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Last weekend’s communiqué from the G-20 finance ministers is a first step to bridge the divide in the ongoing currency wars. I find both hope and disappointment in the Communiqué. It is very positive that the G-20 ministers have called for the IMF to help identify countries with policies leading to large and unsustainable imbalances. This is a step in the right direction, although no specific quantitative indicators have yet been advanced. Even better, in my opinion, is the Communiqué’s decision to shift IMF voting powers toward unrepresented developing countries, which would greatly increase the chances of resolving the currency wars.

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But I am disappointed that there is no recognition of the problem of excessively expansionary monetary policy in the United States and its destabilizing effects on emerging and developing countries. The G-20 has begun to bring the two sides of the currency wars together, but it needs to do more to address the concerns of those who identify U.S. monetary policy as the main culprit.

The Problem

The dangers of large and volatile capital flows for sustainable growth and financial stability are well known to policymakers from developing and emerging countries. After all, an important feature of the numerous currency and financial crises of the 1990s that affected East Asia, Latin America, Russia, and Turkey, among others, was a sharp and sudden reversal of large capital inflows when investors’ sentiments about the financial soundness of these countries changed.

What is different in the current episode of massive capital inflows to developing countries is that it responds to large and increasing economic imbalances in the world economy, mostly reflected in persistent and excessively large current account positions (surpluses and deficits), inadequate monetary policies and misaligned exchange rates in major economies. Global imbalances are widely recognized as being unsustainable; most recently, in last weekend’s Communiqué from the Group of 20 Finance Ministers and Central Bank Governors. It simply follows that if the imbalances are not sustainable, neither are the current large movements and direction of capital flows, at least not in the currently observed magnitudes.

Thus, policymakers from developing and emerging countries receiving large capital inflows have a legitimate reason to worry. The inflows are leading to significant appreciation of their currencies and pressures for increases in asset prices, especially in real estate, government bonds, and the local stock markets. Indeed, this year, countries such as India, Russia, Brazil, and Turkey have seen their currencies appreciate significantly, albeit with large exchange rate volatility. Other countries with significant currency appreciations include Colombia, Chile, South Africa, South Korea, and Peru. Facing deep uncertainties about how and when the global imbalances will be corrected, central bankers from developing and emerging countries are deeply concerned about the formation of asset price bubbles and the consequent destabilizing effects on their economies. A profound concern, not always sufficiently vocalized, is whether the development gains achieved by a number of countries in the last decade might be lost by a potential disorderly resolution of the global imbalances.

The Culprits

Who is to blame for the current threats to global financial stability, in general, and developing countries, in particular? As I discussed in a recent article the international debate is divided in two camps: those who blame the extremely accommodative monetary policy in developed countries (especially the United States) and those who blame China because of its continuous intervention in foreign exchange markets. This division was reflected in the discussions of G-20 finance ministers and governors last weekend, but was not reflected in the Communiqué.

The main argument of the first camp is that the attempts by the U.S. Federal Reserve to revitalize growth and employment through expansionary monetary policy are not having the desired effect of increasing domestic demand. Instead, it is leading to massive inflows of capital into emerging markets considered to be “good performers,” such as those in Asia, Latin America, and other developing regions.

Those in the second camp, which includes top U.S. officials, argue that China’s reluctance to allow its exchange rate to appreciate against the U.S. dollar prevents the adjustment necessary to correct global imbalances. From the U.S. government’s point of view, a faster appreciation of the Chinese renminbi relative to the dollar (or equivalently, a faster depreciation of the dollar relative to the renminbi) would lead to a reduction in both the large current account surplus in China and the large current account deficit in the United States. By boosting U.S. exports, increased flexibility in exchange rate management in China would enhance growth prospects in the United States, which would in turn support global growth.

In my view and from the perspective of developing and emerging countries, both the United States and China are at fault. Both are at the epicenter of the international currency wars, and their actions are hurting developing and emerging countries that allow for a significant degree of flexibility in their exchange rates.

It is true that monetary expansion in the United States is inducing excessive exchange rate appreciation in many developing and emerging market countries through increased capital inflows, but it is also true that the appreciation pressures in these countries are larger than necessary because China refuses to absorb part of the pressure.

The Defensive Response

The defensive response of developing and emerging countries has been diverse. A number of countries, several Asian countries as well as Colombia and Peru, for example, have resorted to increased intervention in foreign exchange markets. Others such as Brazil and Thailand have imposed capital controls in the form of taxes on certain capital inflows. Yet a few other countries, notably Chile, are following the textbook prescription for dealing with excessive exchange rate pressures: fiscal tightening without intervention in foreign exchange markets. Interestingly enough, some advanced economies have also joined the currency wars. In particular, Japan and Switzerland have recently intervened in foreign exchange markets to prevent excessive appreciation of their currencies.

Moving Towards a Solution: The Role of the G-20

What is the answer to this problem? What can stop the currency wars in which individual countries try to avoid appreciation of their currencies, which in turn just magnifies the extent of adjustment that other countries have to absorb? The obvious solution is bilateral coordination between China and the United States. But that does not seem likely in the foreseeable future. As many analysts have already recognized, the opportunity, therefore, lies in the potential for multilateral coordination. In this regard, last weekend’s meeting of G-20 Ministers of Finance and Central Bank Governors brought hope but also some disappointment.

The hope lies in two decisions advanced in the Communiqué, both related to the role of the IMF. The first is the ministers’ call on the IMF to provide an assessment “on the progress toward external sustainability and the consistency of fiscal, monetary, financial sector, structural, exchange rate and other policies.” The idea is that the IMF assessment will contribute to the identification of individual country policies leading to large and unsustainable imbalances, especially on current account positions and exchange rate management. There was no agreement among ministers and governors on specific quantitative indicators to determine when large current account imbalances could be classified as problematic.

A number of analysts are quite skeptic about this G-20 decisions on the grounds that the Communiqué does not give the IMF or any other multilateral organization any power to sanction countries identified as running persistently large imbalances. The argument is that increased surveillance will not be an effective tool to induce countries to change their policies. In contrast, I remain hopeful since I view this decision as the first step in a G-20 process to reverse the movement toward defensive interventions in foreign exchange markets and capital controls. In my view, at this time, it is unrealistic to expect a fully spelled-out solution to the currency wars problem. Negotiations between major economies still need to take place, especially since the two camps in the currency wars debate remain quite apart.

But, I would not be relatively optimistic if it not were for a second decision in the Communiqué: the surprise shift in IMF voting powers toward unrepresented developing countries. This unexpected outcome, which gave me a second reason to be hopeful, allows China and other emerging economies to increase their role in the IMF Board decisions. Indeed, as noted by the IMF itself, “As a result of the quota rebalancing, the large, dynamic emerging market countries Brazil, China, India and Russia move up to be among the top 10 shareholders of the IMF.” In my view, this rebalancing of voting powers could facilitate a more ambitious agreement to end the currency wars during the Seoul G-20 meeting in early November. By becoming important shareholders in the multilateral organization in charge of global economic surveillance, large emerging economies have an increased incentive for collaboration in achieving global stability. Thus, I also consider this move as part of the G-20 evolving process to end the currency wars.

But, I couldn’t end this note without expressing one source of disappointment. While the G-20 Communiqué focuses on the problems of large and persistent current account imbalances and exchange rate misalignments, there is no recognition of the problem of excessively expansionary monetary policy in the United States and its destabilizing effects on emerging and developing countries. Indeed, the Communiqué simply states that G-20 members will “continue with monetary policy which is appropriate to achieve price stability. …” In a very vague statement that makes indirect reference to the United States (the reserve currency country) , the Communiqué also says that “Advanced economies, including those with reserve currencies, will be vigilant against excess volatility and disorderly movements in exchange rates” But there are not even surveillance constraints attached to this recommendation. Countries with reserve currencies, i.e. the United States, are recommended to be vigilant of their own actions—a pretty weak recommendation indeed. The bottom line of my frustration is that the G-20 is moving the process toward dealing with the problems identified by camp 2 in the currency war debate (those that blame China’s exchange rate policy) but falls short in addressing the issues advanced by those supporting camp 1 of the debate (those that blame the U.S. monetary policy).

Will the two camps find a way to meet in the middle? On an overall basis, the G-20 ministers and governors have started a constructive process. I, therefore, look forward to the G-20 November Summit and remain hopeful on further positive surprises!

(This blog takes some material from a recent article published in D+C Development and Cooperation (E+Z Entwicklung und Zusammenarbeit).

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CGD blog posts reflect the views of the authors drawing on prior research and experience in their areas of expertise. CGD does not take institutional positions.