The Exchange Rate of the Won

I had the great pleasure to address the Korea-United States Business Council during its recent meeting in Washington. During that presentation, I commented on the exchange rate relationships between the dollar, Chinese renminbi, Japanese yen, New Taiwan dollar and Korean won. Considerable interest has apparently been expressed in my views on the issue and I want to clarify them in this column.

The United States is facing trade and current account deficits of $550 billion, about 5 percent of its GDP. That deficit has increased by almost one full percentage point of GDP in five of the last six years. As a result, the net foreign debt of the United States is now approaching $3 trillion and is rising by about 20 percent annually. The United States must import $4 billion of foreign capital every working day to finance the current account deficit and its own outward foreign investments.

The trade-weighted average exchange rate of the dollar rose by almost 40 percent from 1995 to early 2002. Every one percent rise in the dollar produces an increase of about $10 billion in the current account deficit. Hence the currency's large appreciation over this recent six-year period accounts for most of the present imbalance.

The situation is unsustainable in two senses. First, dollar overvaluation and growing external deficits have traditionally been the most accurate leading indicators of protectionist trade steps in the United States, especially when they coincide with high and rising unemployment as at present, and we are now seeing an enormous outburst of pressure for new import restrictions (mainly against China). Second, a hugely overvalued dollar will eventually fall sharply and substantially in the exchange markets, risking serious disruption to both the US and world economies.

The United States does not need to totally eliminate its current account deficit. Cutting it roughly in half from current levels, to about $250 billion per year or 2½ percent of GDP, would stabilize the ratio of its foreign debt to GDP at 30 to 35 percent. This requires a decline in the average exchange rate of the dollar of about 30 percent from its peak level in early 2002.

The dollar has already begun to achieve that correction, declining by about 10 percent on average over the past year-and-a-half in a very gradual and orderly manner. However, this represents only about one third of the needed adjustment. The dollar needs to fall, against the average of other currencies, by about 20 percent more.

The decline of the dollar to date, moreover, has been very unbalanced with respect to its different trading partners. It has dropped by about 40 percent against the euro and by about 20 percent against the Canadian dollar. However, it has fallen only 10-15 percent against the yen and the won. It has not dropped at all against the renminbi because China pegs its currency directly to the dollar.

The next, and hopefully concluding, phase of the dollar's adjustment must importantly include the Asian currencies. The large Asian economies have run by far the world's largest current account surpluses over the past few years, accumulating massive reserve levels of more than $550 billion in Japan, $350 billion in China and well over $100 billion in Taiwan and Korea. All these economies have intervened heavily, limiting the market's desire to strengthen their currencies and thus the necessary downward adjustment of the dollar and the US external deficit.

China is the key to the currency equation. By pegging to the dollar, the renminbi "rides the dollar down" when the US currency falls and increases China's competitiveness. Korea and other Asian countries are understandably reluctant to let their currencies rise against the dollar when doing so would produce an equivalent rise against the renminbi, the money of their toughest competitor.

Hence the United States, through Secretary of the Treasury John Snow's recent visit to Beijing, and the finance ministers of the Group of Seven, at their latest meeting in Dubai, have called on China to let its exchange rate rise in value. Calculations at our Institute for International Economics suggest that a renminbi appreciation of 20-25 percent would convert China's modest global current account surplus into a modest deficit that could be readily financed by inflows of foreign direct investment and other private capital. We believe that China should achieve this appreciation through a one-shot revaluation of the renminbi, and in addition widening the band around its new parity and altering its peg from the dollar to a basket that also includes the euro and yen. This would be far more practical and desirable than floating its currency and opening its capital account, which would be distinctly premature in light of the continued fragility of its banking system and the lessons of the Asian financial crisis.

A renminbi revaluation of 20-25 percent would permit Korea, Taiwan and perhaps other Asian economies to participate constructively in the necessary global adjustment by letting their rates float upward by 10-15 percent against the dollar in response to the market forces that clearly want to push them in that direction. This would result in a depreciation of their currencies against the renminbi from present levels that would roughly match their appreciation against the dollar.

It would also be appropriate for the Japanese yen to rise further against the won and the NT dollar, in light of Japan's continuing huge global surpluses and massive reserve buildup. At its recent Dubai meeting, the G-7 also prodded Japan to let the yen appreciate and it has done so to some extent. Hence the won might fall against the yen and indeed depreciate modestly on a trade-weighted basis.

The result of these changes would be a reduction of about $50 billion in the US current account deficit, a downward shift of perhaps $30-40 billion in the Chinese current account position and small changes in the positions of the other Asian countries. The rest of the needed US adjustment would come from the rise in the euro, the Canadian dollar and the currencies of other major US trading partners. The Asian and other surplus countries will of course need to boost domestic demand to avoid adverse effects on their overall economic growth.

Korea has a major interest in the implementation of such an adjustment package. It would gain directly from the improvement in its competitive position with respect to China and probably Japan. It would benefit from the reduction in protectionist trade pressures in the United States, which would inevitably hit Korea even if aimed primarily at China, and from the lower risk of a major dollar crisis if the present overvaluation were permitted to persist. Korea should thus work hard both to achieve the comprehensive package proposed here and to make its own modest contribution to that result.