Japan and Asian emerging market economies have one thing in common: they are desperate to keep their currencies down against the US dollar. They would far rather lend the US the money with which to buy their exports than endanger their competitiveness or become reliant on fickle foreign finance. Does this behaviour make sense? Is it likely to change soon? The answer to these questions is: Yes and, in all probability, No.
The rest of the world has a deep interest in this issue. The Europeans, in particular, long for the Asians to share in the adjustment to the weakening US dollar. This passionate desire is not surprising. According to the February Consensus Forecasts, the current account surplus of the Asia-Pacific region was $234bn last year, against only $35bn for the eurozone. This makes it puzzling, at first glance, that it is the euro, not the Asian currencies, that is soaring.
One explanation could be that the private capital outflow from Asia offsets the current account surplus. But this has not been the case. According to the Institute for International Finance, Asian emerging market economies ran an aggregate current account surplus last year of $73bn. In addition, they had a net capital inflow of $114bn. This is why their foreign currency reserves rose by about $187bn over the year. Meanwhile, Japan's foreign currency reserves rose by $201bn. It has taken vast intervention to prevent the dollar from tumbling against these currencies.
Why, then, have the Asian countries intervened so persistently and on this enormous scale?
Part of the answer is their determination to preserve export competitiveness. This has a regional dimension, as well. In 2001, for example, the countries of east and south-east Asia (including Japan) sent just under half their exports to one another. Moreover, China has become the assembly platform for components made throughout the region. The region's export-oriented countries are determined to preserve competitiveness against its new giant and also against one another.
Yet almost equal in significance are worries about the capital account. For Asian emerging market economies have learnt from the experience of 1997 and 1998 a lesson that is rather different from that drawn by orthodox economists. The latter believe that the crisis showed the danger of adjustable pegs. It would be better, goes the argument, to choose between irrevocably fixed exchange rates (or, better still, dollarisation) and freely floating rates. The directly affected countries drew a different conclusion. Polonius advised his son to be neither a lender nor a borrower. The Asians decided instead that it was far better to be a lender than a borrower.
The chief explanation for this is what economists have come to call "original sin", by which they mean the reluctance of international capital markets to lend in the currencies of emerging economies. If such economies become substantial net debtors in foreign currency, they become vulnerable to mass bankruptcy or public sector insolvency if their currency tumbles. Yet just such a collapse becomes likely as foreign currency indebtedness grows.
The solution then is to prevent the country from becoming a net debtor in the first place. This is relatively simple for most Asian countries, because the saving rates of their private sectors are high. The newly industrialised Asian economies (Hong Kong, Singapore, South Korea and Taiwan) had private savings rates of 22 per cent of gross domestic product in 2002. Japan's private sector savings were 26 per cent of GDP. Asian developing countries, dominated by China, had overall savings rates of 35 per cent of GDP. These high savings rates largely explain why the region is the world's largest capital exporter.
The two obvious ways to eliminate the current account surpluses are an exceptional investment boom (as happened, so disastrously, before the Asian financial crisis) and huge government dissaving (as is happening in Japan). Exchange rate appreciation cannot, on its own, bring about the desired outcome. Appreciation is likely, instead, to generate deflation before the external surpluses re-emerge.
The combination of concerns about competitiveness with risk aversion over foreign currency debt does much to explain Asian exchange-rate policies. But, as Ronald McKinnon of Stanford University points out, there is even more.* The dollar also provides an anchor for monetary policy and, given the undeveloped state of the region's financial markets, facilitates hedging by merchants and banks against exchange rate risk.
The conclusion is that Asian exchange-rate policy is perfectly rational. So when might it change? The answer lies in what Prof McKinnon calls "conflicted virtue". As the stock of foreign currency accumulates, speculation on an appreciation rises, making it ever more costly to hold the currency down. In addition, foreigners start complaining about the trade surpluses, arguing that they are the unfair result of currency undervaluation.
Both these pressures are now emerging. In China, for example, intervention has generated faster growth of money and credit and rising inflation. As Goldman Sachs notes, inflation was 3.2 per cent in the year to December against minus 0.4 per cent a year before. In 1971, Richard Nixon imposed an across-the-board import surcharge as a way to force currency realignments. Since protectionist sentiment is growing in the US, it is possible to imagine this happening once again.
Nevertheless, the pressures are not yet strong enough to trigger a big change in policy. Nor would a change make sense without a significant shift in the region's macroeconomic policies, as well, towards lower savings rates and higher consumption. Any change in exchange rates would also need to be led by China. But, for the moment, the Asian giant seems quite happy to stay where it is.
Whatever Europeans may desire, the prognosis is that Asia will continue to run huge current account surpluses and interfere in exchange markets. Its governments will not lightly abandon policies that they believe work well for the convenience of any outsiders.