The G20 meets today to ostensibly decide on the fate of currencies, but like the Federal Reserve?s QE2 $600 billion dollar injection, their influence on currency values is negligible, and possibly late. Many see the QE2 programme as excessive and unwarranted. There are accusations of a hidden motive, a hidden agenda. And what might that be? To lower the value of the dollar, i.e., to further fuel currency wars.
It is worth recalling why we have a problem in the first place. Why is it that even the World Bank president is calling for a new gold order? It is because the currency system is out of whack. And why is the system broken? There are 82 countries in the world with a population of more than 10 million and there is only one country, one currency, that is accused of ?currency manipulation??China. And China is once again, after a gap of several hundred years, at the centre of attention. It is big, brash, and some might even say arrogant. It wants its currency to move, but move ever so slowly.
The spin mantra of China is that they are a responsible country, and that they will adjust the currency upwards, but do it gradually. Now who can object to gradualism, especially in India, where there has been nothing but gradualism. We are like that only, though some might add that our democratic framework allows us to move only gradually. Coming back to China?s gradualism?can anyone point to even one major policy on their part that was gradual in the last 60-odd years? The Great Leap Forward wasn?t exactly gradual, nor was the Cultural Revolution when after a Mao moment?s notice, engineers were turned into peasants. Nor was the one-child policy of 1974 gradual. The economic reforms instituted in 1978 were not gradual either. Indeed, China is the envy of the democratic world because it does not have to confront the perils of democratic gradualism.
But more to the point, China?s record on depreciating its currency has been the least gradual of all?among all countries and all times. Between 1978 and 1994, the yuan moved from 1.68 to the dollar to 8.62 to the dollar, and stayed close to the latter level till 2005. That is a depreciation of more than 400% in the short space of 16 years. Normally such depreciation occurs in a hyper-inflation regime. In the case of China, inflation was higher than the US, but not by a margin large enough to cause a significant dent in the real depreciation of the yuan with respect to the dollar. The real value of the yuan in 1994 became less than one-third (actually 29%) of its real value in 1978. Gradualism, anyone?
There is only one real outcome that really matters in this ostensibly confusing world. It is that in order for there to be a semblance of any order in currency values, the yuan has to appreciate, and appreciate by something like 5-10% a year for the next several years. Such an appreciation would still be gradual, and so would meet the demands of China. But China is refusing to do even that. So how does the world solve this problem? By meeting in Seoul? I doubt it.
There is another way out. It is for the dollar to appreciate against the major currencies of the world, and depreciate with respect to China and its east-Asian neighbours (excluding Japan, whose currency at 80 yen/dollar is already way overvalued). It also excludes India, a country with a large and widening current account deficit (estimated to be about 4% of GDP in 2010/11).
This way out began to happen almost not so coincidentally with the introduction of the QE2 programme. Though we will have to wait and see, but the Titanic size of the QE2 might be one of the very few mistakes of Bernanke?s regime. The QE2 was envisioned within the context of a near certainty of a double-dip in the US economy (okay, not a near certainty but clearly well above 50%?hence the insurance policy by the Fed). If they had any doubts about their certitude, the Fed would have announced a much lower number for their stimulus?say around $300 billion, rather than $600 billion. But they were quite certain about their numbers and that overconfidence might make them look somewhat irresponsible a few months hence.
Almost simultaneously with the QE2 decision, news began to emerge, from around the world, that the world recovery was intact. Yes, it had gone through a soft patch for the last six months, but no, it wasn?t going to be even close to a double dip. Within the US itself, two days after the QE2 announcement, news came that the economy had added more than 200,000 jobs in October (after revisions for the previous two months). As a surprise to the Germans, and perhaps the Fed itself, the dollar began to appreciate and in just a week it had appreciated by nearly 2% (and more against the euro and the yen).
Movement in exchange rates, as most market participants believe, is much more a function of real activity (GDP growth) than of nominal activity (movement in relative interest rates). If the forecast of a steadily improving US economy is correct, the dollar should continue to appreciate gradually. International pressures should, and most likely will, persist in getting the Chinese to move a bit faster than the glacial pace they have self-interestedly anchored themselves to. So where governments fail, the good old market might come to the rescue. Or stated differently, if the Pope won?t come to the mountain, the mountain will move towards the Pope.
The author is chairman of Oxus Investments, an emerging market advisory and fund management firm