Daily Archives: December 8, 2011

With the renminbi depreciating for six straight days starting last Wednesday, debate about its value has been renewed. Markets are fixated on whether Beijing will allow or even encourage the renminbi to depreciate further although diplomatic pressures remain strong for continued appreciation.

While attention is focused on the value of the renminbi, more important for China is to promote greater flexibility, as I have previously argued. The challenge has always been finding the right opportunity. A pre-ordained nominal appreciation of three to six per cent annually only encourages speculative capital inflows. Thus the recent build-up in the country’s reserves has come as much from money pouring in as from trade surpluses. China must find a way out of this dilemma.

Although the global economy has deteriorated, paradoxically, conditions are better than a year ago for moving to a more flexible exchange rate system. A prolonged and volatile slowdown in global economic activity from the eurozone crisis, coupled with a sluggish US recovery, is now likely. With China’s key export markets under stress, its trade surplus will decline to about 1.5 per cent of gross domestic product this year from around five or six per cent several years ago. Coupled with recent efforts to liberalise imports, China’s trade surplus may soon evaporate. If so, fluctuations in China’s $3,200bn of reserves will be shaped largely by capital movements and currency valuations since most of its holdings are denominated in US dollars and the euro.

Recent moves to discourage property speculation, declining domestic economic growth, and signs that Chinese firms and individuals are investing more abroad, net capital inflows are likely to shrink, thereby reducing pressures for the renminbi to appreciate.

These dynamics are already showing up in the offshore renminbi markets where the trading premium points toward further depreciation. Similarly, the central bank has had to prop up the renminbi in the official market over the past week lest it decline even more than it has. Other east Asian currencies have become more volatile in recent months and on balance have depreciated significantly. Given the strong interlinkages in regional currency movements due to their shared production network, China will also be pulled into greater flexibility. And since inflation in China will remain relatively higher than its key western trading partners, its real exchange rate may appreciate marginally even if nominal rates decline.

All this will create a conducive environment for China to develop a more flexible exchange rate system where the prospect of a decline is the same as of an increase – as it should be.

The writer is a senior associate at the Carnegie Endowment and a former country director for the World Bank in China.

European leaders will meet on Thursday and Friday for yet another “historic” summit at which the fate of Europe is said to hang in the balance. Yet it is clear that this will not be the last meeting convened to deal with the financial crisis.

If public previews from France and Germany are a guide, there will be commitments to assuring fiscal discipline in Europe and establishing common crisis resolution mechanisms. There will also be much celebration of commitments made by Italy, and a strong political reaffirmation of the permanence of the monetary union. All of this is necessary and desirable, but the world economy will remain on edge.

Given that Europe is the largest single component of the global economy, the rest of the world has a stake in helping to avoid major financial accidents. It also has a stake in aiding continued growth in Europe and ensuring that the European financial system supports investment around the world – particularly as cross-border European bank lending dwarfs that of banks from any other region.

Now is also a historic juncture for the International Monetary Fund. The focus of the policy response to the crisis must now shift from Brussels and Frankfurt to the IMF’s boardroom.

From the problems of the UK and Italy in the 1970s, through the Latin American debt crisis of the 1980s to the Mexican, Asian and Russian financial crises of the 1990s, the IMF has operated by twinning the provision of liquidity with strong requirements that those involved do what is necessary to restore their financial positions to sustainability. There is ample room for debate about the precise policy choices the fund has made in the past. But, the IMF has consistently stood for the proposition that the laws of economics do not and will not give way to political considerations. At key points the IMF has offered prescriptions, not just for countries in need of borrowed funds, but also for those whose success is systemically important for the global economy.

Christine Lagarde, the head of the IMF, highlighted the seriousness of problems in Europe to members of the international financial community assembled in Jackson Hole in August. She pointed to capital shortfalls in the European banking system and the need for adjustment to be carried on in ways that were consistent with continuing growth. Now the IMF needs to speak and act on several fronts.

First, it is essential that Italy’s adjustment be carried out within the context of an IMF programme. After European authorities emphasised that Greece was fully solvent and able to service all debts in full, it is unlikely that they, acting alone, have the capacity to reassure markets. Moreover, there are profound intra-European political problems if northern Europe either does or does not impose conditions on Italy. It would be much better to outsource those traumas to the IMF.

Second, as the IMF deals with individual European countries, it needs to recognise more than it did in the past that they are embedded within a monetary system and community of nations with an increasing number of common institutions. It would be inconceivable that the IMF would lend money to a country whose central bank was not committed to an appropriate monetary policy, or that was ignoring contingent liabilities in the banking system. IMF support for any European country should be premised on understandings with the European Central Bank that controls that country’s monetary policy.

Third, when engaging with individual members of a monetary union, the IMF cannot assess the prospects of one member of the monetary union in isolation. If some countries are to enjoy reduced trade deficits, others must face reduced surpluses. If there is no clear path to reduced surpluses there is no clear path to reduced deficits and hence to solvency. More generally, the sustainability of any programme must be assessed in the context of realistic projections of the economic environment. The IMF must be careful not to approve adjustment programmes that are not realistic.

Fourth, the IMF has a responsibility to speak clearly about threats to the global economy. Even if debt spreads in Europe fall and modest growth is reattained, the global economy is threatened by the large-scale deleveraging of European banks. An improvement in the fiscal position of sovereigns will help but this is insufficient. If banks are not recapitalised on a substantial scale soon, there will be a large contraction of credit in the global economy.

After the summit attention will and should shift to the IMF. It must act boldly but no one should ever forget a fundamental lesson of all past crises. The international community can provide support but a nation or a region’s prospect for prosperity depends ultimately on its own efforts.

The writer is Charles W. Eliot university professor at Harvard and was Treasury secretary under President Bill Clinton

The European Central Bank responded on Thursday to the eurozone’s deepening crisis but fell short of a game change. Instead it handed back this responsibility to European leaders who are gathered in Brussels for yet another summit.

The central bank is attempting to strike a delicate balance between three agenda items: respond to a weaker economic outlook, counter the fragility of the banking system, and sequence actions appropriately with European governments, other European institutions and the International Monetary Fund.

The ECB is clearly worried about Europe’s darkening economic outlook, and rightly so. Talk of a “mild recession” is accentuated by recognition that the balance of risks has shifted, especially given the possibility of “disorderly corrections”. This, coupled with a calming inflation outlook, warrants the 25 basis point cut in interest rates, and would have even supported a 50 bps point cut.

A worsening economic situation translates into even greater asset quality problems for banks, as well as growing concerns about the adequacy of their capital cushion. Accordingly, the ECB expanded its use of “non-standard” tools to bolster the sector.

The ECB is boosting banks’ ability to get cash in two ways: by expanding the range of acceptable collateral and by increasing the term of liquidity loans. These steps go well beyond the scope of traditional central banking. By moving the ECB further along the road from a monetary institution to a quasi-fiscal one, they expose its balance sheet to greater risk.

Markets welcomed the increased support for banks. But the initial enthusiasm disappeared once they realised that the ECB’s intentions did not include the third agenda item – that of directly helping European countries struggling with debt issues.

Rather than act at this stage, the central bank decided just to re-iterate the importance it places on governments doing the right thing – namely, better policies to enhance growth and competitiveness, and stronger rules to ensure debt and deficit discipline.

It went further in disappointing the expectations of those that had hoped for an “all in” policy response. Mario Draghi, its president, said he was surprised at how his remarks last week were interpreted to imply greater ECB sovereign bond buying once governments agree on a “fiscal compact”.

Thursday’s move will now be debated fiercely. Those who believe in Colin Powell’s doctrine of “overwhelming force” will argue that, at a time of great crisis, the ECB is being too measured, too timid and too refined. Others will congratulate the institution for positioning itself for success in a marathon rather than an exhausting and disappointing sprint.

But it is clear that the ECB has shifted the burden of solving this crisis back to Europe’s heads of state. It has reminded them, and all others, that its willingness to provide a bridge is dependent on greater assurances that this would be a path to stability, not another bridge to nowhere.

This is Europe’s moment of truth. For the sake of the region and that of the global economy, its leaders must come up with a solution at a time when, to use Nicolas Sarkozy’s phrase, the “euro needs to be refounded”.

The writer is the chief executive and co-chief investment officer of Pimco.

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