As developed countries struggle to recover after the global recession and try to confront the looming sovereign debt crisis in Europe, big emerging markets are now driving global growth.

Given the slow down in developed countries, emerging economies are trying to boost domestic demand to sustain growth — and this is particularly the case in China. But in recent months these developing economies have started to feel the pressure from the slowdown in the West, leading the G20 to put global growth high on its agenda.

Emerging economies have managed to keep up their growth rates and exports, and have thus experienced a trade surplus, while developed countries are facing huge trade deficits and have come to favour protectionism. The importance of recovering growth and jobs in the US, for example, and efforts to sustain export-led growth in China are now creating trade and currency friction between these two countries. For several decades there has also been a consistent increase in the trade deficit between the two — in favour of China — and this imbalance reached over US$200 billion per annum in 2010. The US kept quiet over this for a long time, as the trade deficit helped contain inflation due to cheap imports from China, and the unemployment level was still manageable. But as soon as the US realised this trade friction with China was affecting employment and there was no level playing field for its domestic industries, the Americans resorted to protectionism.

A major allegation against China is that its exchange rate is fixed and is not allowed to appreciate — all in the name of stability. As a result, China’s currency is undervalued, making its exports particularly competitive in the international market. The US has adopted several measures to counter the growth of Chinese exports and boost its own domestic economy. First, it has upped the number of anti-dumping cases against China. And second, the US government passed legislation to punish Chinese exports, as it believes that China is heavily subsidising its export items to the US. There have also been instances of tariff hikes on several import items from China.

The currency friction between China and other developed and developing economies is a matter of concern for the G20. China and the US are not only the world’s biggest economies, but they are highly dependent on each other for their growth — and of course the rest of the world also depends on them. China has nearly US$1.5 trillion worth of dollar-denominated assets, and it will be problematic for the US if China stops buying US government bonds. The US is equally dependent on China for its exports of primary commodities such as meat and fruit, and many US companies are based in China in the hope that domestic demand will rise and they will make profits. But Chinese domestic demand is still largely suppressed, meaning the US is not able to obtain sufficient market access. Meanwhile, China depends largely on the US market to sell its labour-intensive manufactured items. Nearly five per cent of China’s GDP comes from exports to the US. So, the trade friction continues.

The world’s two largest economies must work together toward solving this trade friction and to help avoid a currency war. China must allow its currency to be market determined, while the US must do away with its harsh protectionist measures.

India is an active member of the G20 and works alongside China and other developing countries on major international issues, including the restructuring of global financial architecture, and achieving progress on climate change and the Millennium Development Goals. India is aware the trade and currency friction between the US and China will not only hurt the G20’s agenda and the world economy, but will also affect its own future growth prospects. The US and China are India’s major trading partners, and any slowdown in these two countries would affect India as well. So Delhi has been opposing any protectionist measures adopted by developed countries, and pushing for market reforms by phasing out wasteful and distorting subsidies in countries like China.

India also understands the impact of China’s undervalued currency on its exports and expects China to understand the fair principles of trade. India believes there are bigger and more pressing problems that need the attention of the G20. Its member countries need to focus on solving the European debt crisis, help countries resolve trade and currency friction and give fresh impetus to the Doha Round. Against this backdrop, India needs to play a proactive role in the G20 to make it an effective body for dealing with these issues.

Dr Geethanjali Nataraj is a Fellow at the National Council of Applied Economic Research, India.

1. India losing ground to China on trade with Bangladesh
2. The India-China Strategic Economic Dialogue
3. India, China and Asian economic integration

The slow resolution of the European debt crisis has evolved into a liquidity problem which threatens the global financial system.

And these long-drawn-out efforts to address the sovereign debt problems have heightened uncertainties about resolving the crisis and induced speculative activities, threatening the survival of many European banks. In an effort to contain financial disaster, central banks of the world’s major economies have taken a concerted emergency action to provide cheaper dollar funding to these troubled banks at the end of November 2011. Further, the President of the European Central Bank (ECB) recently pledged readiness to act more aggressively in averting a deeper financial crisis.

This serious threat of financial crisis is not new to the global economy. Triggered by different factors, the world has observed two similar crises within the last decade; the burst of the dotcom bubble in the early 2000s and the beginning phase of the global financial crisis through 2007 and 2008, which culminated in the bankruptcy of Lehman Brothers and the freezing up of global finance. In both cases, aggressive policy easing took place in the leading industrial economies, sending real interest rates to a very low level.

The current situation inEurope may still lead to a global economic slowdown if the debt problems are not resolved, propelling the global financial system into another deep crisis comparable to that of 2008. The policy reaction this time should not be much different from 2008. At the very least, the ECB and central banks should relieve pressure on banks and the financial sector by cutting interest rates further to ensure that affordable liquidity is available for the financial sector. As observed in both the burst of the dotcom bubble and the global financial crisis, such action would result in a low international interest rate environment.

Given the integrated global financial system, any such shock would have implications for small, open economies elsewhere. For emerging ASEAN economies (Indonesia, Malaysia, the Philippines and Thailand), the two episodes of internationally originated financial shocks in the past decade seem to have insignificant effects unless coupled with a global recession that pushed their domestic output down at the same time. To better understand the effects of adverse international financial shocks, however, it is useful to isolate these shocks and analyse their impact on the macroeconomic performance of these economies. This type of structural analysis typically suggests the shock’s effects on inflation and output tend to be largely similar and relatively small. An isolated negative shock in international interest rates would tip the ASEAN economies toward an environment with lower inflation and higher output volatility, albeit generally small in magnitude.

Although small, the impacts of purely international financial shocks on ASEAN economies tend to be long lasting, with implications for the management of future macroeconomic stability. It seems the larger the size of the international financial shock, the greater the consequences of maintaining future economic stability for ASEAN countries.

How should emerging ASEAN economies react to an isolated adverse international financial shock? Typically, to counter a drop in the international interest rates, a country may reduce its domestic interest rate. This discretionary policy action may counter the short-run inflation effects from the international financial shock, but would aggravate the short-run impact on the country’s output gap at the same time. Consequently, the country would end up facing greater volatility in its domestic output. In this way, the cure may worsen the illness. Discretionary monetary policy action may only be sensible when the global financial shock is accompanied by a global recession that also reduces domestic output at the same time. In this case, the cure will have the desired short-run impact of limiting the global shock’s effect on both domestic inflation and output.

Yet, confronted with the external shock’s long-lasting effects, the short-lived domestic interest rate shock will only work for containing short-run volatility implications and will leave domestic policy makers with a hanging problem of managing volatility in the medium to longer term. In this regard, efforts to manage the domestic economic implications of a single, large shock in the international financial system would entail not just a simple short-run policy response in emerging ASEAN countries, but more complicated adjustments to their overall economic structure.

To deal with the effect of an adverse international financial shock, individual authorities in emerging ASEAN economies should opt for policies which provide longer-term structural adjustment to their economy. To this end, emerging ASEAN authorities should support the current efforts to restructure the global financial system in order to reduce future risks of more volatility. In addition, the similar pattern of effects on emerging ASEAN countries highlights the need for enhanced policy coordination and cooperation among these countries to better deal with such disturbances.

Arief Ramayandi is an Economist at the Asian Development Bank. The views are solely of the author’s and do not necessarily reflect the views or policies of the Asian Development Bank.

1. ASEAN economies on the slide?
2. An Asian perspective on financial crises
3. An Asian response to international financial reforms

A falling currency may be normal and acceptable when the economy is slowing, but the rupee’s apparent free fall over the last few months — more than 15 per cent since August — is a serious blow to the Indian economy.

Though a depreciating rupee is not surprising given India’s international investment position, with its higher rate of liabilities than assets, such a sudden fall is worrisome.

There has been no spectacular or abrupt change in the Indian economy’s macro fundamentals over the last couple of months that could have possibly triggered the rupee’s fall, making it Asia’s worst performing currency. But there are multiple factors, both domestic and international, which are responsible for the current scenario. ‘Policy paralysis’; tight monetary policy; high inflation; and a gradual, overall weakening of macro fundamentals have slowed India’s growth. The rupee’s rapid fall reflects investors’ lack of confidence in the Indian economy, which is expected to grow at around 7 per cent this year, lower than the previous target of 8.5 per cent.

Slowing growth can also be attributed to the looming European debt crisis, as most of the European banks and financial institutions have significant exposure in developing countries. The outflow of capital (as investors pull out of India) and slow capital inflows over the last few months have both contributed to the problem.

Though the Reserve Bank of India (RBI) could intervene in the market to reduce volatility and mitigate panic, it is yet to take any action — and for the time being is leaving the markets to determine the rupee’s value. The finance minister’s view is that intervening in the foreign exchange market may not work given the global uncertainty caused by the European crisis and the withdrawal of funds from India by foreign institutional investors. But the central bank’s governor has hinted that market intervention may be used if necessary. Perhaps the RBI should have intervened last year when the rupee was appreciating, instead of leaving it entirely to the market.

Traditionally, depreciation is good for exports and bad for imports, a situation which generally improves a country’s trade balance — but under the current circumstances, this will not occur. Being a net importer, India’s currency depreciation increases the price of inputs, which in turn affects the manufacturing sector. The increased cost of inputs such as petroleum products, steel and rubber adds to the cost of production. In some industries such as automobiles, electronics and computer hardware, the increased costs will be passed onto consumers, contributing to further price increases. More importantly, the rising costs of production reduce profit margins and overall investment activity. The favourable impact on exports is modest, and confined to only a few sectors, as consumer demand is slowing in the US and Europe.

The present scenario does not bode well for India’s external sector and fiscal deficits. Given the price increases on imports, and the extremely limited benefits this will bring to exports, the trade deficit is likely to go up. In addition, the drop in capital inflows is likely to increase the current account deficit. The prospect of a higher current account deficit, and higher budget deficit due to increases in subsidies and slowing growth, will make investors in general — and foreign investors in particular — more sceptical about the Indian economy. There are already whispers in policy circles and among academics about the difficulty of achieving the fiscal deficit target of 4.6 per cent of GDP, and that the target for the current fiscal year is likely to be more than 5.5 per cent.

Overall, it looks like India’s growth story has been derailed, at least for the short term. The government is doing the right thing by speeding up pending reforms — such as FDI in retail and approving infrastructure projects — in order to signal confidence to foreign investors and thereby increase capital inflows. The government needs to fast-track reforms in banking, insurance and FDI to give the impression that India is still a safe haven for investors, with the second-highest growth rate in the world. This would ease pressure on the rupee, which would gradually stabilise.

Yet the government recently withdrew its recent politically sensitive decision to allow FDI in multi-brand retail after the announcement precipitated a great deal of animosity from right-wing opposition parties including the Bharatiya Janata Party (BJP), the left-wing Communist Party and other alliance partners of the Government. The Government succumbed to the pressure and announced that it would put FDI in retail on hold in the first week of December. Nobody is certain how long this suspensionwill last but it is clear that the matter has been postponed at least until the five state elections due in 2012 are over. The decision has created  uncertainty in the minds of investors and the negative results are already being seen in Indian stock markets. This will  put further pressure on the rupee. Though the benefits of FDI in retail are debatable, a complete rollback of this policy will send the wrong signal to investors regarding the government’s dedication to carrying out serious policy reforms. This backflip on FDI policy in regard to multi-brand retail FDI makes it unlikely that  any further decision on FDI in insurance and the banking sector, among others, will be forthcoming.  

The government should create incentives for non-resident Indians to remit money and invest in India, and for corporations to raise dollars through external commercial borrowings. Remittances have been somewhere around US$25–30 billion (around 3 per cent of GDP) per annum over the last few years — a significant amount, which helps with India’s balance-of-payments problems, and with its performance in the foreign exchange market.

Pravakar Sahoo is Associate Professor at the Institute of Economic Growth, Delhi. Views are personal.

1. Is the Indian rupee overvalued?
2. How to manage a float of the Indian rupee
3. Slowing down the Indian economy through restrictive policies

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 global financial crisis and second round of quantitative easing served to highlight the international financial system’s dependence on the US dollar, a currency subject to national management.

Against this backdrop, a number of recent policy initiatives suggest the Chinese authorities have adopted a proactive strategy to promote the international use of the renminbi — referring to the use of a currency by non-residents to invoice trade, make payments and denominate assets and liabilities.

Why has policy turned to promote the international use of this currency? One interpretation, pursued here, is that internationalising the renminbi is a strategy to share the specific risk imbedded in China’s international balance sheet — namely, a large and rapidly increasing foreign exchange exposure. This exposure derives from the combination of China’s openness to direct investment from the rest of the world, its current account surpluses and the renminbi’s lack of internationalisation.

Like many advanced economies, China has a short position in its own currency and a long position in other currencies. But because of large direct investment in China and a substantial net foreign assets position, China’s net long position in foreign currencies is particularly large. The medium-term strategy of denominating some of China’s external claims in renminbi would help normalise this skewed position. This would effectively amount to ‘renminbising’ China’s international assets.

Internationalisation happens when non-residents of China use the renminbi to lend or to borrow. The renminbisation of China’s foreign claims requires that non-residents borrow in renminbi from residents. The subsequent sharing of the foreign exchange risk currently imbedded in China’s international balance sheet is a key motive for the broader process of internationalising the renminbi.

Conceivably, over the medium term, something like one-third of China’s non-reserve holdings of securities might come to be RMB-denominated. In this scenario, China’s sovereign wealth fund, pension funds and insurance companies could, to a significant extent, diversify away from Chinese credit risk, by buying RMB-denominated securities issued by non-Chinese firms, banks and sovereigns, without taking on foreign currency risk.

In addition to the private holding of bonds issued by non-residents in domestic currency, China could lessen its aggregate exchange-rate risk by denominating more of its official external claims in renminbi.

But while denominating and settling trade in domestic currency might encourage greater international use of the renminbi over the medium term, it is unlikely to directly spread China’s foreign exchange risk to the rest of the world in any significant way. Taking Japan as an example, 36.7 per cent of Japanese exports were yen-denominated in 2002, compared with 25.5 per cent on the import side. For China to accumulate substantial net trade claims on the rest of the world, an even larger asymmetry between exports and imports would be required, and this is not likely.

Yet the invoicing of trade in renminbi could still play a supporting role by encouraging the rest of the world to issue bonds and take on RMB-denominated official debt. This would encourage a global sharing of the foreign exchange risk in China’s international balance sheet.

In an apparent departure from its previous hesitancy and go-slow stance, the Chinese government has, since late 2008, proactively rolled out a number of measures aimed at increasing the international use of the renminbi. For example, the People’s Bank of China (PBOC) has signed bilateral renminbi currency-swap agreements with eight central banks, totalling more than RMB800 billion (US$126 billion). Such agreements permit swaps between the renminbi and the counterparty’s local currency for a maturity of up to three years, which is extendable. The PBC reports that, so far, RMB30 billion (US$5 billion) of these RMB800 billion swap agreements have been activated.

For these initiatives to build momentum, borrowers in the rest of the world will have to be convinced that borrowing in renminbi is not subject to a risk of rapid appreciation against other currencies. If the renminbi is perceived to be severely undervalued and subject to a prospective sharp appreciation, firms or sovereigns outside China would be unwilling to hold RMB-denominated liabilities.

There are both academic and policy studies that suggest the renminbi is substantially undervalued. Indeed, the 2010 IMF Article IV Consultation Staff Report posits that the renminbi ‘remains substantially below the level that is consistent with medium-term fundamentals’ (emphasis added). But the Chinese authorities offered alternative interpretations of the evidence that the report used to draw the undervaluation assessment. The report’s assessment was also not agreed to by several of the IMF Executive Board’s directors.

In considering the likelihood of rapid appreciation, it is crucial to remember that, in the economic arena, the Chinese authorities are perceived to follow a gradualist approach and to focus on economic stability. A massive renminbi revaluation poses the risk of serious disruption to China’s domestic economy and its extensive production and trade networks with other Asian economies. If the recent experience of gradualism is given weight, the prospect of a substantial revaluation of the renminbi becomes less likely, and should not impede the currency’s internationalisation.

Full internationalisation will ultimately require a thoroughly open capital account. The steps that China is taking should thus be seen as permitting internationalisation to begin within capital controls and, so far, this is mostly occurring in the offshore RMB-denominated market based in Hong Kong. Lifting the remaining capital controls to allow the renminbi’s full internationalisation remains a policy for another day.

Yin-Wong Cheung is Professor of Economics at the University of California, Santa Cruz. Guonan Ma is Senior Economist at the Representative Office for Asia and the Pacific, the Bank for International Settlements. Robert N. McCauley is Senior Adviser to the head of the Monetary and Economic Department, the Bank for International Settlements, Switzerland. Their research was presented at China Update 2011. The annual China Update conference is hosted by the China Economy Program, in collaboration with the East Asia Forum, at the ANU in July. This article is a digest of Cheung, Ma and McCauley’s chapter, ‘Why Does China Attempt to Internationalise the Renminbi?’ in Jane Golley and Ligang Song (eds), Rising China: Global Challenges and Opportunities (ANU E Press, 2011), available in pdf here. This book is the latest publication in the China Update Book Series, launched at the China Update conference every year. The views expressed here are those of the authors and do not necessarily reflect those of the BIS.

1. China moves slowly to internationalise the renminbi
2. On China’s renminbi becoming a world currency
3. What China is after financially

The G20 Summit in Cannes probably made its most important contribution to global financial stability and economic growth before it even commenced.

The summit, held 3–4 November, became a deadline for European leaders to deal decisively with the economic and financial crises in the euro zone.

Europe is experiencing at least four deep, structural, overlapping and mutually reinforcing crises: a crisis of institutional design; a fiscal crisis; a crisis of competitiveness and a banking crisis. None of the four crises can be solved in isolation, and there does not currently seem to be any single comprehensive solution that will end the crisis promptly.

At the Cannes summit, euro zone leaders agreed on a new set of measures to try and tackle these problems. Though inadequate in scope to bring the crisis to an end and calm financial-market volatility, these measures will help prevent further economic deterioration in Europe. Consequently, the risk of catastrophic spillovers from Europe to the rest of the G20 was reduced.

Ahead of the G20 Summit, euro zone leaders agreed on three principal strategies to contain the crisis: reduction of Greece’s debt; a bank recapitalisation target and new options to leverage the European Financial Stability Facility (EFSF).

First, the planned debt reduction takes the form of a voluntary bond swap with private holders of Greek government debt, resulting in a 50 per cent reduction in the nominal value of their debt. While urgently needed, this will not independently restore Greek fiscal solvency, and additional financial support for the country will be needed. As future support will undoubtedly involve the IMF, G20 members will also have the opportunity to discuss potential approaches to restoring Greece’s fiscal solvency. This voluntary debt swap is unlikely to trigger sovereign default swaps, and it removes a potential short-term source of dislocation in the financial markets. But the lack of payout after a 50 per cent reduction in debt may ultimately lead to the demise of sovereign credit default swaps — at least for industrialised nations — which may lead to increased financial-market volatility.

Second, euro zone leaders agreed to raise capital requirements in banks to 9 per cent Tier 1 equity, and adjust for the effects of market prices of sovereign debt. Although superficially helpful, the imposition of a capital ratio target runs the risk that banks will shrink their lending to businesses (due to denominator effects), rather than raising new capital. Regulators must be vigilant to avoid aggravating a building credit crunch.

Third, two options were agreed on to boost the financial firepower of the EFSF. Both are almost certain to fail. Option one, providing credit enhancement to new state-issued debt, is meaningless; the significant overlap between the insurer and the insured in the euro zone means any stability the measure achieves will be minimal. Option two foresees attracting investments from private and public financial institutions and investors. But few, if any, such investors exist — and possess the willingness and ability to make a material difference for European financial stability.

Fortunately, this does not matter, as both options are a smokescreen to provide cover for the European Central Bank (ECB) to remain directly involved in stabilisation measures. This is critical, as ultimately it is only the ECB, as a central bank with the ability to create new money, that commands the financial resources to stabilise Europe. By creating a distraction in the form of a ‘leveraged EFSF’, the ECB can continue intervening directly in the European debt markets to avoid a catastrophic rise of Italian and Spanish interest. Ironically, by supporting this ruse, G20 leaders will reduce the need to offer money themselves by helping the ECB keep the spread between, on the one hand, Italian and Spanish interest rates, and on the other hand German interest rates.

Usually, international gatherings like the G20 Summit in London in April 2009 deal with large crises by restoring confidence through the credible commitment of large sums of government money. Europe cannot do this. As was evident ahead of Cannes, Europe and the ECB rely on the economic pressure exerted by financial markets to push reform-reluctant leaders into ‘doing the right thing’.

Indeed, were the ECB to publicly declare its intention to act as a ‘lender of last resort’ for Europe, or the G20 to cobble together €2 trillion for the EFSF, the financial market pressure on such leaders to implement reforms would abate. Paradoxically, with Europe’s fundamental economic problems requiring years of tough reforms, Europe can only ultimately solve its economic crisis by prolonging it.

This logic will easily trump anything in the G20 Communiqué calling for enhanced global financial stability and strong balanced global growth. Instead, we can expect high levels of uncertainty and volatility.

Jacob Kirkegaard is a Research Fellow at the Peterson Institute for International Economics, and a Senior Associate at the Rhodium Group.

1. European debt crisis: European fragmentation?
2. China into the European breach, but not just yet
3. The Greek tragedy: Global debt crisis and balance sheets

There is a great deal of speculation around the rise of China’s economy and the eventual changes this will supposedly bring to the international monetary system.

The potential for such change undoubtedly exists as the Chinese economy continues to grow and catches up with more-developed countries. But is growth and size enough to effect fundamental change in the current global financial landscape?

When looking at the renminbi’s future role in the international financial system, analysts must take into consideration the reasoning of institutional investors when deciding where to hold liquid balances. Like China, such investors look for safety, liquidity and the preservation of the balance’s value. But can they find these characteristics in RMB-denominated markets — offshore or onshore? Currently, it would seem not. Onshore RMB deposits are simply not accessible due to China’s currency control regime. Offshore RMB deposits in Hong Kong and elsewhere are available, and have even given rise to a great deal of excitement among academics and bankers. But the reality of the situation is not favourable to investors looking to park institutional funds in such deposits. The return is minimal and purely dependent on expectations of a sufficient appreciation of the renminbi relative to the US dollar.

Those responsible for an international institution’s financial management are unlikely to risk their career by investing other people’s money in an asset class that is solely dependent on Chinese politics. But if the renminbi were to become freely convertible, how would it stack up against the US dollar and other currencies?

Trade volume is an important determinant for private transactors keeping a ‘working’ balance for convenient settlement in a particular currency. Given China’s significant role in international trade, its currency would be attractive for keeping balances, but investors would also incur unexpected receipts and disbursement requests. This is why everybody holds positive balance sheets, despite such balances often yielding very little and having to be funded through the capital resources of the institution concerned.

So, for a currency to be attractive, there needs to be safe and efficient opportunities to borrow or invest funds for short periods in order to minimise idle balances at the end of the business day. Currency systems compete in terms of an efficient money market — with many players and instruments — subject to reasonable and prudential supervision. But China is still a long way from offering facilities that can compete with the US financial markets.

Moreover, there are four other fundamental issues concerning the relative competitiveness of a fully convertible renminbi against current alternatives. First, the renminbi’s business day ends long before the other financial systems. Operating in the US, it is only possible to adjust renminbi balances with a one-day delay, thus severely limiting the ease with which it may be used as an international currency.

Second, investors may be reluctant to keep their working balances in a jurisdiction where property rights have not been held in high esteem for centuries.

Third, when it comes to central banks’ international reserve assets and private asset managers’ long-term investments, the considerations that govern the management of working balances abroad are more relaxed. Liberalised Chinese financial markets, overseen by a decent legal system and rules of corporate governance, may well attract a portion of the world’s savings. But that differs greatly from being an international reserve asset comparable with — or superior to — the US dollar. In any case, it is those who find a currency and its financial markets sufficiently attractive to entrust their savings that decide which currencies occupy such a role.

It seems the world, including China, is stuck with the US dollar. In this respect, the so-called US ‘balance of payments deficit’ is a chimera: nobody knows exactly how much is due to excess US consumption, and how much is due to official and private investors finding US financial markets the best place to store a significant part of their ever-growing savings. Interest rates on US bonds do not support the argument that investors are particularly concerned with the risks of a US default.

And finally, investment in ‘real’ assets is simply not the answer. Buying productive assets also requires expertise in their management across different foreign environments. Chinese executives are very competent at managing productive assets in their own unique environment, and many foreign investors in China underestimate Chinese business acumen to their detriment. But whether those skills will work outside China is less clear.

The solution to this issue must be found in a drastic change in China’s political economy; China must stop subsidising US consumption and do something for the average Chinese citizen, whose living standards are still significantly lower than elsewhere in Asia. Such a policy change would be highly beneficial for the Chinese — but less so for the US.

Gunter Dufey is an Emeritus Professor at the University of Michigan, Ann Arbor. He is currently teaching at Nanyang Business School, Nanyang Technological University.

1. Renminbi internationalisation and the international monetary system: a match made in heaven
2. China moves slowly to internationalise the renminbi
3. Indo-American defence ties: a reality check

On 2 November, on the sidelines of the G20 leaders meeting in Cannes, Zhang Tao, director general of the international department of the People’s Bank of China (PBoC), averred that China’s foreign exchange management strategy was based on ‘the principle of safety, liquidity and adding value’.

Given the US$271 billion in reserve losses presumed to have accrued during the 2003-2010 period as a result of the US dollar’s depreciation, this notion of ‘safety’ appears to be a rather elastic one. With the euro zone in deep distress, and with the euro along with the dollar comprising 90 per cent of globally allocated foreign exchange reserves, clearly there is only so much safety to be had. With the recent recourse to unconventional monetary policies in key developed country markets heaping an added dimension of complex cross-border spillover effects, PBoC’s reserve managers appear to be trapped between a rock and a hard place.

Extricating themselves from this reserve management predicament has been the driver of China’s currency internationalisation strategy. In time, as graduated steps towards internationalisation serve as veritable stepping stones to cross the perilous river of global financial integration, a fully convertible yuan, it is hoped, will assume its appointed role as one of the select few reserve currencies within the international monetary system. More long march than the quick sprint that some observers have recently posited, notably Arvind Subramanian and, more cautiously, Barry Eichengreen, the endgame is neither destined nor assured; it is a journey begun. For reasons that impinge reciprocally on the interests of Beijing and the larger international monetary system, its swift success though is deeply desirable.

At the heart of the recent dislocation in the chain of global financial intermediation is the paucity of safe, short-term and liquid instruments — be it government guaranteed or privately guaranteed — that can serve as attractive reserve assets globally. Driven by frantic considerations of safety, the secular rise of vast and footloose institutional cash pools (that is, centrally managed, short term cash balances of institutional investors and global non-financial companies) that reside outside the government-insured banking system, has made the global financial system increasingly run-prone. In time, as China graduates from net consumer to net issuer of such risk-free assets, commensurate with its heft in the global economic, trading and financial system, its ability to fill the breach in supply of such assets will lend stability to the international monetary order. Full convertibility, such that PBoC can — in the extreme — serve as a ‘market maker of last resort’ for such instruments, is a prerequisite. Along the path to convertibility, as PBoC allows its external surpluses to gradually feed into the domestic price level, a more consumption-driven domestic economy as well as a more internationally balanced monetary system is expected to emerge. Reserve management anxieties too will be consigned to the past.

At the time of the demise of the Bretton Woods gold-dollar standard, it was imagined a world of floating yet managed exchange rates operating alongside a world of convertible yet malleable capital flows would establish a ‘golden mean’, dynamically eradicating the balance of payment deficits that the United States had perforce needed to run to furnish liquidity to the global economy. The reality has proven otherwise. Capital flows have been anything but pliable, their tsunami-like effect exacting terrible punishment on exposed banking, capital and other asset markets in developing and developed countries alike over the past three decades. Terrified, meanwhile, of ceding exchange rate stability or domestic monetary policy independence, PBoC and its BRICS compatriots have largely opted to impose varyingly stringent capital control restrictions — even as they have collectively accumulated trade surpluses and/or a war-chest worth of reserve holdings. Correspondingly — and an irony that the original critic of the Bretton Woods system, Robert Triffin, would have instantly recognised — the primary issuer of the benchmark risk-free asset (the US) continues to run a persistent balance of payments deficit to furnish liquidity to the system, yet at the same time strives to preserve confidence in its currency as a store of value … a confidence eroded daily by its persistent and large external deficits.

Far from establishing a new ‘golden mean’, the current international monetary system appears to suffer from the worst of both worlds — a de facto anchor currency of increasingly uncertain worth and an adjustment mechanism that is frustrated in its means to redress imbalances within.

Going forward, an international monetary order characterised by a paucity of global reserve assets and overly dependent on an insufficiently credible dollar as its sole monetary tether will stand little chance of surviving in a world of unconstrained capital flows. Equally, a future global multicurrency order characterised by hybrid exchange rate regimes and free capital mobility, yet backed by only a weak and fragmented governance structure, will repeatedly be trumped by narrow and domestically generated protectionist compulsions. Building flexibility and capacity within the international monetary system’s regulatory mechanism to accommodate — and accelerate — the financial liberalisation trajectories of its rising stakeholders, most notably China, hence is the foremost medium-term priority of the day. In this regard, novel ideas that facilitate the acceptance and use of emerging market currency-denominated instruments as reserve assets — such as the issuance of emerging market GDP-linked bonds, other forms of pooling and securitisation of emerging market debt into composite assets, as well as a significant expansion in size and share of large, dynamic emerging market currencies within the SDR’s basket composition — each bear considering.

A comprehensive framework, further, that enables China to cope — as it liberalises its foreign exchange and financial system — with the unpredictable herding behaviour of cross-border capital flows, merits examining with an open mind too. A network of permanent currency swap lines, provision of liquidity risk insurance based on simple ex ante conditionality and orderly insolvency processes that on balance privatise the allocation of risk to the vendors of cross-border capital, are but a few examples of the elements that such a comprehensive framework could contain. Full currency convertibility, correspondingly, to avoid frustrating the monetary system’s essential adjustment mechanisms, is the reciprocal imperative for PBoC — currency internationalisation being a necessary but insufficient end. Embedding China’s capital account liberalisation program within this proposed broader institutional framework of inter-governmental liquidity and solvency risk management, rather than the current effort to erase global imbalances via a peer pressure-driven Mutual Assessment Process, ought to be high on the agenda of future G20 summits.

Sourabh Gupta is a Senior Research Associate at Samuels International Associates, Inc. in Washington DC.

1. China’s role in international currency arrangements – Weekly editorial
2. The renminbi’s internationalisation: a reality check
3. On China’s renminbi becoming a world currency

The way ahead in the European debt crisis appears to lie in refinancing the debt held by those countries whose sovereign bond spreads are widening and who are at risk of default: but who will pay?

There is some move to have the private sector contribute — with a new financial transactions tax being debated and writing down the value of government debt  — and while the Germans are resisting, they will more than likely pay most of the cost. Germany, in particular, gained a great deal from the current euro zone arrangement, as its exports benefitted from a lower currency than might otherwise be expected. Now, if they want to sustain the structure as it is, it will cost them.

Refinancing comes with the expectation that recipient economies will also cut spending, which will subsequently build confidence about their ability to repay these debts in the longer term, and potentially reduce the moral hazard problem. But some have argued that this could well be a ‘death trap’. Spending cuts across Europe mean no strong external demand to help countries adjust while US growth also falters.

Another response would be to introduce reforms aimed at raising productivity and evening out competitiveness, as there are surprisingly high divergences among European economies in the quality of economic regulation. Labour market regulation in Portugal, for example, lowers productivity growth. Certain rules, such as those on layoffs and the provision of other services to workers, kick in at specific firm sizes, leading to a larger number of smaller and less productive firms, something which is also highly topical in Australia. Others have talked about how Italy needs a ‘change of regime’.

Though not much discussed by those focusing on the way ahead, micro reform would be a real way out of the crisis: a credible set of commitments might be valued by lenders. But in the current context, this may not work fast enough either. There are other suggestions for a response. The EU President, for example, is now calling for ‘economic union’, or an institutional set-up which would support tighter coordination of fiscal policy and presumably regulatory reform.

Greater fiscal discipline and micro reform measures should already be in play, and the financial market constraints associated with the adoption of the euro were supposed to be their key driver. That was a grand expectation. In fact, the availability of finance from the rest of the world (including East Asia), and the expectation of financiers that lending to EU governments was a good bet, actually reduced the pressure to implement any of this. In any case, the large-scale political reform that would be required to put such a package together is not likely to happen quickly enough either — or if they want to wait until it does, the Germans will be refinancing other people for a long time to come!

The crisis is therefore more likely to drive fragmentation than consolidation, given the timelines and the current situation. The question then arises of who could eventually leave the euro zone. It might seem obvious that the high debtor nations would pull out and go their own way. But Michael Pettis recently pointed out that this would risk a ‘downward currency spiral’ and that Europe might well learn from the Asian financial crisis, and the Korean experience in particular. He also refers to another discussion underway, which speculates that it could be the Germans and other northern European countries who pull out to create a new currency (mark II?) and leave the devalued euro to the southerners.

But whichever outcome eventuates, it will be an interesting scenario from the Asia Pacific’s viewpoint: the potential effects of Europe turning into a constellation of clubs, even overlapping for different purposes, would not be limited to those European countries alone — though France would have an interesting choice to make in such a scenario, and this is perhaps what the English always thought should and would happen.

It is clear now that the EU should have worked harder and sooner on real reform. Europe’s leaders should not have done this in a ‘one-size-fits-all’ manner, as it has not been effective. The current crisis is an important lesson for promoters of sophisticated Asian integration and also for those worried about two-speed structures in existing federations. And the lesson is: do not lose sight of the never-ending task of structural reform, expect diversity in responses across economies and keep productivity growth going.

Professor Christopher Findlay is Executive Dean of the Faculty of the Professions at the University of Adelaide.

1. The European crisis and the G20 Summit
2. The Greek tragedy: Global debt crisis and balance sheets
3. China into the European breach, but not just yet

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