Before delving into the arguments against currency pegs in general, a
clarification of sorts may be required.
The basic argument that has been made in a research report by Bank of America
Merrill Lynch, titled "Peg to Differ" [1,2] and a host of financial media
observations since the Dubai debacle of a week ago, is the idea that Dubai
adopted a "bad peg" while China adopts a "good peg". The arguments go on to
explain that while the currency peg in Dubai created an asset bubble at home,
the Chinese currency peg helps to augment the stability and integrity of the
global financial system.
Utter, unfiltered, hogwash.
Let's put the argument in the simplest and most unambiguous possible form that
can be distilled by even the most obtuse of
financial media reporters: every single currency peg is bad and will end in
tears.
For a topic with the sheer scale of associated misunderstanding as currency
pegs, it is likely that one can make basic errors in where to start. I have
written about currency factors previously (see
Why China must revalue, Asia Times Online, June 30, 2007), and
sometimes tongue in cheek (see
The dead dollar sketch, Asia Times Online, March 4, 2008). Therefore, I
would encourage everyone to spend a few minutes to consider the following
background information before jumping to the rest of the article:
As the global currency that is preferred for all payments, the US dollar is
always in short supply. [3] Therefore, its "price", ie its exchange rate,
depends on the availability of future US dollars. Typically, asset bubbles
denominated in US dollars are therefore negative for the US dollar exchange
rate, and the deflation of those asset bubbles denominated in US dollars is
positive for the US dollar.
For many decades now, the basic orthodoxy of the International Monetary Fund
and the World Bank has been to consider the export competitiveness of emerging
economies; in effect accentuating lower factor costs of these economies to make
inward investments more economically supportive for an export-oriented
infrastructure. This has in turn fed into the US dollar dominance that is
discussed immediately above. (See also
The new imperialism, Asia Times Online, July 21, 2007.)
Inherent in this system is the notion that there are no latent credit risks
within the dominant currency, namely the US dollar. That argument is now
debatable because not only are the top-rated US dollar debt instruments prone
to default (as in triple-A rated mortgage paper) but also increasingly are the
instruments issued by US states. It isn't just Treasury Secretary Tim Geithner
but the next 20 US Treasury secretaries who will begin their terms with a visit
to Asia, essentially begging the region to continue purchases of US Treasury
bonds and those of related enterprises.
Another embedded feature of currency management is the notion of the "unholy
trinity". This concept implies that between interest rates, currency exchange
rates and capital controls, policymakers can only choose to "fix" one measure.
Some countries may choose to peg their interest rates and therefore allow
exchange rates and capital flows to vary; yet others may choose to control
capital flows but let the other two variables move around. No country can ever
allow the free flow of capital and also try to control its exchange and interest
rates. This rule of the "unholy trinity" has never been broken.
Lastly, in a world with embedded demographic changes, the notion of pegging
one's currency to another ("absolute peg", for example the Hong Kong dollar),
or one currency to many ("basket peg", such as the supposed future for the
Chinese yuan) or indeed even a bunch of currencies to each other ("common
economic unit", as in the euro) is fraught with not just the usual economic
danger but also the whiplash effect of economic hubris. If you think of a gold
peg as a currency pegged to a finite quantity of a common purchasing equivalent
(namely gold), making it essentially like a pier jutting out towards a ship,
then a currency peg should conceptually be akin to a bridge between two ships.
Asset bubbles galore
The research report mentioned in the note below, along with random gleanings
from the financial media over the past few days, infuriated me primarily
because of the notion of finger-pointing to Dubai as if the place was an
exception of some sort. The idea perhaps was to debunk any notion of a systemic
crisis emanating from Dubai; as I wrote in last week, but without having to
resort to such unfair comparisons:
The total size of Dubai obligations,
at US$80bn or so, represents a boil on the backside of the debt monster running
amok in the developed and developing markets. For example, it represents barely
5% of the mortgage obligations of the US market alone; a paltry 10% of the
sovereign wealth fund in neighboring Abu Dhabi; a smallish 3% of the foreign
exchange reserves of China and so on.
Then again, there is the normal contagion which the likes of the IMF and World
Bank are familiar with (being the root causes of the same); then there is the
"contagion from extrapolation" that markets are more familiar with. This is
where things actually get hairy. (Dubai,
debt and a dose of reality (Asia Times Online, December 1, 2009.)
What was missed was that Dubai was merely the symptom of the asset bubbles that
accompany any currency peg. Name any currency peg and I will show you a sector
that has randomly benefited from the move, without intrinsic support or indeed
fundamental reasons. Look around the Asian region, for example:
A. Exhibit A is China. The nation that is often praised for
keeping its currency peg stable has witnessed epic boom and bust cycles in both
its property and stock markets. If I were to extrapolate only from the stock
market, it would appear that the Chinese economy is both expanding and
contracting at an annualized 30% rate - depending of course on which part of
2009 I used for my calculations. A number of high-ranking people in China,
ranging from heads of banks to heads of property companies not to mention the
odd communist party leader, have mentioned the bubble-like conditions prevalent
in the property and stock markets. Policy actions in the next few weeks will
likely force larger state-owned enterprises to return loans received from
banks, which will instead lend the money to smaller companies and individuals.
All these gyrations are of course a function of the peg.
B. Exhibit B is Hong Kong. The territory has an independent
currency peg of the Hong Kong dollar to the US dollar. As a result of the sharp
decline in US interest rates which it has to follow due to the currency peg,
and the government-funded stimulus in China, Hong Kong has seen a powerful
increase in its asset prices over the course of 2009. The net effect is to
create conditions that were the opposite of what prevailed between 1998 and
2002, that is, a pronounced deflation in house prices (many calculations show a
decline of 60% peak to trough). The current asset bubble could run for as long
as the economies of the US and China are out of sync and whenever they go back
in sync there will be a painful correction in Hong Kong property prices yet
again.
C. Exhibit C is Malaysia. A number of self-serving arguments have
been made about the Malaysian currency peg that supposedly saved the Asian
region from the attacks of "hedge funds and speculators" in 1998. Yet, 10 years
after the Asian financial crisis, Malaysia is still the laggard in comparison
to many countries such as South Korea that went through a far more pronounced
and yet ultimately market-driven correction during the crisis. Lacking the
essential skill sets required to justify its continued fascination with
export-led recoveries, Malaysia has been gradually hollowed out to outsourced
materials from China, leaving it as a pure assembler of goods; in effect the
most commoditized manufacturers of medium-end goods out of Asia.
D. Exhibit D is the United States of America. The US itself has
been the beneficiary of all the world's currency pegs to the US dollar. In the
past, such currency pegs involved economies small enough that the net effect on
US asset prices was barely discernible. As current account surpluses from Asia
against the US started crossing the $100 billion barrier in the late 1990s and
soon went to over $500 billion, the net effect on US asset prices became
apparent. By keeping interest rates low and disallowing a sterilization of
borrowings through more prudent central banking, the US effectively imported an
asset bubble; the rest, as the good bard would say, is history.
E. Then there is, Exhibit E, the world's largest currency peg
namely, the European Common Currency, or euro. By combining a bunch of cold
(declining industrial powers like Germany and Italy) and hot (asset
bubble-based economies like Ireland and Spain) economies, the euro has become
an unwieldy policy currency for the European Central Bank to manage; eventually
it will collapse under the weight of its own lies. Then again, no one I know
particularly cares about the future of Europe because, not to rub salt into
their wounds or anything, they ain't got one.
Fair-weather friends
At the best of times, a currency peg can be a fair-weather friend. Every
example given for the reasons for currency pegs to remain in place ultimately
fails because the rules of the "unholy trinity" cannot be broken: between
(open) capital flows, (floating) interest rates and (floating) currency rates,
policymakers can only choose a single control variable. The US chose to control
its interest rates while countries like China control their exchange rates; the
dissonance between these variables is the root cause of longer-term volatility.
When the dust settles on the current financial crisis, and the jury is still
out on whether a double-dip recession or something far worse looms on the
horizon, do not be surprised if the global consensus will emerge to incorporate
floating currency rates as specific conditions in a new World Trade
Organization-type regime. In effect, the day is not far off when only countries
that allow their currencies to freely float will allow free trade between each
other.
All that is, however, a tale for another day.
Notes
1. The Bank of America Merrill Lynch report titled "Peg to Differ" was
apparently intended as some sort of response to distinguish between the
unstable pegs of the type that Dubai indulged in, and the apparently more
robust one that underpins the Chinese economy. I couldn't read the actual
report because I don't subscribe to their research, but based on the precis
provided in the e-mail, was able to distill a number of arguments; all of which
are specious in my view.
2. I don't, as a general rule, read research reports and particularly not
anything published by Wall Street; the main reason for this being my complete
absence of faith in the very ability of the denizens of the Street to write
anything that even closely approximates their own beliefs. The other reason I
don't read research reports is the likely impact on my writing: readers may
know of an incident a few months ago when I was sent an e-mail with an
interesting quote about the US second-quarter gross domestic product report,
which I reproduced without realizing that a copyright violation had occurred
because the e-mail itself had been lifted verbatim from a research report.
3. See Dollar
appreciation in 2008: safe haven, carry trades, dollar shortage and overhedging,
by Robert N McCauley and Patrick McGuire, BIS Quarterly Review, December 2009.
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