Meetings of the Group of Seven (G-7) countries in Washington this week could feature a clash of views that have sparked an international currency war even as the International Monetary Fund (IMF) warned that growth in developed economies is slowing.
The conflict represents a fundamental disagreement about how to sustain the global economic recovery among countries that prefer flexible exchange rates like the United States, and others that are resisting calls to allow its currency to appreciate, like China.
In its World Economic Outlook report yesterday (Wednesday) the IMF warned that while emerging markets such as China and India will remain at the head of the growth class, European public debt problems will continue to undermine the recovery in industrialized nations.
Growth prospects for the United States took the IMF's biggest hit, falling to 2.3% from a previous estimate of 2.9%. China's growth is expected to fall to 9.6% in 2011, from an astonishing 10.5% expansion this year. A "greater-than-anticipated slowdown" in the Asian juggernaut could hurt the global recovery, the IMF said.
The IMF said a sustained, healthy recovery requires a careful rebalancing act, both domestically and on the global front.
Emerging countries need to strengthen private demand, which would make room for budget cuts. Countries like the United States, which are plagued by large deficits, need to boost their net exports, while surplus countries, particularly Asia, must cut their net exports.
In a thinly veiled reference to China's currency, the IMF said the rebalancing could only be done with support from greater exchange rate flexibility from undervalued currencies.
Economic Balancing Act
The currency battle is taking place as countries around the globe are mulling how to revive a sputtering global economic recovery while dealing with seemingly out-of-control deficits.
While specific plans to cut budgets to reduce public debt are urgently needed, the IMF recommended that some countries should postpone their planned belt-tightening if growth slows more than expected.
"Simultaneously addressing both budgetary and competitiveness problems in a deteriorating external environment is likely to take a heavy toll on growth," the IMF said.
The unexpected decision by the Japanese central bank on Tuesday to drop its interest rate to "virtually zero" and expand its balance sheet follows the U.S. Federal Reserve's move toward more quantitative easing (QE) - the policy of creating money by enlarging the central bank's balance sheet.
Federal Reserve Chairman Ben S. Bernanke said on Oct. 4 that the quantitative easing policy had aided the economy by buying $1.75 trillion of mortgage debt and Treasuries from August 2008 through March 2010. Pacific Investment Management Co. (PIMCO) says a new round of QE, is "likely."
Central Banks Reverse Course
The revival of quantitative easing is a reversal from earlier this year, when central banks were reining in stimulus programs or debating how quickly to tighten borrowing costs. The change in direction became necessary when industrial economies began to lose momentum.
"The bottom line for the U.S. is a growth trajectory so slow you'd nearly call it stalled," Paul McCulley, a portfolio investor at PIMCO, wrote on the company's website this week.
Not all policymakers are changing course. The central banks of Israel and Taiwan raised interest rates in the last two weeks and the European Central Bank (ECB), whose Governing Council convenes tomorrow (Friday) in Frankfurt, has indicated it wants to continue drawing down liquidity for its member-country banks.
The ECB will be forced to postpone tighter policy as European exports fade and investors continue to fret about peripheral euro-area economies such as Portugal and Ireland, Silvio Peruzzo, an economist at Royal Bank of Scotland Group Inc. in London told Bloomberg News.
Other central banks are exercising caution by suspending their interest-rate increase campaigns, but so far have drawn the line at buying assets.
After embarking on the most aggressive policy tightening in the Group of 20 (G-20), the Reserve Bank of Australia unexpectedly left its benchmark rate unchanged at 4.5% for a fifth straight month yesterday. Bank of Canada Governor Mark Carney, who has overseen three rate hikes this year, on Sept. 30 said "the unusual uncertainty surrounding the outlook warrants caution."
Push Against the Yuan
Still, the currency dispute remains the elephant in the room as the fight to increase exports has nations at loggerheads over trade policies.
China and its neighbors in the region will need to adopt "appropriate appreciation" of their currencies to bolster incomes and purchasing power, the IMF said.
Asia faces policy challenges as capital flows to the region increase, raising the risk of inflation, asset price bubbles and financial sector instability, the fund said. It estimates that capital inflows to emerging Asia in the past 12 months more than quadrupled from 2008 levels.
"Where large current-account imbalances may reflect an undervalued exchange rate, currency appreciation is the best response to capital inflows," the IMF said.
The yuan has risen about 2% versus the dollar since the People's Bank of China (BOC) in June pledged greater flexibility in the currency after pegging it at about 6.83 for two years.
China's moves to boost the yuan are "not exactly what we would have hoped ourselves," ECB President Jean-Claude Trichet said this week. The U.S. House of Representatives passed a measure on Sept. 29 that would let American companies seek compensation for imports from countries with misaligned exchange rates.
Chinese Premier Wen Jiabao this week called for "relatively stable" exchange rates, rebuffing U.S. calls for a stronger appreciation of the yuan.
Moves by countries from Japan to Brazil to weaken currencies and loosen monetary policies underscore the growing "stakes" for the global economy and the need for policy makers to correct imbalances together, Bank of Canada Senior Deputy Governor Tiff Macklem told Bloomberg.
"The stakes are getting higher," Macklem said in an interview in Montreal. "These recent events are illustrative of the fact that the pressures for adjustment are building,"
News & Related Story Links:
- Wall Street Journal:
IMF Cuts 2011 Global Growth Prospects
Global Central Bank Action May Follow BOJ Moves
IMF Says China, Asia Should Allow Stronger, Flexible Currencies
G-7 Stakes Rise on World Policy Divide, Canada's Macklem Says
- Money Morning:
Currency War Heats Up as Japan Lowers Interest Rates to Devalue Yen
- Money Morning:
You Heard It Here First: A Global Currency War is Being Fought - And There Will Be No Victors
- Money Morning:
Seven Ways to Profit From the Worldwide Currency War
- Money Morning:
We Want to Hear From You: Are You Prepared for the Global Currency War?