Europe Must Look East to Deal with the Euro
Op-ed in the Financial Times
© Financial Times
The euro has recently hit a succession of record highs against the dollar. A number of European leaders, including Nicolas Sarkozy, the French president, and Jean-Claude Juncker, chairman of the group of 13 eurozone ministers, have called on the United States to take action to halt the trend. The issue will be high on the agenda of the forthcoming Group of Seven leading industrialized nations and International Monetary Fund meetings in Washington. The eurozone should look to Beijing rather than Washington, however, if it wants to avoid the costs to its economies of a much stronger currency.
The bad news for Europe is that the dollar is likely to decline by at least another 15-20 percent on average. Growth differentials have now moved against the United States, which may experience the slowest expansion of any G-7 country in 2007. Differentials in short-term interest rates have correspondingly moved against the dollar. The US current account deficit is still running close to 6 percent of gross domestic product and, along with America's own capital outflow, requires financing through an unsustainable $7 billion of foreign capital inflow every working day. The sharp pickup in US productivity growth that underpinned the strong dollar for a decade has been fading. The euro creates a meaningful international competitor for the dollar for the first time in a century and will attract continuing portfolio diversification from around the globe, including the super-rich sovereign wealth funds.
The good news for Europe is that most of the remaining decline of the dollar should take place against the currencies of the East Asians and the oil exporters. They are running the counterpart surpluses to the US deficits. They have piled up massive foreign exchange holdings that already far exceed any plausible needs. They are enjoying rapid economic growth that could most easily accommodate the reductions in external surpluses.
Many of them need to shift their growth patterns to domestic expansion for internal reasons. A few of the surplus countries have moved in this direction. The currencies of South Korea, Indonesia, and Thailand have risen more against the dollar than has the euro. Kuwait has abandoned its dollar peg and let its rate float upward.
But the exchange rates of the largest surplus countries of Asia have barely budged. China is, of course, the most blatant case. Its global current account surplus is likely to exceed $400 billion in 2007, more than half of America's global deficit. This will represent more than 12 percent of its GDP and provide one-third of its total economic growth. The renminbi needs to rise over the next several years by a trade-weighted average of more than 30 percent, and much more than that against the dollar, as part of a broader rebalancing of China's growth strategy towards relying more on domestic consumption than on investment in heavy industry and climbing trade surpluses.
China claims to have adopted a market-oriented currency policy in July 2005. At that time, it was buying $20 billion to $25 billion monthly in the foreign exchange markets to block appreciation of the renminbi. It is now intervening at $40 billion to $50 billion per month. On that metric, its exchange rate is about half as market-oriented as two years ago. It is thus no surprise that the renminbi's rise of about 10 percent against the dollar over this period was more than offset by the dollar's fall against other currencies, so that China's average exchange rate is weaker today than it was then, or in the early part of this decade when China's current account was near balance and the dollar was at its record peak. Nor is it a surprise that China's external surplus continues to soar.
Many other Asian countries hold their currencies down, through sizeable intervention of their own, to avoid losing competitive position to China. This is especially true of Hong Kong, Malaysia, Singapore, and Taiwan. Most of the large oil exporters intervene heavily to maintain undervalued pegs to the dollar as well. Japan's currency is also substantially undervalued, though due to its appropriately easy monetary policy rather than any official manipulation. A substantial rise of the renminbi would almost certainly pull at least the other Asian currencies, including the yen, up with it.
The problem for Europe is that the inevitable further decline of the dollar will continue to occur mainly against the euro unless the large Asian countries and oil exporters permit substantial increases in the value of their currencies. Hence eurozone leaders should be addressing their concerns to Beijing, and to some extent Tokyo and Riyadh, rather than Washington, especially with the US current account deficit now falling and the budget deficit for fiscal 2007 at a mere 1.2 percent of GDP. Even if the euro were to rise a bit more against the dollar, large appreciations from the Asian countries and oil exporters would limit or even negate any further increase in its trade-weighted average and thus in the eurozone's global competitiveness.
Rather mysteriously, Europe has been largely absent from efforts to address global imbalances over the past three years, in spite of warnings that it had the biggest stake in a geographically diversified outcome. The obvious places to start are effective implementation of IMF rules against competitive currency undervaluation and "prolonged, large-scale one-way intervention," and the World Trade Organization rules against "frustrating the intent (of the Articles) by exchange action" and export subsidies, as Ben Bernanke, Federal Reserve chairman, has labeled China's currency practices. Perhaps a euro at $1.50 or $1.60 will focus European minds on these imperatives.