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Exchange Rate Flexibility Is in Asia's Interest
A commentary by Raghuram Rajan, Economic Counsellor and Director, Research Department
and Arvind Subramanian, Chief responsible for macroeconomic studies, Research Department
International Monetary Fund
Published in Financial Times
September 26, 2004

The International Monetary Fund has been calling for a concerted effort to reduce global current account imbalances. This will require an increase in saving in the US and an increase in demand outside the US. One element helping to increase demand from emerging Asian economies will be greater exchange rate flexibility.

Michael Dooley, David Folkerts-Landau, and Peter Garber suggest the imbalances reflect a conscious and stable arrangement between surplus and deficit countries—a "New Bretton Woods" system*. An undervalued nominal peg to the dollar is a perfectly reasonable arrangement, and calls for changes are misplaced, they say. Such arguments are rapidly gaining influence. But do they hold up under scrutiny? We think not.

The basic argument is that countries, notably China, at the periphery have more than 200m surplus workers who must be absorbed into the workforce rapidly to avoid social instability. Given the inefficiency of companies oriented to domestic production, why not create jobs and efficient companies by exporting to the core—the US—aided by an undervalued exchange rate? This creates tensions as core jobs are "lost" to the periphery. But the periphery helps overcome this by investing its surplus back in the core, and allowing companies from the core to invest in it and profit from using cheap workers.

One could quibble with this. Does China really have a strategy of undervaluation? If so, why did China allow its currency to strengthen with the dollar a few years ago? As the Fund's Eswar Prasad has argued, the political economy story also sits inconveniently with the fact that the net foreign direct investment flowing to China comes from Japan and other Asian countries from which China is a net importer of goods, rather than from the US. But the bigger issue is: if there were such a conscious strategy of undervaluation, would it be sustainable and desirable?

Economic theory suggests governments in the periphery cannot control the real exchange rate by fixing the nominal rate. As trade expands, the export sector will adopt new technologies and learn how to do things better. Because of these productivity improvements, real wages in the export sector and hence in the whole economy, must rise. This is development in action. The domestic-oriented (non-traded) goods sector does not enjoy the export sector's productivity gains, so, for companies to break even, prices in this sector must rise. The large reserve army of unemployed and underemployed moderates the rise in wages and prices, but because some forms of labour are in limited supply, rise they must. With a fixed exchange rate, real appreciation will take place through inflation.

The periphery can keep a lid for some time on this inflation. On the microeconomic side, this can be achieved through distortions such as price controls, but these would make the domestic sector even more unprofitable. On the macroeconomic side, the inflationary consequences of current account surpluses and reserve accumulation can be addressed through sterilisation (selling government paper to mop up money), financial repression and a closed capital account. Sterilisation neutralises the monetary consequences of reserve accumulation while repression (such as interest rate controls) and a closed capital account limit the direct fiscal costs and keep in check further capital inflows that could otherwise overwhelm sterilisation.

But the New Bretton Woods system contains the seeds of its own demise. The costs of microeconomic distortions—an unviable domestic sector exerting a drag on long-run growth—will mount and be reflected in the fiscal burden of accumulating non-performing loans in public-sector banks. On the macroeconomic side, barring a sustained decline in growth, China will continue to attract capital. The capital account will become more open as expanding trade makes it easier to evade capital controls. As sterilisation reaches its limits, capital inflows will push up credit and prices.

Given all this, it is better to move towards exchange rate flexibility. It is like white-water rafting: when you enter the rapids, you have a better chance of steering if you are paddling; attempt to stay still and the currents can overwhelm the raft. The IMF has therefore been advising more exchange rate flexibility not just to reduce global imbalances, but because it will be in emerging Asia's own interest.


*Direct Investment, Rising Real Wages and the Absorption of Excess Labor in the Periphery, National Bureau of Economic Research working paper 10626.


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