Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. An earlier vesion in Project Syndicate.
August 17 – Observers of international monetary economics have shifted attention back to the exchange rates of Asian currencies. The concern is that China’s yuan, Japan’s yen and Korea’s won are undervalued. All three countries run trade and current account surpluses, at a time when the US is running corresponding deficits. But given the fundamentals that keep US interest rates higher than the three Asians’, foreign exchange intervention is unlikely to be helpful.
- Three Asian currencies
Brad Setser has recently argued that, “The world should not ignore China’s undervalued currency”, while Gopinath, Gourinchas and Rey have responded that the US-China exchange rate is not the root cause of current account imbalances and does not warrant action by other countries. Should Beijing be internationally pressured to push its yuan upwards, as Donald Trump has long argued? (The People’s Bank of China used to intervene in the foreign exchange market to impede an appreciation. It stopped doing that in 2014, and started intervening to impede depreciation.)
Japan’s yen is said to be undervalued at the same time. For this reason, the US Treasury intervened in the foreign exchange market to boost the yen on July 31, in cooperation with the Japanese authorities. It was the first time that has happened in this century. One could hear reverberating echoes from the Plaza Accord of 1985.
Political pressure from the US Treasury to get Asian currencies to appreciate is an old story. Among the Asian currencies the Treasury considers undervalued is the Korean won. In explaining US participation Treasury Secretary Scott Bessent told Nikkei on August 4 that “many Asian currencies follow the Japanese yen.” Korea reportedly joined in on the coordinated intervention, buying won at the start of August.
- Foreign exchange intervention
Does the rare three-country currency operation signal a break in the new US unilateralism? There is little left of a US-led international community that can act in the common interest in such matters as exchange rates. President Trump has seen to that, although to be fair, the trend was already underway since the turn of the century.
True, Secretary Bessent used the language of mutual US-Japan comity in explaining the recent currency intervention. But many inferred that the US motivation was to prevent Japanese interest rates from rising, under a belief that this would force US interest rates up, which the Administration wants to avoid. That the US used euros to buy the yen rather than dollars is consistent with the stated desire to avoid an increase in the US treasury bill interest rate. And Bessent’s egregious failure to consult with the European Central Bank in the use of its own currency belies any idea of a return to notions of multi-lateral cooperation or multilateral norms.
Many economists think that intervention in the foreign exchange market cannot affect the exchange rate, except to the extent that it changes the countries’ money supplies. There is a lack of recent experience, because intervention by G-7 countries has been rare since the turn of the century. So, we should go further back for evidence as to whether it can be effective. The most famous example is the set of coordinated interventions around the Plaza Agreement of 1985. The Plaza was successful at bringing down the dollar. Indeed interventions in the 1980s and 1990s appear to have often accomplished their purpose of moving the exchange rate in the desired direction, at least for a while. The operations were more likely to be effective (i) when the US joined in with an international effort, (ii) if they were publicly announced, and (iii) if they caught the markets by surprise. The 3-way intervention at the start of August met these conditions; sure enough, there was an immediate appreciation of the yen and won.
- Currency manipulation
The bi-annual US Treasury Report to Congress on Macroeconomic and Foreign Exchange Policies of Major Trading Partners of the United States has long been congressionally mandated to relay findings of possible currency manipulation. The most recent report, issued July 23, names seven Asian currencies on its Monitoring List of ten “major trading partners whose currency practices and macroeconomic policies merit close attention”: China, Japan, Korea, Taiwan, Thailand, Singapore, Vietnam, Germany, Ireland, and Switzerland. (No country was named an outright manipulator this time, however, in the Treasury report.)
Those who worry that the yuan, yen, and won are undervalued (vis-a-vis the dollar) are usually talking about these countries’ trade surpluses and current account surpluses, and the US deficits, particularly bilateral, all of which are indeed substantial. But bilateral trade balances are not among economists’ standard criteria relevant for judging undervaluation of a country’s currency. The IMF has long considered the relevant criteria to be “protracted large-scale intervention in one direction in the exchange market,” excessive international reserves, and an overall current account imbalance. Also relevant is whether the country is selling its goods at prices below the world price even after adjusting for productivity, as China was doing 20 years ago.
- How to address current account imbalances
The best interpretation of the current trade imbalances is similar to diagnoses going back as far as the early 1980s and early 2000s. The fundamental reason why China is running a large current account surplus is its high rate of national saving. Even assuming that intervention were successful at raising the value of the yuan and reducing the current account surplus, that would just divert more of the high national saving into high investment, probably mediated by a low real interest rate. With China already in deflation, this is not what it needs.
What China needs is the a set of reforms that economists (both domestic and foreign) have been recommending for some time: A shift away from manufacturing to services, a reduced reliance on investment spending and export demand, and a greater role for household consumption. The private saving rate would be more moderate if the government provided more of a social safety net, including health care and social security. Other desirable reforms include increasing the flexibility of land markets and labor markets e.g., allowing workers to migrate and yet retain social benefits.
The weak yen can also be attributed to economic fundamentals. The interest rate in Japan is very low, especially in light of recent Japanese inflation. Markets apparently expect Japan to continue to monetize its huge government debt. Instead, the Bank of Japan should probably raise the interest rate.
The fundamental reason why the US is running a large current account deficit is its low rate of national saving, especially the negative government budget balance. The national saving identity tells us that the current account balance must equal national saving minus investment: a country that does not save enough to finance its investment and government spending at home necessarily borrows from abroad. Even assuming that intervention were successful at reducing the value of the dollar and subsequently improving the US current account deficit, this would crowd out investment.
The channel transmitting the crowding out of investment would probably be a high real interest rate: the Fed would have to raise interest rates more rapidly than otherwise, to head off inflation. Inflation, already boosted by Trump’s tariffs and war on Iran, would be further exacerbated if the dollar depreciated. This is at odds with US Treasury’s desire to prevent rises in the US interest rate.
The bottom line is that the exchange rate is more often a symptom of economic fundamentals than an independent lever of its own The US ought to work on strengthening its government budget. It has exhausted much of its ability to persuade other countries to do things. Whatever such capacity is left should not be squandered on exchange rate actions that are of dubious benefit.
This post written by Jeffrey Frankel.