US Treasury Currency Report: Foreign Exchange Policies of Major Trading Partners -- The Long-term Effects of China's Currency Manipulation

Tyler Durden of ZeroHedge has posted a very useful note on the Treasury’s latest foreign currency report here. Of the passages he highlights, the following provide particularly useful guidance for those formulating a new US trade policy for the 21st century:

"[China] has a long track record of engaging in persistent, large-scale, one-way foreign exchange intervention, doing so for roughly a decade to resist renminbi (RMB) appreciation even as its trade and current account surpluses soared. China allowed the RMB to strengthen only gradually, so that the RMB’s initial deep undervaluation took an extended period to correct."  

 "... distortions in the global trading system resulting from China’s currency policy over this period imposed significant and long-lasting hardship on American workers and companies"

These "significant and long-lasting hardships" are still with us today!

Although China is not manipulating its currency today and has not done so for about two years, China -- and the United States -- allowed the RMB to remain undervalued for so long that China’s manufacturing sector was able to increase its productivity sharply while hiding behind an undervalued currency. Because of the breakdown in the global exchange rate determination system, the RMB/USD rate failed to adjust in response to this productivity increase.[1]  Hence the "significant and long-lasting hardships" that America continues to suffer.

Conclusion: Any trade policies for the 21st century that Congress and the new Administration may develop should include a mechanism such as the Market Access Charge (MAC) that will correct existing currency misalignments – even if there is no active currency manipulation going on today.
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[1]. This failure reflects the collapse of the classical link between exchange rates and balanced trade in the 1970s when exchange rates came to be set more by trade in capital assets than trade in real goods and services. (For more on this fundamental change that is central to America's trade deficits today, see  Exchange Rate Determination – The Paradigm Shift).

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Would a MAC Harm America's Financial Markets?

"A MAC could cause chaos in America's financial markets."

True or False?

A reader asked the other day if introducing a MAC could seriously upset America's financial markets, thereby causing more harm than good.

This question can be addressed from several different perspectives such as interest rate levels, liquidity, and profitability.

Without doubt, the MAC could have an impact in each of these areas. For example, moderating the inflow of foreign capital will mean less capital circulating in US financial markets, and this could raise interest rates. However,  would be good rather than bad. Today's pathologically low rates today discourage savings, encourage speculative risk-taking, and facilitate wasteful expenditures. Raising interest rates gradually, as the MAC would do, would provide a "soft-landing" transition to a stable environment that supports sustainable real economic growth.

Likewise, moderating excessive capital inflows would reduce market liquidity, but excessive liquidity can hurt rather than help growth and stability as IMF studies  have shown. Furthermore, liquidity in America's financial markets, as proxied by the ratio of stock market capitalization to GDP or total credit market debt outstanding to GDP, is far higher today than it was when America was growing on average by three percent per year -- about 50 percent faster than it is growing today.

But these are issues for another time. Perhaps the best way to look at the probable impact of the MAC on US financial markets is to look at the impact of changes in the Fed Funds rate. This approach is very reasonable given that the MAC and the Fed Funds rate are similar in nature, purpose and size.

Nature

The Fed Funds rate is an interest rate. Without going into all the details, we can safely say that changes in the Fed Funds rate produce changes in the effective cost of capital circulating within the United States.

The nature and impact of changes in the MAC rate are directly analogous to changes in the Fed Funds rate -- both change the effective cost of capital in America's financial markets.

Purpose

The Fed Funds rate and the MAC are both designed to moderate the demand and supply of capital. The Fed Funds rate affects capital circulating within the United States, while the MAC provides its long-missing counterpart, a tool needed to moderate the demand and supply of foreign-source capital.

The Fed Funds rate moderates the domestic flow of capital by changing the cost of borrowing.[1]  The MAC moderates the inflow of foreign capital by changing the cost of borrowing from abroad.  

By making foreign-source capital slightly more expensive to US borrowers, the MAC encourages borrowers to obtain capital from domestic rather than foreign sources.  Conversely, by leaving foreign lenders with a lower net return, the MAC reduces the inflow of foreign capital, thereby reducing upward pressures on the dollar's value. Highly analogous to the impact of changes in the Fed Funds rate.

Size

In addition to being similar in purpose, the size of proposed periodic changes in the MAC and actual changes in the Fed Funds rate over the past several decades are similar.

The Fed Funds rate normally changes in increments of 25 to 50 basis points, which is the same as that recommended for the MAC. [2]  As the MAC is very similar in design to the Fed Funds rate, it is reasonable to predict that the impact of changes in the MAC rate on domestic financial markets will be essentially the same as that of similar changes in the Fed Funds rate. On this basis, we can draw the following conclusions regarding the probable impact on US financial markets of implementing a MAC:

1. The Fed Funds rate has been in operation for decades. During this period, rate changes have occasionally caused larger-than-normal fluctuations in the short term, but they have never created a crisis in US financial markets. Quite the contrary, changes in the Fed Funds rate have continued to be used for over sixty years precisely because they help prevent market instability and crises.
   
2. The MAC would serve as a vital complement to the Fed Funds rate, helping prevent havoc like the housing and stock market bubbles that ended with the Crash of 2008. These crises, by the way, were caused to a very significant degree by excessive foreign capital inflows.
   
3. The size of periodic changes in the Fed Funds rate and those proposed for the MAC charge are identical. Since changes in the Fed Funds rate have never wrecked havoc with America's financial markets, there is no reason to think that changes in the MAC would.
   
4. Changes in the MAC rate would be made for the same reason as changes in the Fed Funds rate -- to "take away the punch bowl" whenever US financial markets become overheated. Traders who make their living from the market -- and who make the most when the market is "hot" -- rarely like to see the punch bowl removed. But taking away the punch bowl strengthens and stabilizes markets -- it does not wreck havoc.
   

Introducing a MAC would certainly change the status quo. In the process, some groups will benefit more than others.We know what groups benefit most from hot markets and overvalued dollars. We know what groups are seriously harmed by hot markets and overvalued dollars.

In the end, we Americans must decide if our country is best served by assuring out-sized profits for those engaged in speculative trading, a portion of the economy that adds relatively little to real output, or if it is better served by assuring the competitiveness of America's factories, farms, and other directly productive activities.



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 [1] For simplicity, "borrowing" as used here covers obtaining money through both equity and debt transactions.
[2] Since 1990, 70% of the changes in the Fed Funds rate have been 25 bp and an additional 26% have been 50 basis points. The remaining 4% have been changes of 75 bp.

America Needs a Competitive Dollar - Now!

Germany has parlayed its Eurozone membership into massive trade surpluses.

When challenged about its massive trade surpluses, Germany seems to enjoy hiding behind the euro “whose value it cannot control.” Meanwhile, Germany holds down domestic wages and prices, effectively devaluing the euro within Germany against the euro for other European countries.

If the Eurozone countries had implemented a Market Access Charge (MAC) when the common currency area was created, the Eurozone Crisis might well have been avoided, or at least significantly reduced.

Prior to 2008, German vendor finance and outright bank lending had flooded into Europe’s southern periphery countries (Greece, Italy, Spain, and Portugal), driving wages, prices, and overall inflation there sharply higher. Their goods became less competitive because of rising domestic prices, and with no ability to change the euro's exchange rate to reflect their own national reality, imports became artificially cheap and exports became artificially expensive. This was the primary cause of the large current account deficits and foreign debt liabilities that drove the acute crises in these four countries.

The cross-border flood of German credit may have been engineered as part of Germany’s aggressive export policies. Whatever the motive, a key mechanism was the large spread between interest rates in Germany and those in its neighbors to the south, a spread driven primarily by Germany’s exceptionally high domestic rate of savings and the consequent surplus of domestic capital -- factors highlighted by Klein and Pettis in their highly influential book, Trade Wars are Class Wars.

For example, the average spreads over German rates for Spain and Italy averaged 3.3 percent between 2011 and 2013 (see chart below). Adding Greece to the unweighted average would raise the spread to an astounding 6.9 percent.

As Maastricht criterion long-term bond yields (mcby) in Germany averaged only 1.9 percent during this period, German bankers lending to the southern European countries earned returns 1.7 to 3.7 times higher than at home. Such spreads proved irresistible, especially when the German banks’ perceived risks of currency mismatch and default within the Eurozone were close to zero.

If each Eurozone country had implemented a MAC when the so-called “common currency area” was created, MAC charges would have been triggered in the southern tier nations as soon as their trade deficits reached one percent of GDP. Although an initial MAC rate of 25 to 50 basis points would not have had an immediately tangible impact on cross-border lending, the market access charge would have made Germany’s bankers think twice about the rising risks of lending to such markets.

Over time, with semi-annual increases of 25 to 50 bp, the combination of falling net yields and rising risk perceptions would have slowed the flow of capital from Germany into these countries. After two or three years, this process would have moderated foreign credit inflows, thereby reducing inflation sufficiently to return domestic prices and wages to more competitive levels.

In this way, country-specific MACs within the EZ might well have prevented or significantly reduced the impact of the Eurozone crisis that came about largely because of excessive intra-zone, cross-border capital flows.

I would be the last to claim that a policy tool such as the MAC would be sufficient to solve the Eurozone’s problems. The problems there are extensive, complex, and deeply ingrained, the result of historic national differences of culture, priorities, and experience. Policy initiatives on multiple fronts will be needed. Establishing banking and fiscal authorities with executive powers over the individual countries to assure policies consistent a common currency area  are probably needed, and policy reforms going far beyond these basics will also be needed, especially in countries like Greece.

Nevertheless, I would suggest that, even today, introducing a MAC in each of the European countries could make a major contribution to establishing the conditions needed to maintain the unity and viability of the Eurozone. While not sufficient by itself, the MAC or something very much like it may well be necessary. 

In fact, a new Plaza Accord that included the same dynamic link to balanced trade that is built into the MAC would eliminate the Achilles Heel of the original Plaza Accord -- the lack of a dynamic like to market realities. The 1985 accord was simply a on-shot exchange rate adjustment determined by bureaucrats sitting around a table who, despite being highly intelligent and well-meaning, had no way of pre-determining the series of exchange rate adjustments that would be needed to maintain balanced trade for the United States and other countries indefinitely.

Implementing the MAC would provide this urgently-needed dynamic link, assuring market-driven consistency between market exchange rates and balanced trade forever.

Revised Jan. 26, 2022

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