Triangular Trouble: the Euro, the Dollar and the Renminbi

by Jérémie Cohen-Setton on 29th November 2009

What’s at stake: China has come under renewed pressure this weekend to begin strengthening its currency as the European Troika – ECB president Trichet, Eurogroup chairman Juncker and Commission president Barroso – visits the country  for their annual summit with Chinese PM Wen Jiabao und People's Bank of China governor Zhou Xiaochuan.

Kevin O’Rourke says the issue of the renminbi peg to the dollar is one that needs to be confronted sooner rather than later, for everyone's sake. Based on an analysis of the trade collapse in the interwar period, O’Rourke argues that if we want to avoid such a scenario, we need to avoid two things. First, policy makers must ensure that the recovery continues as many of the worse political and economic-policy transformations only came after the Great Depression was into its second and third years. Second, recent research by Eichengreen and Irwin shows that severe exchange rate misalignments teamed with rising unemployment lead to much of 1930s protectionism. As exchange-rate overvaluation and protectionism went hand in hand during the interwar period, the issue of the undervaluation of the renminbi needs to be addressed quickly.

Anton Brender, Emile Gagna and Florence Pisani argue that the crisis has broken the close correlation between differences in expected interest rates and the euro-dollar exchange rate. The authors attribute this change to the sharp increase in risk aversion triggered by the collapse of Lehman Brothers and consider that fluctuations in risk aversion explain the path followed by the euro-dollar exchange rate since the beginning of the financial crisis. Their exercise doesn’t say much about where the euro-dollar exchange rate will be in a year from now. But it tells us that expectations about monetary policy differences will regain traction in influencing foreign exchange markets as risk aversion diminishes.

Ansgar Belke says that the pain threshold for the euro is at $1.55 as at this level exporters start withdrawing from markets. Every time the euro climbed new peaks in the past, the export industry and its lobbyists regularly raised the pronounced call that the exchange rate threshold had been passed. But this time exporters and their lobbies might be right as the analysis by Belke – based on an econometric model which takes into account the price elasticity and the path-dependence of exports – reveals that we’re getting close to a point where the exchange rate starts to hurt. If, as a result of global imbalances, the external value of the euro increases even further, the demand for German exports will fall dramatically and some German firms will stop trading internationally. The author further notes that re-entrance into international trade will be severely hampered, even if the euro will depreciate again in the future, because of hysteresis.

Willem Buiter says that the euro has become a currency on steroids. The euro’s excessive strength is contributing to a significant and persistent undershooting of the rate of inflation the ECB deems to be consistent with price stability in the medium term. The author reviews Article 2, 4 and 105 of the Treaty Establishing the European Community to argue that the ECB is actually mandated to pay attention to the exchange rate beyond what the behaviour of the exchange rate implies for price stability in the medium term. Turning his attention to a possible coordinated FX intervention, Buiter says that if the ECB were to implement just a 50 bps cut in the Main refinancing operations (fixed rate) and in the rate on the Deposit facility to complement a coordinated foreign exchange market intervention to weaken the euro, this would enhance the odds that the intervention would be effective.

Gary Becker says that the US in its own interest should not be urging China to appreciate its currency. On the whole, he believes that most Americans benefit rather than are hurt by China's long standing policy of keeping the renminbi at an artificially low exchange value as the benefits to American consumers far outweigh any loses in jobs. Since the opposite effects hold for China, he cannot justify their policies from the viewpoint of their interests. Their consumers and importers are hurt because the cost of foreign goods to them is kept artificially high. Their exporters gain, but as in the US, that gain is likely to be considerably smaller than the negative effects on the wellbeing of the average Chinese family.

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