positive externalities leading to higher living standards in the near future.
Much of East Asia has been trying to preserve a policy mix of maintaining a stable nominal exchange rate to promote exports and to anchor the domestic price level, and the pursuit of this policy has resulted in the accumulation of large amounts of foreign exchange reserves by most East Asian central banks. Moreover, with a few exceptions, East Asian economies have also practised fiscal restraint in order to ease real exchange rate pressures stemming from Balassa-Samuelson effects. The rationale of this policy mix comes from the boost to growth that these economies can generate from an export-led strategy. In turn, robust export growth relaxes the balance of payments constraint that would otherwise limit the import of capital goods and new technologies. The added benefit of low real exchange rates translates into low real wage growth moderating consumption growth and leading to higher saving rates across East Asia. …