March 18, 2016

Currency Manipulation or Currency Misalignment?

Listen to the presidential candidates talk about trade deficits and the Trans-Pacific Partnership, and most will say that the TPP will hurt America because it lacks any enforceable rules to stop currency manipulation. But if America wants to reduce its trade deficits, is currency manipulation really the key problem it should be tackling?

The United States and the IMF have tried for years to keep countries from manipulating their currencies, but these efforts have generally failed. Even when successful, the results are generally temporary and America returns to running major trade deficits. Why?

This note concludes that overall currency misalignment, not the subset of misalignment caused by currency manipulation, is the primary reason for America's trade deficits.

What is the difference between currency misalignment and currency manipulation?

The distinction between currency misalignment and currency manipulation is very important. If we fail to diagnose the cause of America’s economic ill health correctly, the economic policies prescribed as medicine may do more harm than good.

Some of the policies being prescribed today such as countervailing currency intervention might well help in the short term. However, such measures, which have no self-terminating exit mechanism, could lead to currency and trade wars. And in the longer term, by disguising the impacts of the far larger problem of currency misalignment, fixing only the currency manipulation problems could easily lull Americans into thinking that America’s trade deficits have been fixed – “Mission Accomplished."  

However, failures to solve trade imbalance problems today could undermine people’s confidence tomorrow in the professional competence of economists and policy makers alike – opening the door for blatantly populist preachers of protectionism to take center stage and guide America into its next failed effort to balance trade and restore jobs. Hence the need to get the diagnosis right.

OK. So what is the distinction between "currency manipulation" and "currency misalignment." 

Currency Misalignment

Currency misalignment is easy to define and identify. Whenever a country runs persistent, significant overall trade surpluses or deficits, its currency in misaligned.

Yes, we can quibble about how long “persistent” is, and how big “significant” is. But for the United States, these are non-issues. America has been running external deficits for roughly forty years – going all the way back to the first OPEC oil crisis. The deficits have clearly been persistent.

And at times the deficits have clearly been significant. For six of the past fifteen years, for example, the current account deficit exceeded the growth of GDP (both expressed in current prices). In those years, the U.S. violated a commonly accepted criterion for sustainable trade deficit – one that can continue indefinitely because total external debt grows more slowly than GDP, thus assuring that it will not rise as a share of GDP. Furthermore, in 2005-2006, the current account deficit as a share of GDP reached almost six percent – nearly double the three percent limit that many consider the maximum sustainable rate. 

More importantly, every one percent of external deficit as a percent of GDP today represents about one million jobs. Consequently, America’s current account deficit, which the IMF estimates will reach about three percent of GDP this year, means the loss of three million jobs. This translates into a two percentage point increase in the unemployment rate compared to the level of employment that America would enjoy if the U.S. dollar were not misaligned.

America’s trade deficits and thus its currency misalignment are clearly both persistent and significant.

Currency manipulation

Defining currency manipulation is more difficult because the term has become as much a political as an economic concept. So rather than trying to present a "consensus" definition based on the definitions floating around today, let’s use the definition of currency manipulation as given in the rules of the IMF, the world's ultimate authority on such matters:

"A member will only be considered to be manipulating exchange rates in order to gain an unfair competitive advantage over other members if the Fund determines both that: (A) the member is engaged in these policies for the purpose of securing fundamental exchange rate misalignment in the form of an undervalued exchange rate and (B) the purpose of securing such misalignment is to increase net exports.” (emphasis added) [1]

Because of the IMF’s ongoing efforts to make its definition of currency manipulation more relevant to current world realities, and to make the definition both more precise and more flexible, the IMF’s rules regarding currency manipulation appear in various forms in various places in its documents. Although the text quoted here is only one example of the IMF’s definition of currency manipulation, it provides a good starting point for discussion. 

Note the following implications of individual concepts within the above quote:
  • Official Acts. By limiting currency manipulation to actions by members, the IMF makes it clear that currency manipulation always reflects actions taken by an official government entity (usually the monetary authority). Identical actions taken by the private sector are not considered currency manipulation even if they have exactly the same impact on exchange rates as official actions. The status of sovereign wealth fund transactions is not entirely clear.
  • Unfair Competitive Advantage. By defining currency manipulation as official actions by members to gain unfair competitive advantage over other members, the IMF excludes, as currency manipulation, domestic actions such as improving education systems, supporting R&D, or expanding infrastructure facilities – even though these can have a major positive impact on the nation’s competitiveness and thus on its net exports. However, since these actions do not involve interaction with the global monetary system or direct efforts to alter existing market exchange rates, they are treated as producing “fair” rather than “unfair” competitive advantage and do not count as currency manipulation.
  • Exchange Rates. By specifying that the currency manipulation must involve manipulating exchange rates, the IMF rules effectively exclude all actions, including those listed in the previous point, that have an impact on the real effective exchange rate rather than on the market exchange rate.
  • Undervalued Exchange Rate. By specifying that currency manipulation involves securing a “fundamental exchange rate misalignment in the form of an undervalued exchange rate,” the IMF effectively dismisses short-term misalignments that may result from official portfolio rebalancing by sovereign wealth funds, for example. Consequently, the IMF rules focus only on persistent, long-term official interventions undertaken with the intent of establishing long-term structural undervaluation and thus “unfair” competitive advantage.
  • Increase Net Exports. Positive net exports are a standard indicator of fundamentally undervalued exchange rates. This part of the IMF’s definition of currency manipulation therefore seems to duplicate the previous point. However, the rule states “increase” rather than “maintain” positive net exports. Therefore, official interventions designed simply to maintain positive net exports would not count as currency manipulation under this IMF rule.
  • “Purpose” This is the loophole that trumps everything else. In its nearly 70 years of existence, the IMF has never found a country guilty and sanctioned it for currency manipulation. This reflects the fact that a member government can get away with virtually any of the above prohibited actions, even though it gains a competitive advantage that increases its net exports, if the country claims that this was simply an unintended side effect – that the actual purpose or intent of its actions was strictly to promote domestic stability, growth or well-being. Quantitative easing is an excellent example.
The "purpose" loophole has been made even more explicit as a result of pressures on IMF management by member countries seeking to minimize the risk that they would ever have their hands tied by the IMF’s currency manipulation rules. As a result, the following language has been added:
"Any representation made by the member regarding the purpose of its policies will be given the benefit of any reasonable doubt." (emphasis added)
In sum, “currency manipulation” as defined by the IMF refers to a very specific set of actions that cause currencies to become misaligned, but such actions constitute “currency manipulation” only if taken by official entities with the purpose of gaining competitive advantage. 

Causes of currency misalignment

In stark contrast, currency misalignment refers to all situations in which a county’s currency is not valued at its trade-balancing equilibrium exchange rate. Currency misalignment may be caused by currency manipulation, but the causes of currency misalignment also include the following, to mention but a few:

1. Actions by member governments that look like currency manipulation and have impacts on currency values just like actions that would normally qualify under IMF rules as currency manipulation, but don’t quality as such because of loopholes like those mentioned above.

2. Exceptional demand for a country’s currency by private as well as official investors like sovereign wealth funds because the currency is:
a. the world’s dominant reserve currency; 
b. the standard currency for writing and settling contracts for international current and capital account trade – even if the currency is not the domestic currency for either party to the contract; 
c. the currency used in the financial market most favored by global investors because of its breadth, depth, liquidity, reliability, and safe-haven status; 
d. the currency a country offering exceptional opportunities for direct investment in non-financial assets such as factories and real estate, both rural and urban. 
3. Political and/or economic problems in other countries that would otherwise have provided attractive domestic environments for investments in financial and real assets.

4. Fundamental global trade imbalances that have generated a global glut of private and official savings in the hands of those seeking yield and safety.

Does this list have any relevance to the global demand for dollars and dollar-based assets? Of course it does. In fact, this list provides a far better explanation than currency manipulation alone of the forces driving the international capital flows that have driven the dollar so far above its equilibrium exchange rate. But, you may ask, is this conclusion borne out by empirical evidence? Absolutely.

Data show that currency manipulation is not the primary reason for America’s trade deficits.

The US Treasury maintains the Treasury International Capital (TIC) database that records in detail America's financial inflows and outflows. TIC data show flows in terms of duration (long- and short-term), country of origin, type of instrument (direct, portfolio, other), and whether the buyers and sellers of US securities are official or private. [2]

We know from the above discussion that the only currency-misaligning flows that could possibly qualify under IMF rules as currency manipulation are official flows.

Furthermore, given the many restrictions and loopholes that have been negotiated into the IMF’s definition of currency manipulation over the years, we also know that only a small part of the official flows is likely to qualify as currency manipulation. So what do the TIC data show?

Figure 1 clearly indicates that official purchases of US securities play a very minor role compared to purchases by the foreign private sector. Private sector inflows, which can never be considered "currency manipulation" under IMF rules, have totally dominated official inflows for most of the past 35 years.

The same picture emerges from the Table 1 above, which shows that:

1. Official purchases in the US of dollars and dollar-denominated assets are a very small part of total inflows.

2. Even during 1980-1995, the peak period of official inflows, the share of private sector inflows in total foreign purchases of US securities was fifty percent higher than that of official inflows (60% vs 40%).

3. After 1980-1995, the share of official inflows fell to about half its previous level, averaging about 20% of total inflows between 1995 and 2010. In other words, the share of private inflows, which cannot be defined as currency manipulation, was four times larger than the share of official inflows. To say that America's trade deficits were caused by official inflows, which were only one fourth the size of the private inflows during the same period, would be like claiming the tail wags the dog.

4. During the past five years, currency manipulation clearly cannot explain the sharp rise in the dollar's value. During this period, official inflows were negative to the tune of about $7 billion on average, offsetting part of the private inflows during the same period, which averaged $237 billion.

5. By 2014-2015, potential currency manipulation was actually sharply negative by over $109 billion as foreign official bodies cashed in their dollar-based securities in the US and took them home -- or to other more attractive locations.

Another useful way to test the hypothesis that normal private cross-border capital transactions, not official currency manipulation, has been the main driver of the dollar's exchange rate and thus America's trade deficits, is to add the trade-weighted exchange rate for the US dollar to the chart above so that we can directly compare official and private flows with changes in the dollar's value (Figure 2). 

Without question, private capital inflows track the dollar's valuation far more closely than official inflows do. In fact, official flows are little more than an inconsequential side show when you look at the big picture.

Furthermore, central banks may have perfectly legitimate portfolio allocation motives for investing part of their foreign exchange reserves in US treasuries purchased in the United States. Rates on Treasuries may be low, but at least they are higher than leaving cash in central bank vaults, and the safety is good.

This quantitative analysis should make it clear that currency manipulation is a relatively minor issue today -- and that it was probably never more than a side show compared to the massive private cross-border capital flows that have been taking place in today's highly financialized world. The private cross-border flow of foreign capital into America, not official currency manipulation, has clearly been the primary source of America's trade deficits, lost jobs, and closed factories.

From this we must conclude that, if America is to restore its global competitiveness, jobs, and world-class manufacturing sector by balancing external trade, it must move the dollar back to its trade-balancing equilibrium exchange rate, a task that can be accomplished only if we stop focusing so much of our attention on currency manipulation and focus instead on moderating all foreign capital inflows in a way that keeps them consistent with a fair, competitive exchange rate for the dollar and thus with balanced trade.

America Needs a Competitive Dollar - Now!

1. The quote given here is actually only one of many that can be found in IMF documents. This one is used here because it is reasonably precise and largely consistent with the others.

2. Because of confidentiality problems, the BEA data on foreign investment inflows presented here cover only Portfolio Investments (purchases of US securities) and Other Investments (changes in balances held by foreigners in the US banking system). Data on foreign direct investment into the United States, broken down by official and private flows, are not available on a directly comparable basis. However, it is possible to construct a parallel series showing investment by "Government and government-related entities" from data published in the September issue each year of the BEA's Survey of Current Business (SCB).

The official flows reported in the SCB averaged only 4 percent of total FDI inflows over the past eight years, the remaining 96 percent being from foreign private sector entities. Since total FDI inflows averaged only 20 percent of total foreign investment inflows in recent years, official incoming FDI represents only 0.8 percent of the total foreign investment inflows.

Adding the tiny share of official foreign direct investments to the already small share of official portfolio and other investment inflows further reduces the share of official FDI in total FDI inflows. This leaves private net investment inflows even more dominant than indicated above.

Conclusion: Even if 100 percent of all three types of official foreign investment inflows were found to be motivated by the intent to manipulate the US dollar, an unthinkable situation, official currency manipulation as defined by the IMF would still be insignificant as a cause of the US dollar's overall misalignment and overvaluation

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