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Wednesday April 12, 2006 - 17:42:22 GMT
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Everyone Agrees Asia FX Needs To Rise. Why Not A Higher Yen As Well?

Even the former Fed Chairman Alan Greenspan weighed in on the need for appreciation in emerging Asian currencies to aid in adjustment. Trichet did the same last week. Finance Ministers in the US, Europe, UK, Canada and yes Japan concur. At the crux of the call is the yuan.

But the call rings hollow. The yuan is up over 4% versus the US$ and about 2% vs the euro...clearly not a lot and certainly not reflecting market-determined levels. However, movement is movement and China surely will respond with more in time. But even more sooner will not close the wage differentials (real and nominal) with the rest of the world short of a massive 20-30% yuan reval which could bring on a global jump in inflation followed by recession. Short of this kind of draconian realignment, not much would happen to exports leaving China headed to the US, Europe and Japan (more like exports leaving China and crowding out Japanese exports leaving for the US and Europe).

Additionally, most emerging Asian currencies outside of the yuan are up substantially vs the dollar and euro since China revalued in July of 2005. The won for instance is approaching range in place before the Asian currency crisis. Even the maligned Philippine peso has risen substantially in the last 6 months by any measure. And a similar story can be told for the THB (despite a political crisis), SGD and the IDR.

So all these officials are still largely calling for a yuan rise. Why if in their heart of hearts they know it won't mean a hill of beans difference to bilateral trade balances?

Dare I say that the motivation for pushing China to reval more rapidly is political - head off protectionist trends in the US Congress and probably in the not too distant future the European Parliament.

And then there is the central banker concern that China's currency policy is contributing to a global distortion in credit markets (some share of blame goes to oil producing nations too awash in petrol-dollars). All those Treasuries purchased just to keep the yuan from rising too fast make for lower than otherwise US rates which in turn imprint yield structure everywhere else. There is a second order concern too for central bankers on China's yuan policy...what it is doing to domestic money supply in China. If China had a real functioning money market the PBOC would need to sterilize this intervention which would mean flooding markets with paper...some of this goes on but nowhere near what China is amassing in dollar reserves. So thank goodness that China's political leadership can essentially dictate what the banking system lends or China would have a serious inflation problem brought on by monetary policy aimed at a currency target.

And if China stopped buying dollars by letting the yuan float, it would be a disaster for the US Treasury market and global interest rates. A recession would be set in motion in no time.

No one want China to float, most want it to allow for faster rate of appreciation to check protectionist tendencies abroad and to wean monetary policy of an unsustainable currency-target-based policy.

What I simply fail to see is why is Japan given get out-of-free-trade-jail pass so willingly? In February of 2004 G7 met in Boca Raton, Florida (yes there once was even a G7 meeting in Queens, New York) and called for flexibility in regions where there is less flexible exchange rates - i.e. Asia. At the time US Treasury Secretary Snow made it very clear that Japan was not included in this indirect call for Asian currency appreciation. Japan's MoF went home with more than a sun tan - they believed they had the blessing of G7 to intervene in the FX market to prevent the yen from rising until the cows came home, or more accurately, until China revalued. MoF went on an orgy of currency intervention which G7 (US Treasury) demanded an end to and so it stopped just weeks after the Boca G7 meeting in mid-March. MoF has not directly intervened since.

Where has the yen gone since? It is at a record low vs the euro (euro is up over 7% vs yen) and the dollar has appreciated by 12% versus the yen. Japan's surpluses with Europe and the US are wider. Japan has gladly stayed out of the currency limelight while China has been headlining ever since. With Japan's economy revitalized and deflation in the rearview mirror, it is time for Japan to shoulder some of the adjustment process and not bee allowed to hide behind China's measured pace of currency reform. Moreover, currency movements in dollar/yen will translate more into change in trade than movements in dlr/yuan as Japan real and nominal wage differentials with the US are not so severe as they are between the US and China.

Europe too needs to bear some of the adjustment burden, but arguably Japan is far behind the Euro Zone in terms of shouldering the burden of a decline in the dollar in the name of trade adjustment if we turn the clock back to 2001.

No currency-related adjustments alone will not bring the US deficit back to balance. Ultimately that will require a higher US savings rate and lower foreign savings rate. But to ignore the shock absorbing function of flexible exchange rates in the adjustment process simply elevates the risk of a disorderly adjustment later.

It is high time markets and officials recognize that the yuan and the yen need to rise in the spirit of an orderly global adjustment and arguably Europe would be more inclined to tolerate another necessary but not sufficient condition to trade adjustment...a higher euro versus the dollar.

David Gilmore


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