Asia’s exchange rates set for centre stage
November meetings of leaders from the Group of 20 industrialized nations may not have had exchange rates on the agenda, but the notes prepared by the International Monetary Fund included some meaty foreign exchange references.
The first is the view that although the dollar has moved closer to medium-term equilibrium it “still remains on the strong side”. The second is the (widely held) view that the dollar “is now serving as the funding currency for carry trades” which has contributed to upward pressure on the euro.
The third was the acknowledgement that the Chinese renminbi has depreciated in real effective terms and remains significantly undervalued from a medium-term perspective. To deal with the latter the IMF prescribed the usual recipe; namely that “exchange rate appreciation would help limit capital flows” and “facilitate a shift towards domestic consumption that is needed in many emerging economies, notably those with large external surpluses”.
None of the points put forward by the IMF on foreign exchange are ground breaking. However, the fact that the IMF judged it appropriate to outline these issues ahead of the G20 meetings is suggestive of the economic and thus political relevance of these issues. China’s exchange rate peg is clearly at the forefront of these issues.
Also significant is the IMF’s mention of the upward pressure on the euro, which could be seen as acknowledging that the euro (along with the yen) is bearing the brunt of the dollar’s downward adjustment. By recognising that the dollar is “still on the strong side”, the IMF may be warning that the upward pressure on the euro may have further to run.
Now that the euro/dollar is back at 1.500, the market will again begin to wonder whether at some point the authorities may act to stem the appreciation of the euro/dollar. Intervention in euro/dollar cannot be completely ruled out but it remains a remote possibility because it would avoid the real issue. The dollar’s decline is being driven by inflows into higher yielding markets which is unlikely to be turned around by intervention in euro/dollar as long as the market is forecasting low Fed rates and as long as risk appetite holds. The rise in the euro vs the dollar is merely a symptom of these flows but the appreciation of the effective euro (and that of the yen) is being compounded by the fact that as the euro rises vs the dollar it also rises vs the renminbi. At present, the effective euro exchange rate is creeping back to its December 2008 high which represents an all time high. Rather than seek to rebalance euro/dollar, officials should be increasing pressure on China to address its policy regarding its exchange rate.
It is not just the Europeans and the Japanese that should be worried about the impact of non-flexible exchange rate policies. The World Bank last week warned that asset price bubbles in parts of Asia are being driven by a rapid increase in equity and house prices notably in China, Hong Kong and Singapore.
The World Bank advised that policy should be tightened by “removing some of the support for liquidity in domestic and foreign currencies”. Calls for the breaking of some exchange rate pegs within Asia are becoming more commonplace and China’s size will mean that its exchange rate policy will garner most attention.
The issue of exchange rate flexibility in parts of Asia is promising to be one of the most dominant foreign exchange topics of 2010 and President Obama’s visit to Beijing this week could kick it back into the headlines.