Eyes on the Prize: Yuan not Yen

There is much focus on the upcoming G7 meeting. European finance ministers have bemoaned the yen’s weakness. The US policy toward China prevents it from being sympathetic towards Europe’s concerns.

There was time not too long ago when US officials would use a formulaic expression to refer to Japan. “It was the most important US relationship bar none,” they would say. That was then and this is now. Gradually since the late 1970s, when Deng Xiaoping put China on the road to development, the Middle Kingdom has increasingly eclipsed the Rising Sun.

That Japan had been stuck in its own version of the Great Depression for more than a decade may have accelerated the shift in the regional gravity, just as much as China’s sustained and rapid growth did. Japan remains the world’s second biggest economy, though probably next year or in 2009, China will surpass Germany to move into a distant third.

China’s export-led development strategy and the under-development of its own financial markets are remarkably similar to other countries in the region. However, its sheer scale is re-orienting trade and investment flows in a way that might not have been seen since the rise of Germany and the United States in the last quarter of the 19th century. In some respects, China’s emergence is aggravating the global imbalances, which many policy makers and economists regard as among the biggest threats to the world economy.

Declaratory and Operational Policy

Declaratory policy is what policy makers say. Operational policy is what they do. The US declaratory policy is that China should let the market’s decide the value of the yuan. This is the new orthodoxy. Most of capitalism’s history, including periods of the most rapid development, including Asia’s experience from the 1960s through at least the 1997-1998 financial crises, took place under fixed or very stable exchange rates.

Operationally, the US, but also to arguably a lesser extent, Japan and Europe, want the yuan to appreciate. A couple of years ago, a senior Japanese official from the Ministry of Finance argued that China should allow the yuan to appreciate by 5% a year for the next decade. US policy makers put a little more faith in the markets to accomplish the same goal. A year ago the US Treasury said that China should allow greater flexibility into its currency regime so that the yuan would appreciate.

Such faith may be misplaced. If China would allow the yuan’s value to be set in the market, which would require a more open capital account, it is not entirely obvious that the yuan would rise. The only argument that it would rests on China’s current account surplus, but as the weakness of the Japanese yen and Swiss franc illustrates, current account surpluses do not necessarily produce appreciating currencies.

Indeed, three separate forces would likely be unleashed by such liberalization that could see the yuan sink rather than float higher. First, a lot of hot money, i.e., short-term speculative flows, has moved into China, betting if you will that administrative steps will lift the yuan. Under conditions of an open capital account and a free yuan, the hot money would likely look for new opportunities.

Second, multinational companies, which in partnership with some local firms, account for roughly half of China’s exports, would be freer to repatriate their earnings, which would lead to a sale of the yuan for dollars, euros, yen and sterling.

Third, the economic elites in nearly every country put part of their wealth in foreign markets. China appears particularly susceptible to such outflows, given the authoritarian society and seemingly fragile financial institutions.

Yuan and Yen

European officials, who in the past seemed more concerned about the euro-dollar exchange rate, now seem particularly agitated by the yen’s weakness. Until the last couple of years, US policy makers and industry lobby groups had more angst about the dollar-yen rate. Now they are more exercised over the yuan.

The US Treasury’s stance toward the yuan means that it cannot really sympathize with Europe’s anxiety over the yen. Japanese policy makers have done exactly what the US asked for. First, to end deflation, some US economists, like Paul Krugman, advised “dropping yen from a helicopter”, which is a colorful way to say debase and weaken the currency, which Japan did, through a number of channels, including massive sales of yen (and purchases of US dollars). Second the US Treasury then urged Japan to resist further intervention and even advised against verbal intervention as well.

As the US Treasury Secretary explained to US auto makers and to Congress, Japan has not intervened in the foreign exchange market materially for nearly three years and does not appear to have jawboned the market in at least a year. The market is setting the value of the yen. How can the former chairman of the investment bank of Goldman Sachs object?

Both Treasury Secretary Henry Paulson and his deputy Timothy Adams (who recently announced his resignation effective when a replacement is named) have recognized that there are fundamental considerations that have weighed on the yen, like weak economic data and low interest rates.

The US cannot be seen resisting market forces in terms of the Japanese yen and at the same time tell China to embrace those same market forces.

What is to Be Done?

Besides whining, it is not clear what the European finance ministers intend on doing about the yen’s weakness. Given the disappointing string of economic data from Japan in recent weeks and the risk with the decline in oil prices, that Japan experiences deflation again, do these finance ministers really want the Bank of Japan to hike rates aggressively? Or alternatively, do they want the European Central Bank to raise the saliency of the euro-yen exchange rate in setting monetary policy? Both questions must be answered in the negative.

Part of the problem is that European officials do not generally embrace the philosophic principle that the price of foreign exchange, like other prices, are best set in the market. Since the end of Bretton Woods, they have tried various schemes to limit the fluctuation of their currencies against each other, culminating in the creation of a single currency.

Although Anglo-American officials appear to embrace market-determined foreign exchange prices, they would likely not object to Chinese officials agreeing to a substantial revaluation of the yuan, even if it were to be delivered in steps. Ultimately the pragmatic minded officials are more interested in achieving their pre-determined outcome than in their ideological commitment to flexible currencies.