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Guard againstneo-mercantilism 


Published with the kind permission of the author

If the IMF cannot be persuaded to enforce the ‘scarce’ currency clause onChina and Germany, unilateral trade actions by the US would be justified

During the past two decades, China andGermany have followed neo-mercantilist policiesthrough “exchange rate protection”. Thisinvolves maintaining an undervalued real exchangerate to generate a trade surplus, byindirectly subsidising exports andtaxing imports (see Corden:Economic Policy, Exchange Rates,And the International System ps.37-38, 94-95). These trade surpluses, particularlyof China, have been a concernin the US, just as those of Japanwere in the 1980s. These were tackledby negotiating voluntary exportrestraints’ (VERs), by which Japaneseexporters of cars and semi-conductorsagreed to limit their exports tothe US to a given quota. This impliedthat the implicit tariff embedded inthe export quota (raising the price to US consumers)was collected by the exporters and not the US. Thisentailed a double welfare loss for US consumers:Through the raised price of the import, and the loss ofthe implicit tariff revenue to foreigners. From the1990s onwards, the US has attempted to tackle the burgeoningChinese current account surpluses by judgmentsof the US Treasury Secretary on whether Chinawas manipulating its nominal exchange rate. To dateChina has been exonerated of such manipulation.

This is inappropriate as can be seen through theAustralian model of the balance of payments. Thiswas outlined for the Indian context in Lal, Bery andPant: “The Real Exchange rate, Fiscal Deficits andCapital Flows — India: 1981-2000,” EPW, November23, 2003, and “Erratum and Addendum,” EPW, April16, 2005. In this model which integrates both realand monetary aspects for a small open economy, thecrucial relative price is the real exchange rate (er): Theratio of the price of the non-traded good Pn (determinedby domestic demand and supply) and that ofthe traded good Pt (determined by the world price P*and the nominal exchange rate (e*)). [So, er= Pn/e*Pt].

It can be shown that, with a fixed nominalexchange rate, and fiscal cum monetary policy maintaininginternal balance by equating domestic expenditure(E) with domestic output (Y), endogenouschanges in the real exchange rate through a rise/fall inthe price of the non-traded good willmaintain external balance with notrade surplus or deficit. In a fully floatingexchange rate regime changes inthe nominal exchange rate can providethe needed change in the realexchange rate, without any change inthe non-traded good’s price.

For exchange rate protection togenerate a current account surplus,the real exchange rate will need todepreciate, and domestic expenditurewould need to be less thandomestic output (EI), and exports (X) being greater thanimports (M): (X>M). This is how the “savings glut” and“global imbalances” of continuing international concernhave arisen. In a fixed exchange rate system, thereduction in domestic expenditure will create anexcess supply of the non-traded good and lead to itsprice to fall, and thence to the depreciation of the realexchange rate. This shows that attempts to look at“currency manipulation” by just looking at the nominalexchange rate are inappropriate. What is neededis an estimate of the contingent real exchange rateand to see its deviation from the equilibrium realexchange rate which maintains internal and externalbalance. There are few attempts to estimate realexchange rates because it requires price data on amyriad of goods (including those which are madenon-traded by import quotas and tariffs) to estimatethe price of the composite non-traded good (Pn). Thealternative of using the real effective exchange (ep)which is reported by the IMF and the RBI as a proxyfor (er) is also inappropriate, being based on purchasingpower parity (ep), corrects the nominalexchange rate e* for the difference between the domestic and foreign price levels. But, as a proxy forthe real exchange rate it is vitiated by the fact of onlybeing equivalent (to er) if there are no non-tradedgoods in the economy! (see Lal, Bery, Pant, op. cit.)

This implies that the only way to judge if a countryis engaging in exchange rate protection is to see if it isrunning consistent multilateral trade surpluses overa period of time. The table shows the current accountbalances of China and Germany since 2007. Clearly,both are indulging in real exchange rate protection.

But, as we saw, a complementary policy to generatetrade surpluses from a depreciated real exchangerate is a deflationary macroeconomic policy keepingdomestic expenditure (E) less than output (Y). Thiswas also the worry the Bretton Woods architects facedabout the balance of payments adjustment processthey had endorsed in the adjustable peg currency system.Whereas countries with chronic current accountdeficits were required to maintain internal and externalbalance through macroeconomic policies of disabsorption,and expenditure switching throughexchange rate depreciation, no such obligation wasplaced on current account surplus countries. Themost egregious example of the consequences of thisasymmetry was the treatment of the Club Med countriesby Germany in the eurozone, when it entered theeuro at a depreciated rate providing it exchange rateprotection, whilst bullying deficit countries to dealwith their debt and balance of payments crises withmassive deflations — most notably in Greece.

This lacuna in the asymmetric adjustment burdenof deficit countries when surplus countries failedto boost domestic demand was filled by the IMF’sarticle 7, the “scarce currency clause” (see my column“Global financial crisis II — Is protection next?”December 30, 2008). This allows deficit countries torestrict imports from a surplus country whose currencyis declared “scarce” by the IMF, whilst maintainingunrestricted trade with everyone else (seeRoy Harrod: The Dollar, p. 109).

The scarce currency clause has not so far beeninvoked, as during the post-war dollar shortage it wouldhave been churlish for the deficit countries of Europeto have the dollar declared “scarce”, given the munificenceof the US Marshall Plan in reviving theireconomies. When the US became a debtor in the 1960s,it did not want to penalise its “surplus” allies in the ColdWar. Whilst since the opening up of China in the 1980sthe US turned a blind eye to Chinese mercantilism, asit hoped that as China became rich it would alsobecome a liberal democratic liberal country. This hopehas been shattered, with China showing its true coloursunder President Xi, as an unreconstructed Leniniststate using authoritarian state capitalism to challengeUS global hegemony. As I argued in my March column,Chinese surpluses are now being used to createvassal states in a new Chinese “empire”.

President Trump seems to have understood theChinese challenge. But, his trade strategy in dealingwith the Chinese dragon would be greatly strengthenedif he invoked the “scarce currency clause” tolegalise his Chinese trade restrictions and allow themto become multilateral. Finally, to tackle the Germansurpluses the European Central Bank should be askedto adopt and enforce the IMF scarce currency clause.There have been various suggestions about alternativesto enforcing the “scarce” currency clause; surveyedin John Williamson: “Getting SurplusCountries to Adjust”, Policy Brief, PB11-01, PetersonInstitute of International Economics, but they do notinspire much confidence. If the IMF cannot be persuadedto enforce the “scarce” currency clause onChina and Germany, the Trump administration’sunilateral trade actions would be justified.