Only a few years ago, the European common-currency arrangements were held up as a possible model for Asia.

With the euro under serious threat, we do not hear much about this now, but the current mess in Europe could well contain a number of lessons for Asia.

Lesson one might be surprising at first sight: membership of a currency block is still seen as valuable. Ireland, Portugal and Greece seem ready to undergo years of wrenching austerity in order to stay in. Greece understands that in leaving the euro, it would be swapping one set of problems for another. And countries such as Turkey are still very ready to join.

Lesson two is more obvious: it is hard to make common currencies work. Currency blocks work smoothly only if the member economies have a lot in common. There was always the promise — or hope — that membership would be the catalyst to make Greece more like Germany. But for Greece, there has been neither economic nor political convergence, and continuing membership may prove to be unworkable.

Lesson three is an old one: financial markets are prone to radical changes of risk assessment and lemming-like herding. The markets initially treated Greek debt as more or less on par with German debt. But when they belatedly perceived the reality, they pulled the plug.

Lesson four is that support mechanisms are needed when markets lose confidence. Even countries like Spain and Ireland — which are trying harder than Greece to be good euro citizens — need external support. The euro arrangements are providing this through loans and the support of the European Central Bank (ECB). There is a further sub-lesson here: when the crunch comes and confidence is lost, the supportive response is always tentative, inadequate and chaotic. It is always too little, too late.

So, what are the implications for East Asia’s emerging economies? Despite strong international advice after the Asian crisis to adopt freely floating exchange rates, these countries are yet to adopt a pure free float. They are managing their exchange rates, not only to smooth out volatility, but also to resist appreciation pressures that would diminish their international competitiveness. And as their production structures are becoming increasingly integrated through supply-chain frameworks, maintaining competitive parities with neighbours is becoming more important.

So far, this maintenance of competitive parity has been an informal affair, and it could be given more regional structure. If each country maintained stability (perhaps within a band) vis-à-vis a common basket of currencies — including a heavy weighting of Asian currencies — this would have some of the characteristics of the early stages of Europe’s move to the euro.

While this sort of structure creates tighter relativities, it sets up potential vulnerabilities. In Europe, the euro’s precursors — the ‘snake’ and the European Exchange Rate Mechanism — both broke down. So support arrangements like those offered by the ECB would be an essential part of any tighter currency arrangements. Emerging East Asian economies might receive help from the IMF, but many still carry bitter memories of the Fund’s failures in 1997. And while the Chiang Mai Initiative is exactly the sort of arrangement that might do the job, it proved unusable when it was needed in 2008, and in its present form provides only trivial support.

Asia might also heed the lesson that currency blocks should choose their participants carefully. One suggestion is that a smaller yuan-based grouping of ASEAN, China, Hong Kong and Taiwan might make more sense than a region-wide linkage.

All this leaves Asian exchange rates in an awkward policy space. The managed rates of the post-1997 period are working well enough, but continued reserve accumulation is not sustainable, and running chronic current account surpluses is not optimal. Capital should be flowing ‘downhill’ to these emerging countries, not in the reverse direction. Establishing a stable range of relativities among a sub-set of the region might be a start in the right direction.

Stephen Grenville is a Visiting Fellow at the Lowy Institute for International Policy and a former Deputy Governor at the Reserve Bank of Australia.

An earlier version of this article was first published here on the Lowy Institute for International Policy website.

1. Regional cooperation and national sovereignty: Asia and the euro crisis
2. The financial crisis and East Asia
3. India’s role in East Asia: lessons from cultural and historical linkages

The Australian economy presents a conundrum for both policymakers and outside observers.

Despite a spectacular effort in evading the worst of the 2008/09 downturn and an impressive recovery trajectory in the labour market through 2010, a striking undercurrent of pessimism has emerged.

Australian households seem to be acknowledging that it was a combination of luck and good management that delivered the remarkable resilience of recent years; if things had broken slightly differently, the aggregate outcome could have been significantly different — and not in a favourable way. That perception has engendered caution and a desire to consolidate: the opposite response to that historically associated with terms of trade upswings.

This has produced a macroeconomic environment that is characterised by unequal parts of hope (the resources boom) and trepidation (the indebted household sector, the businesses that serve them and currency sensitive tradable industries). But observing that Australia is suffering from the antipodean strain of Dutch Disease (aka the Gregory Thesis in Australian parlance) seriously under-estimates the complexity of the situation presently confronting the economy.

Australia’s policy mandarins are attempting to respond to these forces in the face of an increasingly malignant external environment. Three surveys provide a useful insight into the state of economic play in Australia.

The Westpac-Australian Chamber of Commerce and Industry Survey of Industrial Trends, Australia’s longest running business survey, has just celebrated a sombre 50th anniversary. The 200th issue of the survey, describing the September quarter, indicated that the manufacturing sector contracted for a second consecutive quarter. Manufacturers report weak hiring plans, soggy order books, declining exports, diminished profitability, downgraded capital spending plans and a sharp decline in overall business conditions.

In the Westpac-Melbourne Institute Consumer Sentiment Survey, the tone is equally downcast. Consumers report considerable unease about the state of their family finances, a rising tide of job insecurity and a distinct preference for risk-averse investment options. Households have raised their savings rate to more than 10 per cent of their income, from the negligible rates prevailing before the global financial crisis. Mortgage equity withdrawal has become a thing of the past. The appetite for spending on durables has flagged and the desire to pay down debt has increased. Expectations for house price appreciation have come down significantly. And these observations all pre-date the global financial turbulence that has burst into the national consciousness in recent weeks.

The third report, the Australian Bureau of Statistics’ survey of expected private capital expenditure (colloquially known as CAPEX), indicates that the mining industry plans to boost its investment spending by more than 70 per cent in 2011/12, an extraordinary number coming off an already high base. The mining industry is responding to the spectacular price signal that has pushed Australia’s terms of trade to record levels, with their confidence buttressed by the fundamental view that the urbanisation/industrialisation dynamic in emerging Asia has a considerable time yet to run.

The Reserve Bank’s response to date has been to give priority to managing the expansionary impact of the mining boom and the income stimulus imparted by the terms of trade. Historically, mining booms have been an inflationary force in the Australian economy. In this cycle the Reserve Bank has sought to pre-empt that outcome through a prudent interest rate setting that ‘makes room’ for mining by suppressing activity elsewhere. That has led them to pitch their policy interest rate at a level that is exerting a degree of restraint on activity. The correct adjective to place in front of the word ‘degree’ is a robust topic of debate.

With house prices now falling in most major capital cities, credit growth at many decade lows, dwelling approvals falling, a rising unemployment rate and retail sales scraping along at recessionary rates in per capita terms, interest rate sensitive activity seems to imply that the adjective ‘considerable’ is more appropriate than ‘modest’.

The Reserve Bank’s position has been increasingly questioned as the year has aged. The Bank’s view seems to have revolved around an expectation that the economy was close enough to full employment that policy needed to be extra vigilant against upside risks. Yet now that it has become increasingly clear that the income stimulus from the terms of trade is going towards boosting national savings (with households, firms and government all using the opportunity to improve their balance sheets) rather than lifting consumption and non-mining investment, resulting in a record run of trade surpluses, a different framework is required.  Put simply, with the unemployment rate now rising rather than falling, a more flexible approach is now likely to gain support. Short term market interest rates indicate that easier monetary policy is expected in the not too distant future.

On fiscal policy, a substantial tightening is underway at the state and federal level. The public balance sheet is a major beneficiary of the resources boom. Unlike in previous booms, in the current period the public sector is seeking to improve its own saving position, and it is thus not recycling the revenue boost from mining back into the household sector. That severely limits the expansionary effect of the rise in national income brought about by the terms of trade. Households and businesses outside the direct sphere of influence of the resources sector are feeling the heat from restrictive financial conditions (including the heroics of the Australian dollar) and they are being accosted by high food and energy prices (both fuel and electricity). Yet fiscal policy still remains on a contractionary bent, with a dramatic improvement in the government’s bottom line anticipated between 2010/11 and 2012/13.

The uneven nature of activity — ebullient miners and crestfallen consumers — is amplified by the stance of both monetary and fiscal policy. This observation lies at the heart of the palpable pessimism (or lack of optimism) that belies the ‘view from the North’ of Australia as a country with robust fundamentals that should exempt it from the deep anxieties that are pervasive in the North Atlantic and Mediterranean economies.

Huw McKay is Senior International Economist at Westpac Banking Corporation and a graduate scholar at the ANU.

The Author would like to apologise to Daniel H. Rosen and Trevor Houser for borrowing their phrase in the title of this piece.

1. Confidence in Indonesian economy
2. The Fijian economy: Time to build confidence
3. Australia lifts its bank guarantees

In reforming the international monetary system, exchange rates usually get primary attention front and center — such as in numerous meetings of the Group of 20. Indeed, at the G20 meeting in November 2010, President Obama attacked China for not appreciating its currency.

But China’s monetary policy has been oriented toward keeping the renminbi-dollar rate stable since 1994, which served China well as a nominal anchor for its domestic price level and to smooth exchange relationships with its smaller neighbours. In addition, there is no clear evidence that China’s exchange rate was, or is, undervalued vis-à-vis Europe or the United States relative to their ‘real’ multilateral exchange rates averaged over the past 20 years.

Not finding any agreement on exchange rate practices, the G20 meetings shifted to trade imbalances. Last November, the United States suggested that countries with trade surpluses cap them at, say, 4 per cent of GDP. But trade surpluses simply reflect net saving surpluses: the difference between national saving and investment. And in market economies, governments don’t directly control either. Nor, contrary to popular opinion and that of ‘China bashers’ who are calling for China to appreciate the RMB, can exchange appreciation be used as an instrument to reduce any creditor country’s saving.

Yet in light of the November impasse of the G20 and continuing stalemate in 2011 on exchange rate and US fiscal issues, it is clear that movement on these issues will be a long time coming.

With exchange rates and trade balances off the table for now, what remains for constructive international monetary reform? Almost all emerging market economies at the G20 meeting in November 2010, and even more now in 2011, complain about ultra-low interest rates at the ‘centre’ inducing hot money flows to the ‘periphery’. In addition, the US Federal Reserve’s ‘Quantitative Easing’ for reducing long rates (ending in June 2011) exacerbated the problem. In 2010-2011, the resulting ‘carry trade’ has induced a flood of hot money into emerging markets — which have higher growth and naturally higher interest rates.

The combination of very low American interest rates and a declining dollar have provoked large outflows of financial capital (‘hot’ money) into emerging markets for almost a decade. When emerging market exchange rates are not tied down by official parities, their ongoing appreciation induces even more hot money inflows. Speculators see a double benefit: the higher emerging market interest rates combined with their currencies appreciating against the dollar or yen.

For emerging markets exchange rate flexibility is no protection from foreign interest rate disturbances. In the short run, exchange rate flexibility may actually enhance the returns that carry traders see as the target emerging market currency appreciates against the dollar.  To slow the appreciations of emerging market currencies, central banks typically intervene to buy dollars with domestic base money.  And these interventions have been truly massive. From the first quarter of 2001 to the first quarter of 2011, the dollar value of emerging market foreign exchange reserves rose six fold, with — from $1 trillion to $6 trillion! China accounted for about half of this huge buildup.

This sharp buildup of emerging market foreign exchange reserves has been too big to fully offset by domestic monetary sterilization operations. The resulting loss of monetary control in the emerging market economies led (and leads) to inflation generally higher than that in the developed market economies. On a world scale, the most striking inflationary impulse is seen in primary commodity prices. Year-over-year to 21 June 2011, the Economist’s dollar commodity price index for all items shows an average increase of 38.6 per cent, with food prices alone rising 39 per cent.

Near-zero interest rates in the mature industrial countries contribute to commodity price inflation in two ways. First, they generate hot money inflows into the emerging market economies and emerging market demand for primary commodities rises.  Secondly, once commodity prices begin to rise, ‘commodity’ carry traders find they can borrow ultra cheaply in New York or Tokyo to fund long positions in commodity futures. Of course, this adds to the upward price momentum making commodity prices, and asset prices in general, more prone to bubbles.

What are the implications for international monetary reform? In the new millennium, world monetary instability has been (and is) provoked by large and persistent interest differentials that induce ‘carry trades’: the willingness of speculators to borrow in low- interest- rate currencies (source currencies) to invest in higher yield currencies (investment currencies). But what can governments do about this?

Central bankers from the G20 could meet continually to monitor each other in order to prevent wide interest differentials from developing. True to its newly professed virtue, the IMF should refrain from criticizing countries who attempt to impose capital controls to stem hot money flows. It could also provide technical advice on how to do so most efficiently.

To better preserve financial and exchange rate stability in the transition, the big four central banks — Fed, ECB, Bank of England, and Bank of Japan — should move jointly and smoothly to phase in a common target minimum target — say 2 per cent — for their basic short-term interbank rates. By escaping from liquidity traps which so impair the efficiency of domestic bank intermediation, and lessening the bubbles problem, the mature economies would benefit along with the emerging market economies.

Reducing the spread in interest rates would dampen carry trades and hot money flows in an important way. But it may not be sufficient to end them altogether. So acknowledging the legitimacy of emerging markets using capital controls and other devices to dampen hot money inflows should be an important part of the new G20 discussion. Indeed central banks in the mature industrial economies could monitor their own commercial banks to help central banks in emerging markets enforce their controls.

But there is an important asymmetry here. Capital controls are not for everybody. In particular, the United States at the centre of the world dollar standard cannot itself impose capital controls without destroying the world’s system for clearing international payments multilaterally. Thus everybody has a vested interest in rehabilitating the unloved dollar standard with open US financial markets. The first of many necessary steps in the rehabilitation process is for the Fed to abandon any thought of a QE3 while phasing out its policy of keeping short rates near zero.

Ronald I McKinnon is the William D Eberle Professor of International Economics at Stanford University.

1. China’s monetary and exchange rate policy and the global economy
2. The China syndrome on exchange rates
3. US, Japan and EU monetary policy: Monkeying with interest rates

The mainstream view is that China can still go on growing at 8 per cent and above in the next five to ten years.

This is increasingly questionable. China’s economy is too bubbly and will soon slow down. China’s European and American partners should prepare for when China will need to rebalance its economy as it adapts to slower rates of growth.

China’s growth has been over stimulated since its 2008 RMB4 trillion (US$618 billion) stimulus package, which focused on physical capital investment. This helped build useful infrastructure, but there are too many new factories now with limited profit prospects. Investments make up a record 48 per cent of GDP, much higher than in other East Asian economies with overinvestment problems before the 1997-1998 financial crisis.

Money from excess savings is feeding a credit, asset and housing bubble. The authorities have tried to curb lending by increasing bank capital requirements or setting quotas, but this has been to little avail. Inflation is haunting the economy. China’s currency, pegged to the US dollar, has its hands tied: it cannot raise interest rates significantly enough to effectively fight inflation. Yet revaluation of the RMB contains risks, notably a shock to the financial system.

There are three scenarios. First, China could see, within the next two years or so, a financial meltdown followed by an extended period of low growth, say around 4 per cent, as China’s imbalances reveal themselves to be deep rooted. The second scenario would see a similar financial meltdown due to the bursting of the credit and housing bubble, followed by a swift recovery thanks to some financial and structural reforms. Growth would then sail along at 6–7 per cent. There could also be, as a third scenario, a ‘soft landing’ and a slow yet steady rebalancing of the economy with growth rates standing at around 7–8 per cent for another few years. The second scenario is the most plausible. The first scenario is a real possibility. The third is the best anyone could hope for.

It has become a cliché to say that China’s economy needs rebalancing. This rebalancing is already happening. Consumption is rising. Salaries are rising. Energy efficiency is improving. But the share of services raised only 2.5 per cent of total value added in 2005–2010, missing the 3 per cent target set in the last Five-Year Plan.

China’s stimulus package was meant to keep its economy afloat until the real engine of its growth — demand in the established big Western markets — got going again after the Great Recession. Europe remains China’s first export destination and the US second, but growth in the West remains stubbornly anaemic. Without the spur of Western demand, one can legitimately ask where China’s new factories will send their products. Although exports to other booming emerging markets have increased, these are not yet mature enough to make up for an eclipse of the West.

Direct international contamination resulting from a possible financial shock is not a major risk, as China’s financial system remains insulated from world financial markets. A crash in currently highly-bubbly Hong Kong however, where many big Chinese conglomerates raise money, could have important global ripple effects.

The first major effect to expect is a significant drop in commodity prices. This will affect the world’s commodity exporters in the emerging world and force them to go back to the drawing board to build more sustainable growth strategies involving less resource dependence. The second effect will be a slow-down in capital goods exports from industrialised nations, notably Germany, currently the only engine of growth in Europe.

Europe and the US are still too narrowly focussed on lobbying China over its undervalued currency and global imbalances. It is the Chinese authorities themselves that will decide soon enough when to end an exchange rate policy that no longer serves them well. As China’s wealth grows, trade between it and the US and EU will increasingly be based on product quality and diversity. Policy based upon this assumption is likely to make more sense in dealing with China.

The US and Europe have also pumped a lot of money into their economies. This will be a drag on growth. While the latter wind down their deficits and debts, devising a competitiveness strategy that involves China would be advisable. The strategy could focus on constructive work with Chinese authorities on product standards, notably environmental ones. It could also contribute to Chinese reforms to improve its investment climate and allow more Western investment in services (like banking, telecommunications, environmental services and higher education). A final issue such a strategy could address is getting rid of the kind of Western protectionism that targets China’s declining cheap-labour-intensive exports. This includes the vexing looser-than-average anti-dumping standards the EU currently applies to China because it does not recognise China as a market economy. According to WTO rules, this allows the EU to be more lax in its criteria to determine dumping.

Iana Dreyer is an independent analyst based in Paris. She is currently working with the European Union Institute for Security Studies on a global political and economic forecasting project.

1. Toward a world economy with slower growth and higher inflation
2. Western-style political reform in China is still a long time coming
3. ASEAN economies on the slide?

So far, the discussion of revaluation of the yuan has been almost exclusively about the impact on China’s trade balance.

But it is at least as important to ask what effect it may have on the country’s inward foreign direct investment (IFDI), which plays such a crucial role in China’s economic development, and its outward FDI (OFDI), which is receiving increased attention worldwide.

China has been the developing world’s largest recipient of IFDI since the mid-1990s, attracting US$95 billion in 2009. A revaluation of the yuan will make it more expensive for foreign firms to establish themselves (or expand) in China (the world’s most dynamic market), giving an advantage to foreign firms already established there over new entrants. At the same time, exports of foreign affiliates, which account for 54 per cent of total exports, will become less competitive internationally, although the increased costs will be partly offset by lower costs of imported inputs. Foreign affiliates can also expect to repatriate higher profits from sales in China in terms of their own currencies.

However, the most notable development of recent years has been the take-off of the country’s OFDI since the government in 2000 adopted the ‘go global’ policy encouraging Chinese firms to invest overseas. China’s OFDI doubled from US$12 billion in 2005 to US$27 billion in 2007, and then doubled again the following year, to reach US$56 billion. Outflows continued to rise to US$57 billion in 2009, even as world FDI flows collapsed by 50 per cent. In 2009, China was the world’s fifth largest outward investor.

The increasing international competitiveness of Chinese firms and an encouraging government policy have been the main drivers of this surge. The 20 per cent revaluation of China’s currency against the US dollar in 2005–2008 undoubtedly provided a favourable condition facilitating this in the case of host countries whose currencies did not also appreciate against the US dollar. There is ample evidence in the academic literature that a weaker exchange rate induces increased IFDI.

Revaluation of the yuan would likely accelerate growth in China’s OFDI. This is precisely what happened with Japan after the yen was revalued by over 50 per cent against the US dollar between 1985 and 1987, following the 2005 Plaza Accord. Japan’s OFDI tripled from US$6.5 billion in 1984 to US$19.5 billion in 1986, peaking at US$48 billion in 1990.

A renewed yuan appreciation would boost China’s OFDI growth even further by lowering the cost of overseas assets for Chinese firms, which have strong cash reserves from both retained earnings and large-scale state credit allocations that put them in a position to invest internationally. Like competitors elsewhere, they need to invest abroad to acquire a portfolio of locational assets to protect and increase their international competitiveness through better access to skills, technology, natural resources and markets.

Revaluation would combine with already rising wage pressures inside China.  Labour-intensive firms in China’s coastal provinces are under pressure to seek lower labour cost by either investing in China’s interior or abroad. Already more than 700 Chinese affiliates have been established in Vietnam. Revaluation would push even more in that direction.

Suspicions of non-commercial motivations behind China’s OFDI are widespread because most of the country’s OFDI is by state-owned enterprises (SOEs). However, there is no systematic evidence that China’s SOEs, like their counterparts elsewhere, are driven by more than normal commercial considerations. At the same time, private or semi-private entities have been investing abroad. As their operations are less visible, it is likely that their OFDI, and therefore China’s total OFDI, is understated.

Fears of Chinese OFDI, like Japanese and Korean investment in earlier decades, are misplaced. It is good for China and for host countries: Chinese FDI, like all FDI, can bring to host countries a bundle of tangible and intangible assets needed for economic growth and development. While a good part of China’s OFDI initially takes the form of trade-supporting FDI, it can be expected to lead relatively quickly to a shift of some production out of China, including to the US and Europe, thereby reducing exports from China. Moreover, OFDI is a key mechanism for integrating China into the world economy and making it a responsible stakeholder in it.

Chinese firms will have to learn from the past mistakes of other emerging multinationals about how to operate in the highly sophisticated developed-country markets and in developing countries. They need not only to overcome the ‘liability of foreigness’ that any multinational faces when establishing itself in a foreign market, but they also need to overcome the ‘liability of the home country.’ In particular, they need to establish a good social brand name so that they are seen as making not only a positive economic contribution to their host countries but are also seen as good corporate citizens.

The Chinese government can play a crucial role by adopting a code of conduct for all Chinese enterprises investing abroad, in line with internationally accepted norms and taking into account the increasing importance of sustainable FDI. For their part, host countries need to accept the ‘new kids on the block’ and not discriminate against Chinese investment, nor establish protectionist barriers against it.

Karl P. Sauvant is the founding Executive Director of the Columbia Program on International Investment and a Research and Guest Professor at Nankai University, China. Ken Davies is a Senior Staff Associate at the Vale Center for Sustainable International Investment at Columbia University. This is a chapter from the Vale Center publication ‘FDI Perspectives: Issues in International Investment.’ The full publication can be found here.

1. The appreciation of the yuan: A compromise solution
2. Chinese manufacturing firms’ overseas direct investment
3. Foreign direct investment in China: trading competitiveness for access?

China’s emergence as the second largest economy in the world, and on some reckoning an economy that is already nudging America for the top spot, inevitably raises questions about how this remarkable and rapid shift in world power will affect the global economic order as we know it and what role China can now be expected to, and will, play in running the world economy.

At the end of the Second World War, the United States bequeathed the GATT, IMF and World Bank-based international system and assumed leadership in establishing the rules and norms in running the global economy. America was by far the largest economy in the world, accounting for upwards of 60 per cent of world output. The United States alone still accounts for almost a quarter of global gross domestic product, calculated at current exchange rates and around one fifth measured in real (or purchasing power parity). The European Union is collectively larger but no single country is yet a match for American economic power, nor the influence that power still has in shaping the global rules whereby economic behaviour is regulated or shaped.

As Wendy Dobson observes in this week’s lead essay, China’s embrace of the global institutions and the norms which the United States and its partners have created over the past sixty years has helped guide and drive China’s spectacular economic growth and integration into the world economy. The most immediate question that surrounds China’s economic rise is not how China’s new economic power will translate into political and military power, but how China’s economic power affects the running of the global economic system. Indeed, more than any other factor it is the interaction between China’s growing economic power and the global rules of the economic game which will condition the shape of China’s political and military choices down the track.

China’s impact on the global economic order is, of course, still an open question. China’s sheer size and dynamism make it a major force to be reckoned with.

Dobson argues that so far China’s influence has been constructive and, despite recent signs of political assertiveness in the Asian region and at home, China’s deliberative behaviour and policy strategies have worked to support the status quo in managing the global economic order, not to undermine it. China has played by the rules and assumed a largely constructive role in the international system and a positive and responsive role in Asia Pacific economic cooperation. China appears overwhelmingly to be a ‘responsible stakeholder’ in the international system, not as a regime spoiler.

As Dobson also argues, just playing by the established rules will be a less and less adequate strategy the larger China’s impact on the global economy. Chinese policy initiative and change will be a more and more important element in the stability of the global economic order. Nowhere is this more pressing than in the management of China’s role the international exchange rate regime. China’s foot-dragging on modernising its exchange rate regime is seen as damaging to the international order. The Chinese leadership openly accepts that change is required but pleas for time to set its own pace according to the political importance of steady growth in output and employment. In any case, the transition in the exchange rate regime will not be easy as it will need to be accompanied by extensive domestic restructuring, challenging powerful interests at home. Adjusting the exchange rate alone will not solve the problems that US Congress-people hold undervalued RMB responsible for. It may reduce some of the pressure but the pace and extent will be limited by the need for China to painstakingly put in place the reforms that will allow retreat from capital controls to be and heavy exchange rate management.

As soon as we accept that just playing by the rules is not enough, it follows that the rules-based international system is dynamic and Chinese initiative will be important in shaping the evolution of the rules down the track. The global financial crisis saw the rules tested and found wanting. The key to whether China’s contribution to running the global economic system will continue to be constructive lies in the interface between the state and the market. Notwithstanding the differences in approach, there are no signs that China intends to retreat from entrenchment of the market economy. Even if China’s leadership could do so, a retreat from market based reform is not possible because of what it would do to economic growth and stability, inflicting massive political damage at home.

Internationally, the establishment of the G20 opens up a cooperative space within which China and the other emerging economies can, together with the established powers, contribute to constructing a more robust set of rules to make markets work better. Here too, in the G20, China is playing a constructive role.

The lesson of history is that rising economic powers only slowly assume global economic leadership. America left that burden to Britain for decades after America’s rise. As struggle with exchange regime reform illustrates so starkly, the institutional and policy capacities for leadership take time to acquire, the responsibilities for provision of global public goods are weighty and difficult to exercise without taking on the huge domestic challenges that ultimately lead to success.

This all suggests that China is not in a position, and will remain most reluctant, to take over running the world economy any time soon despite its growing economic weight.

1. Toward a world economy with slower growth and higher inflation
2. World economy not quite out of the woods yet
3. Fixing global economic imbalances

American authorities have been baying for months about flexing up the renminbi (RMB — the Chinese currency) to help turn around China’s current account surpluses and reduce America’s deficits. Whether a sharp appreciation in the rate of exchange between the RMB and the US dollar should be relied on as the main instrument for effecting that change smoothly is a much debated question.

Appreciation of the RMB is certainly one crucial part of the solution, but there are also more fundamental structural problems that need to be dealt with to cut back China’s net international savings and achieve the reverse in the United States.

After President Hu Jintao’s visit to the US last week, a flexible Chinese RMB looks a less distant, and more daunting, prospect than it might have seemed to American critics, especially if it is tied to Beijing’s plans for the RMB’s emergence as a world currency.

Not that Hu announced an appreciation of the Chinese currency or any immediate or managed solution to the immediate dispute over its valuation with his American counterparts. That was never on the cards. But what has happened in the lead-up to his visit was something that might ultimately be much more important in developing a Chinese exchange rate regime in which the RMB can more readily float to its proper market rate and assume a more important place in the global monetary system.

As Barry Eichengreen discusses in this week’s lead essay Beijing’s decision, in the lead-up to Hu’s visit, to allow the state-controlled Bank of China to offer RMB-denominated bank accounts and currency conversion services in New York is as an important step in positioning the RMB to become a true international currency. It’s not just a publicity stunt designed to deflect attention away from China’s refusal to let its currency appreciate against the dollar: it is another small but significant step, as Eichengreen observes, in the internationalisation of the RMB, even if President Hu’s visit may have explained the timing of it.

‘There has been an important shift in Chinese strategy and rhetoric since March 2009 when People’s Bank of China Governor Zhou made some much-commented-on remarks calling for an enhanced role for the IMF’s Special Drawing Rights, or SDRs, as an alternative to the dollar in the international sphere’, Eichengreen argues. ‘Chinese officials speak now not of an international monetary system centred on SDRs (or the US dollar) but on a system that rests on a handful of existing currencies: the dollar, the euro, and the renminbi.’ China now gives every sign of resolutely moving to put the new international currency order in place.

In the joint Press Statement after the Hu-Obama talks, on currencies, the United States and China agreed ‘that currencies in the SDR basket should only be those that are heavily used in international trade and financial transactions’, and the United States supported China’s efforts over time to promote inclusion of the RMB in the SDR basket.

Eichengreen notes that ‘China still has a long way to go in order to internationalise the RMB. It will have to make its financial markets at home more liquid. To create a bond market of the requisite size, it will have to “overfund” its debt, issuing more sovereign debt securities than would be necessary otherwise. To gain the confidence of foreign investors, it will have to make its financial markets more transparent and strengthen rule of law. To accommodate a larger volume of capital inflows and outflows, it will need a more flexible exchange rate. Above all, it will have to avoid serious financial problems.’

As Takatoshi Ito finds in his Asian Economic Policy Review paper last year (see also the relevant appendix), according to the basket currency regressions during the period in which the Chinese currency was gradually appreciating against the US dollar from July 2005 to August 2008, the RMB had already acquired strong influence on the Asian currencies. The weight of the RMB turns out to have been higher than that of the US dollar in the Singapore dollar basket. The RMB is fast gaining the status it needs to be a regional anchor currency and for a float.

While many central banks have not yet acquired RMB denominated assets as foreign reserves, China has made a decision to promote RMB denominated cross-border transactions. As capital controls are lifted, transactions of assets denominated in the RMB will increase. Although the RMB may still have a long way to go in challenging the US dollar and the Euro as key reserve currencies, the process toward at least becoming a regional key currency, and eventually an international key currency, has begun.

1. The future of the international currency system and China’s RMB
2. China’s role in international currency arrangements – Weekly editorial
3. The valuation of China’s currency – Special editorial

On November 3, shortly before US President Barack Obama’s arrival in India, the Federal Open Market Committee (FOMC) of the US Federal Reserve announced that it intended to undertake a fresh round of purchases of longer-term treasury securities in an aggregate amount of US$600 billion until the second quarter of 2011, at a pace of approximately US$75 billion per month.

Even though Fed Chairman Ben Bernanke had done his best to ‘trail’ (that is, anticipate) this decision, starting with a speech at Jackson Hole, Wyoming in late August, the formal announcement of this move (so called QE2, denoting the second round of quantitative easing) has unleashed a firestorm of criticism both within the US and internationally.

In the run-up to the G20 Leaders’ meeting in Seoul (where Prime Minister Manmohan Singh and President Obama were both present) China, Brazil and Germany were among the most vocal critics of this monetary expansion. These countries have portrayed it, in my view incorrectly, as an ill-disguised attempt by the US to depreciate the US dollar as part of a feared circle of competitive devaluations across the major economies.

As widely noted in the international press, India has been more supportive. At his joint press conference with President Obama, Prime Minister Singh observed, ‘A strong, robust, fast-growing United States is in the interests of the world … and therefore, anything that would stimulate the underlying growth and policies of entrepreneurship in the United States would help the cause of global prosperity.’ While some of this may just have been the courtesy of a polite host in the presence of an honoured guest, it also seems to imply a more mature and relaxed attitude towards exchange rate flexibility on the part of the government. This interpretation is also consistent with both the relatively limited intervention in the exchange markets by the Reserve Bank of India in recent times, despite strong capital flows, as well as statements by Finance Minister Pranab Mukherjee that India was not contemplating limiting foreign flows into its equity markets.

Nevertheless, this episode has served to crystallise the issues and tensions in the present international monetary system. If anything, these issues are likely to gain even greater prominence now that the meeting in Seoul has concluded, because France has taken over as the chair of the G20. President Sarkozy has already signalled that he intends to make review and reform of the international monetary system (IMS) a core agenda item of that Presidency, and is bound to raise these issues when he visits here early in December.

India has in general been relatively passive on these aspects of the global financial architecture, showing more interest in the governance reforms of the International Monetary Fund (IMF). Yet, as happened over the previous decade in the area of multilateral trade negotiations, India could easily be asked to play a central role in the redesign of certain aspects of that regime. Accordingly, it is important that there be a more robust domestic debate on the key issues, so as to help our officials better articulate our core concerns and interests.

What, then, are the important issues that might arise in an agenda for international monetary reform? Unfortunately, the public debate on these issues is rather confusing, combining as it does elements connected with what one might call the ‘real’ economy (savings and investment; current account deficits; global imbalances) with the monetary system. As Ted Truman of the Peterson Institute in Washington has observed, the enormous expansion of global finance over the last decade now means that the latter increasingly sets the rules for the former, at least until and unless there is a fundamental roll-back of private cross-border finance, of the type that took place during the great Depression.

Within the more narrowly defined monetary area, the key issues have to do with the exchange rate regime, the accumulation of reserves, the supply of reserve assets, volatility in exchange rates and volatility in private capital flows. While under the post-war Bretton Woods system, fixed exchange rates against the dollar were the norm, the vogue today is for ‘market-determined’ flexible exchange rates, at least for systemically important countries, even though ‘clean’ floats are more the exception than the norm in most emerging markets, India included.

At the same time, exchange market intervention has crept back into the financial armoury of even the advanced countries, such as Switzerland and Japan, with the clear objective of influencing (the polite word is ‘stabilising’) the nominal exchange rate. The challenge here will be to devise rules that are appropriate for both the advanced countries and for large emerging markets such as China, Brazil and India. India will need to be vigilant to ensure that these rules strike the right balance between policy flexibility and harmful mercantilism.

Equally difficult judgments arise on the appropriate stock of reserves. The bulk of reserves accumulation over the past decade has been by major emerging markets, primarily as a form of insurance against volatile capital flows and possible speculative attacks. Despite their high cost, such reserves did demonstrate their worth as a protective device in the crisis. At the same time, it is these reserves that have been cited as one cause of the financial crisis.

Finally, there is the role of the dollar as the central reserve asset. It is being argued again now as in the 1960s, that the reserve role of the dollar has encouraged unsustainable policies, and that a range of alternatives is needed. But a move to a multi-currency reserve system (or to a synthetic unit such as the IMF’s SDR) needs careful management to avoid destabilising flows.

Emerging markets have now become systemically important, China most of all, but India and Brazil in due course. Yet they remain ‘emerging’ and will be for a considerable time to come. At the same time, the negotiating skills and power of the advanced countries way exceed those of the emerging markets. As monetary reform approaches centre stage, we must be careful not to throw the baby out with the bathwater.

Suman Bery is Director-General, National Council of Applied Economic Research.

This piece originally appeared in the Business Standard and may be found here.

1. Global reform: Fixing interest rates trumps fixing exchange rates
2. Will Asia have common interests in global monetary system reforms at the G20?
3. India: Monetary policy dilemmas

Today, the National Statistics Bureau released October’s batch of economic data. Almost all indicators for economic activity, including fixed asset investment, industrial production and even retail sales, slowed in October (as measured by year-on-year growth rates). The whole country’s attention, however, was firmly fixed on inflation data. CPI was up by 4.4 per cent year-on-year in October, compared with 3.6 per cent in September and the consensus forecast of 4.0 per cent.

This was the highest level reached in 25 months. Food prices, in particular, increased by more than 10 per cent.

This increase in the inflation rate is more alarming if looked at from the perspective of a month-on-month reading, which accelerated to 0.7 per cent in October from 0.6 per cent in August and September. This implies that the annual inflation rate is already running at above 8 per cent, and is perhaps why a senior policymaker admitted several days ago that CPI in 2010 would likely exceed 3 per cent, the official target. And the October increases may not be the end of the current inflation cycle given tighter food market conditions, accelerating wage growth and very loose liquidity conditions.

As to the level of growth, it is true that growth is moderating, evidenced by both monthly economic data released today and quarterly GDP growth data (down from 10.3 per cent in the second quarter to 9.6 per cent in the third quarter and possibly around 9 per cent in the fourth quarter). But most economists agree that the current growth slowdown is likely to be limited. The market generally expects GDP growth to stay at the 8.5-9.5 per cent range in 2010.

The term ‘marginal stagflation’ has been suggested by a government official during internal discussion. It refers to the situation when growth is decelerating but inflation is accelerating. This combination certainly complicates economic policymaking: should the central bank tighten or ease monetary policy? Fortunately, the People’s Bank of China (PBOC) already provided an answer to this question last night by hiking the reserve requirement ratio by 0.5 percentage points.

Clearly, then, inflation is the number one risk, at least for now. Because of the widespread labor-shortage problem, wages are currently growing at 20 per cent. New loans amounted to RMB 587.7 billion in October alone, and total new loans in 2010 are likely to exceed the RMB 7.5 trillion target set by the central bank. This follows a record of new loans at RMB 9.6 trillion in 2009. Although PBOC hiked the base deposit rate by around 25 basis points three weeks ago, today’s CPI data made the real interest rates even more negative. Wherever possible, money is chasing goods and assets madly. Prices of sugar, cotton, beans, apple and garlic are skyrocketing one after the other.

The Fed’s QE II (second phase of quantitative easing) may further complicate China’s inflation picture. To be fair, given the current condition of the US economy, there is nothing wrong with the Fed supplying a lot of money. In fact, quantitative easing has already had some positive impact on the US economy, by allowing for financial intermediation and pushing long-term bond yields. But it has produced two problems for the rest of the world. The first is that unfortunately the greenback that the Fed is printing is a global reserve currency. And the second is that, with a sluggish economy, close-to-zero interest rates, and expected depreciation, the US dollar is the best currency for carry-trade. So ironically, by adding massive liquidity to the global economy, the US may produce an asset bubble outside its borders. It is most likely that such a bubble would occur in the area of global commodities and/or affect emerging market economies.

There is nothing China can do to change the Fed’s decision. But China should try its very best to avoid becoming the victim of loose US monetary policy. My own reading from the latest policy changes is that the authorities have probably concluded that preventing the creation of a new bubble in China is of utmost importance. Since the beginning of the year, the government has already implemented two rounds of tightening policies for the housing market.

But the key policy changes have, and will continue to, take place in monetary policy, in the forms of currency appreciation, rate hikes and temporary capital account controls. The need for currency appreciation is well understood by now, although resistance remains strong. A stronger currency is necessary to avert a currency war and to rebalance the Chinese economy (internally and externally).

PBOC introduced the first rate hike on October 19. This was an important departure from its previous position of holding the interest rate unchanged when the currency is under pressure to appreciate. This previous position was motivated by a fear of attracting more hot money inflows. But this rate hike is critical in order to combat inflation and prevent asset bubbles. It is true that higher interest rate might attract capital inflows. But caps on asset prices, and other measures discussed below, should actually discourage hot money flows.

Finally, it is possible that the authorities may also adopt some temporary measures to control short-term capital flows. Such measures may fall into two areas; cracking down on hot money inflows (through current account channels) and restricting short-term capital flows (by imposing a reserve requirement or a Tobin tax). Some measures may be necessary in order to provide a stable market environment for gradual exchange rate adjustment and to deal with likely spillovers from the Fed’s QE II.

These restrictions are likely to be temporary since the government is determined to accelerate capital account liberalization over time.

Yiping Huang is professor of economics at the China Center for Economic Research at Peking University and in the Crawford School of Economics and Government in the ANU.

1. US-China economic imbalance: Alternatives to appreciating the Chinese yuan
2. The turning period in Chinese development
3. China needs to adjust its monetary policy now

The East Asian countries responded with coherence and vigour to the weaknesses in their financial systems revealed by the crisis in 1997-98. This raises two issues. First, how important does that earlier agenda remain? Second, is it is reasonable to expect comparable alignment among the Asian members of the G20, particularly on the inter- related issues of global imbalances and the reform of the international monetary system?

Among the ASEAN+3 group of countries (the ASEAN 10, Japan, Korea and China), there is a well-established narrative on the 1997-98 financial crisis. The crisis had its roots in an excessive reliance on short-term foreign debt, stimulated by fixed exchange rates and inconsistent monetary policies, intermediated through fragile and poorly supervised banks.  By contrast, fiscal policies were not to be blamed. There was also extreme anger at the high-handed treatment countries received from the International Monetary Fund.

Based on this assessment, the regional policy response was two-fold. One pillar was the Asian bond market initiative (ABMI), designed to deepen local currency bond markets in the major emerging markets of the region, so as to provide an alternative to bank financing. The second was the Chiang Mai Initiative (CMI). While this originally consisted of bilateral swap lines among regional central banks, it has now been expanded in scale and has also been multilateralised to provide a regional source of liquidity to complement support from the IMF.

The third element of the region’s response was the massive resort to ‘self-insurance’ through the accumulation of foreign exchange reserves in a number of countries. This has triggered fierce controversy, particularly between China and the US, on the role of this Asian ‘savings glut’ as an underlying driver of loose monetary conditions.

So what should be done now? And is it likely that the other Asian members of the G20 (India, Indonesia and Australia) will feel able to make common cause with Japan, Korea and China for a distinctive Asian view on international monetary and financial reform?

All G20 countries clearly desire a monetary order that supports orderly, non-inflationary  global growth. however, of the six Asian members of the G20, only China and Japan seem likely to have chronic saving surpluses into the indefinite future. The remaining four will have an interest in a global monetary order which remains conducive to vibrant flows of cross-border capital.

China has been most aggressive in condemning  the post-Bretton Woods reserves ‘system’ (or non-system) as providing the United States an unacceptable ‘exorbitant privilege’ as reflected in the scale of its current account deficits.

While there can be legitimate criticism of the conduct of US monetary and fiscal policies over the last two decades, these have relatively little to do with the role of the US as the supplier of reserves. Indeed, one could just as well argue that China has enjoyed an equivalent privilege in its ability to become the workshop of the world while maintaining a depreciated real exchange rate. It seems to me unlikely therefore that Chinese efforts to replace the dollar will, by themselves enjoy much support.

As pointed out by Barry Eichengreen, any displacement of the dollar is likely to be a market-driven response, based on global perceptions of the quality of economic management in the US. There is also a logical fallacy at the heart of the Chinese critique. Supplying the world with dollar reserves does not oblige the US to run a deficit on its current account, merely a deficit on its basic balance.

The recent resort by Japan to currency intervention suggests that even the advanced countries are beginning to feel the burden of major swings in nominal exchange rates. Yet it is difficult to believe that the genie of mobile capital will easily be put back in the bottle. One should not forget that, for all its imperfections, it is under the post-Bretton Woods non-system that Asia has prospered.

It is unlikely that there will be a common ‘Asian’ view on international monetary reform at the G20. China apart, most of the other members remain at ease with a US anchored monetary system, with the comfort of alternatives, initially the euro, and in due course the renminbi. What is desirable is to strengthen the safety net available to emerging markets so they feel less need to accumulate reserves. This initiative, being pushed by Korea, probably represents the limits of what is feasible, and perhaps even what is desirable. And as for the earlier Asia-specific reform agenda, it is no longer where the action is likely to be.

Suman Bery is director-general, National Council of Applied Economic Research, and member of the Prime Minister’s Economic Advisory Council.

This is an article from the most recent edition of the East Asia Forum Quarterly: ‘Asia and the G20’.

1. India and global monetary disorder
2. China’s monetary and exchange rate policy and the global economy
3. Reshaping global economic governance and the role of Asia in the G20