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Monday, September 22, 2003

No Plaza Accord This Time Round

Despite the fact that I find the conclusions far too optimistic, an interesting analysis of where we are in the currnecy game right now. The interesting problem is what will happen if the anticipated global expansion does not materialise as envisaged. The dollar is considered to be 20% overvalued, but the euro clearly can't take much more pounding.

Is Asia holding up global economic adjustment? With a current account deficit already more than 5 per cent of gross domestic product, rapidly increasing net external debt and a marked shift in deficit financing from stable long-term inflows to short-term "hot" money, the US economy is under unprecedented pressure. There are two ways out: either the dollar weakens, raising the competitiveness of domestically produced goods and services; or overall US demand must grow at a much slower pace than elsewhere - which in the current anaemic global economy would probably involve a protracted recession.

Most analysts conclude that a further drop of 15-20 per cent is needed to bring the US current account back to sustainable levels in the medium term. Asia, which accounts for nearly a third of US trade and has strongly undervalued currencies, should be a key part of that adjustment. However, while the euro, the pound and virtually every other non-Asian currency have strengthened against the dollar in the past 12 months, Asian central banks have been intervening to prevent currency appreciation, purchasing nearly $500bn in foreign exchange reserves since the beginning of 2001 and sterilising the resulting extra liquidity at home.

This is not sustainable. European economies are weak. There is a big risk that a stronger euro will overshoot, further weakening growth and spurring a destabilising backlash. Asia is facing pressure to adjust exchange rate polices. Japanese leaders have been leading the charge against China's de facto renminbi peg, and sluggish growth in the US has made policymakers take a hard look at China and Japan. Demand will surely grow for a new Plaza accord, aimed at convincing Asian countries to let currencies strengthen in a multilateral context.

Unfortunately, a new accord is unlikely to come about. Conditions are different from the mid-1980s Plaza accord era. First, US imbalances are no longer so visibly an Asian problem. In the first half of the 1980s the US trade deficit ballooned from 0.9-3.2 per cent of GDP, with a worsening bilateral balance with Asia accounting for more than two-thirds of that change. By contrast, in the past decade Asia accounted for 0.8 percentage points of the 3.5 per cent of GDP decline in the US trade balance. The main culprits were Europe, Canada and Mexico.

Second, the number of important Asian players has grown, making agreement more difficult to reach. Japan was the only Asian country that mattered in the 1985-87 adjustment process, accounting for more than 80 per cent of Asia's total current account surplus. Now that share has fallen to well under half. Despite its enormous surplus with the US, China's overall current surplus is only one-eighth of the total.

Third, economic conditions in Asia are much worse than in the mid-1980s. Between 1985-1987 the US, EU and Japan grew at an average annual rate of 5 per cent. Last year the major developed economies barely expanded at all, and growth may not exceed 1.5 per cent in the next two years. Asian exporters are still struggling to regain pre-2000 capacity utilisation levels while domestic investment has never been lower as a share of income.

Finally, the one country that could easily digest a stronger currency is unlikely to play ball. The Chinese economy is strong, with solid export growth, substantial net capital inflows and rapid bank credit expansion. However, Chinese policymakers are focused on the domestic agenda and are mistrustful of exchange rate volatility and a co-ordinated revaluation. They may hold to their long-term goal of a flexible exchange regime, but there will only be a small and gradual widening of renminbi trading bands - far too little to have any immediate impact on China's external balance.
Source: Jonathan Anderson, Financial Times

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