China continues to manipulate the renminbi to the extent that it is now undervalued by at least 20 percent. Japan has resumed intervention on a massive scale to lower the yen. Switzerland recently spent more than $100 billion to keep its franc from rising. All these countries, and a number of others, already run large trade surpluses and hold huge reserves but nevertheless want to weaken their exchange rates to boost growth through exports.
Now some deficit countries, notably Brazil, feel compelled to emulate these interventions to defend their competitive positions, even though they too already hold large reserves. Virtually all economies, including the European Union and the United States are seeking to avoid stronger exchange rates. In short, the competitive undervaluation of China is infecting the entire global economy.
This exposes a glaring gap in today's international monetary system: the absence of effective discipline on surplus countries. All adjustment pressures fall on those with deficits-resulting in an inherent deflationary bias that is especially acute during global slowdowns. The International Monetary Fund (IMF) was set up to stop the competitive devaluations that deepened the Great Depression, but it has never been given the tools to do so.
The United States suffers especially from this shortcoming. Other countries can set the dollar exchange rate, by intervening to hold its price up and their own currencies down, as China has done by buying a daily average of $1 billion for the past five years. IMF guidelines call on member countries to take into account the "interests of other members, including those of the countries in whose currencies they intervene," but there is no indication that those intervening ever do. Europe will increasingly face a similar problem with greater international use of the euro, while Japan already complains about China's operations in yen.
This gap can be filled, however, by the introduction of a new policy instrument: countervailing currency intervention. When China or Japan buy dollars to keep their currency substantially undervalued, the United States should sell an equivalent amount of dollars to push back. The IMF should authorize such intervention when necessary to discipline countries that are violating their obligations by engaging in deliberate undervaluation.
The traditional trade policy tool of countervailing duties against illegal export subsidies is a useful model. When World Trade Organization (WTO) members violate commitments not to subsidize, importing countries can apply offsetting tariffs. While subject to occasional abuses, the procedure works reasonably well. The US House of Representatives last week passed a bill to treat deliberate undervaluation as an export subsidy, as it surely is, and to authorize countervailing duties. However, a currency misalignment affects all of a country's foreign sales, not just specific sectors, and all imports, too. So countervailing duties are inferior to a monetary response.
The United States has, of course, bought foreign currencies for dollars on numerous occasions. It purchased euros in 2000 and yen in 1998, when it was widely agreed that those currencies had become far too weak. The most important interventions came in 1985-87, under the Plaza agreement, when the United States bought German marks and yen to help correct an overvalued dollar. But these were carried out with the cooperation of those involved, whereas a countervailing intervention would punish a country that was deliberately undervaluing its exchange rate. Hence the target country should be able to appeal to the IMF, if it thought it could make a persuasive case that the new tool was not being used to promote widely agreed systemic objectives.
In the case of China there would also be technical problems. The renminbi is inconvertible for capital flows, hence proxies would have to be found such as renminbi futures contracts and debt instruments. This would probably limit the scope of counterintervention well below the magnitude of Chinese dollar purchases. But the message would be unmistakable. Private capital would flood into China, around its capital controls, and push the currency upward as needed. More importantly the principle is clear: The new policy instrument would fill a major gap in the global monetary system and reduce a substantial threat both to financial stability and open trade.