Asian governments have been fighting a rearguard action to hold down their currencies. They have stopped external surpluses from fuelling domestic inflation. But they are at their limits.
The dollar’s recent slide seems to have been triggered by the news that China had decided to raise its interest rates. That set the markets speculating that the Chinese renminbi would be detached from its peg to the dollar. And if the renminbi appreciated against the dollar, other Asian currencies would follow suit.
Markets are right in one way. The dollar will resume the secular decline that began in early 2002. After seven fat years of dollar appreciation, along with strong US GDP growth in the hi-tech revolution of the late 1990s, we are now in seven lean years of dollar decline, and slower productivity and GDP growth.
Where markets are wrong is to suggest that the renminbi will be the main driver of the dollar’s demise rather than just part of it. Asian currencies are set to appreciate in value significantly over the next few years anyway because of structural improvement in the operation of domestic economies and reduced dependence on foreign capital.
The Chinese are switching from administrative measures to market interest rates for macroeconomic management. Within six months will come the move from a rigid
currency peg with the dollar to a crawling peg on a basket of currencies that rises slowly.
The upward march of the renminbi will give a boost to all emerging-market currencies. And that marks the beginning of a new era for Asian and other emerging-market economies.
Rise of the Asian consumer
The post-war Asian growth miracle was based on such countries as Taiwan, Japan and Korea running huge trade surpluses, but not allowing their currencies to rise. How was this possible? Because the consumer was oppressed, deprived of access to credit and forced to save to fund a massive investment programme that drove industrialization under strict government guidance.
This model cannot work today. Many emerging markets, particularly those in Asia, have developed into something akin to consumer societies. Today, consumers have access to foreign goods and services as well as the credit to buy them. Householders can get mortgage finance. All this means that external surpluses will sooner or later pop up as credit growth and so boost inflation.
The job of holding down emerging-market currencies with one hand and controlling domestic credit and inflation with the other is getting tougher. These days Asia runs a
surplus not only on its trade account but also on capital flows.
In the old model of Asian growth, the capital account was highly regulated, if not closed. It was the home-grown savings of the workforce that funded all those mega industrial and infrastructure projects. So there was only one surplus and one source of external currency pressure for the government to deal with.
But now inward investment into equity and bond markets or into Asian corporations has been freed up. And it’s pouring in. The result is an inexorable pressure on currencies to rise.
The US has peaked economically and politically and is entering a long cycle of mediocre economic performance compared with Europe, Japan and many emerging markets. In this sort of long-cycle adjustment, the currency always leads the way down. The structural problems are enshrined in the bloated balance sheets of US households, where both property and debt are equally inflated. This sort of wealth inflation (as opposed to creation) has created excessive consumption, inadequate savings and massive reliance on foreign capital to fund the difference.
Many argue that the current account deficit will be financed indefinitely by Asian economies recycling their dollar surpluses back into US financial assets as they have nowhere else to park them.
But this cannot last. In reality, this sort of dollar recycling reflects only a momentary stable state of economic disequilibria that will vanish as soon as foreign savers feel the US is either unsafe or unrewarding to invest in.
Also, US assets are not going to deliver the sort of returns achieved in the 1990s. Productivity growth will be slower, profit margins will narrow from their currently heady heights and a weaker dollar will induce even further reluctance by foreigners to invest.
Countries with long-standing twin external surpluses (on the current and capital accounts) and rising international reserves cannot hold down their currencies for ever. Either they revalue their nominal exchange rate or the feed-through from the external surpluses to the domestic money supply will ultimately push up domestic inflation and revalue the real exchange rate.
The instruments Asian governments have used to stop soaring foreign exchange reserves becoming domestic money supply are nearly exhausted. Currency appreciation is now the only policy tool to control domestic inflation.
