Currency Exchange Rates: Playing Musical Chairs with Fire

Currency exchange rates have been much in the news as President Obama makes his first visit to China. The dollar is sinking, and China has ensured that its yuan falls in tandem with the dollar. Other nations, disadvantaged by the drop in two of the most important currencies in the world, complain vociferously. The U.S. government proclaims a strong dollar policy, and then looks away as the dollar continues to fall. The Chinese government scolds the U.S. government, which lectures back.

The currency markets are different from other markets. They don't just consist of private buyers and sellers. Governments also get involved, and generally do so for political and macro-economic reasons. Since nothing is as unpredictable as politics, currency exchange rates can move in ways that seem seriously out of whack.

To make things worse, currency exchange fluctuations are, at best, a zero-sum game. One currency's gain comes at the expense of other currencies, and resulting trade imbalances have a similar effect on the nations issuing the currencies. Only today, it's worse than that. Two powerful nations--America and China--rely on policies that may produce near term gains for them but potential longer term losses for everyone. The currency markets may now be a negative sum game.

For decades, China has linked the yuan to the dollar. Thirty years ago, the rate was about 8 yuan to the dollar. Today, it's around 6.8 yuan to the dollar. By contrast, the Japanese yen has tripled in value against the dollar during the same time period. The yuan has never been fully convertible into other currencies, as China has sought to prevent the rapid inflows and outflows of foreign capital that have bedeviled the development of other Third World nations. Considering the devastation wreaked in Asia by the 1997-98 financial crisis, one would have to concede that the Chinese have a point. They aren't unvarnished capitalists, and won't allow markets to operate freely simply as a matter of principle. They utilize market forces pragmatically, mixing in government dictat whenever they believe Adam Smith's invisible hand may be a little shaky. By holding the the yuan relatively steady against the dollar, they ensure pricing stability for their exports to dollar bloc nations (i.e., nations that use the dollar or maintain currency stability against the dollar, including the U.S. and, at times, various nations in Latin America). Chinese manufacturers could largely ignore the complexities and costs of currency fluctuations and commit to low, fixed prices to buyers abroad.

China's fixed exchange rate did much to make China a dominant exporter. But it had to take a lot of dollars in exchange--ultimately trillions of dollars. These were mostly invested in U.S. Treasury securities and American mortgage-backed securities (on which the Chinese have already taken nasty losses resulting from the mortgage crisis). Now, as the dollar falls in value, China loses more money on these assets. Hence, China's scoldings to the U.S. government to get its house in order and prop up the greenback.

The U.S. government in turn has countered that China is itself responsible for this dilemma, having created the trade imbalance that resulted in its enormous dollar holdings. The U.S. government would have China restructure its economy to focus on domestic consumption, and reduce exports to take pressure off the dollar.

However, neither government is doing much to change the status quo. China's government has launched a major stimulus program to forestall economic slowdown, with much of its spending directed at building infrastructure. These are wise expenditures for a developing nation, but they do little to promote domestic consumption. The Chinese are among the world's most frugal people, because they have no other choice. China has no Social Security system. Most Chinese have no pensions; the pensions that exist are meager. The health insurance that was part of Communist China's iron rice bowl has disappeared along with sales of Chairman Mao's little red book. The Chinese save because it's the only way they can have health care and a half-way decent retirement. The Chinese government has done nothing to alter this dynamic. Since China needs about 8% economic growth every year simply to keep up with population growth, it has no choice except to keep exporting. And to do that, it has to keep its currency stable against the dollar.

The U.S. government has responded to America's economic crisis primarily by borrowing and printing dollars--shiploads of dollars. Pushed by the forces of a lot of supply and not so much demand, the dollar has not surprisingly fallen in value. Euro bloc nations have grumbled about the rise of the Euro, especially export-dependent Germany. Several smaller Asian exporting nations have recently been buying dollars in order to defend their currencies. Oil exporters, like Russia and the OPEC nations, have complained of losses in their holdings of dollar-denominated assets and hinted at pricing oil in a basket of currencies to free themselves of dollar risk. In short, the U.S. government's primary response to the economic crisis has imposed losses on the rest of the world.

The flood of the cheap money being pumped out by the Fed has fueled the "carry trade," in which speculators borrow dollars at extremely low interest rates, convert them into currencies where interest rates are higher (such as in much of Asia) and invest overseas for those higher returns. This outflow of dollars is stimulating economic activity in other nations, and appears to be creating asset bubbles in Asia. While other nations don't mind a touch of stimulus courtesy of the Fed, many in Asia have vivid and disturbing memories of the Asian financial crisis of 1997-98, when asset bubbles fueled by inflows of foreign capital burst painfully and caused severe recessions.

There is little sign that the U.S. government intends to pull its stimulus back. The Fed has made clear its intention to maintain zero interest rates as far into the future as one can foresee. The carry trade will expand and perhaps even explode--in a time of slow economic recovery, it's one of the very few ways to make fast money. China will complain and lecture, but won't change the exchange rate of the yuan by much, because it needs continued access to American markets. Other exporting nations will grumble and defend their currencies with little likelihood of long term success. Oil exporters and other holders of dollars (including China and Japan) will take more losses on their dollar reserves, as there is no other currency or asset into which they can easily transfer their wealth.

American and Chinese expediency have created dangerous dynamics in the world economy. America can win only if other nations continue to fund its gigantic deficits and tolerate its uncontrolled printing of dollars by taking losses as the dollar falls. China can win only if it continues to export to America and hope that other nations will help it fund America's deficits while they become more vulnerable to Chinese exports themselves. The rest of the world is scrambling to figure out how to limit its losses and avoid being blown up by carry trade asset bubbles. Everyone, one way or another, is trying to shift their economic problems to other nations, a process that won't have a happy ending. This is starting to look like a game of musical chairs where the limited number of chairs is diminishing and all could end up net losers. If, somehow, the people running these nations would stop playing a children's game.