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The Price of Money

By DAVID O'REAR

What's a [select your currency of choice] worth these days? As in our calculations of the cost of oil, we need a reference point, and unlike petroleum, there is no clear marker. The European Monetary System (the predecessor to the euro) was attacked in 1992 and 1993, forcing two members to devalue. Several Latin American currencies collapsed after Mexico adjusted its exchange rate in late 1994. Most East Asian currencies fell sharply in 1997-98.

But, what of the benchmark, the U.S. dollar? The greenback substantially devalued in 1985-87 following the Plaza Accord, an agreement among the major nations to work toward rebalancing their economies. The key features were economic stimulation measures in France, Germany, Japan and the U.K. The first graph clearly shows the strong appreciation of the yen and deutschemark in the late 1980s.

Devaluations are often predictable, although the timing is always tricky. In a U.S. Federal Reserve Board study of 81 devaluations during 1959-93, the strongest warning signs were a decline in foreign exchange reserves, a deteriorating current account (trade) position and a growing fiscal deficit. Based on those indicators, the U.S. dollar is overdue for a more substantial fall. The budget deficit is the largest as a percentage of GDP in history, and the current-account shortfall is setting records of its own. But, as the world's reserve currency, the greenback, gets considerable leeway.

Not so for smaller countries' currencies. The second graph, with a base in the first quarter of 1998, shows the fluctuations in currencies hit hardest by the Asian financial crisis. From the weakest point, all but the Philippine peso have recovered well. In the more severe cases, political issues contributed to pushing the exchange rate further than it would have gone on purely economic grounds. The Hong Kong dollar pegging to the U.S. dollar in 1983 is a case in point, although politics certainly was an active factor in Southeast Asia in the late 1990s. Finally, there is the bandwagon syndrome. One of the main reasons why Korea was dragged into the Crisis was because so many other neighboring economies were in trouble. Contagion is real (as Brazil and Russia learned), and it doesn't take much notice of generally sound economies.

China today is facing a different kind of exchange rate issue: revaluation. The strong in-flows from foreign investment, and previously large trade surpluses have boosted the country's foreign exchange reserves by half in the past 18 months to US$470 billion at mid-year. This year, the trade balance turned to a deficit in the first half, but since then has returned to surplus. The main pressure to adjust the exchange rate, however is political. U.S. politicians eyeing (re)election in November are pressing the hot button that supposedly links China's exchange rate to U.S. unemployment. The link is pure fiction, but it plays well to the voters.

What might China do to relieve the real economic pressure on the renminbi? The prospect of further inflation as a cure, partly due to trade revenues being converted into local currency and thus adding to the money supply, is unappetizing. Rising domestic prices should in theory eventually translate into higher export prices and thus lower demand. But, China has few real competitors in a wide range of product categories, and so the inflation or revaluation would have to be quite extreme to have any impact on the trade balance.

The short term solution is to find a way to either export less (threatening politically sensitive job creation) or to import more, preferably both. Yet, there is only so much the economy can usefully absorb from the rest of the world.

Enter oil. Rather than "importing" U.S. treasury bills or gold bullion, China might import more oil -- much more. While this would seem counter-intuitive at a time of US$40+ prices, there is some logic to the notion. What other countries would think about this increased demand's effect on prices is an entirely different matter.

China's oil imports rose 25 percent -- in volume, or barrels -- over the past 18 months, as compared to the rest of the world's mere 1.2 percent rise. On a dollar basis, that works out to nearly 40 percent more paid for fuel, or US$12 billion. The country's reserves are sufficient to cover only a few months of consumption, whereas the U.S. has some three to four years worth of petroleum in its strategic reserve. So, if imports were, say doubled, and remained high for a year or more, China might be able to push its reserves to a full year's worth of demand.

The downside is that higher prices (or, sustained high prices) would likely push the U.S. to the brink of recession. That would directly hit imports from both China and from China's other main trading partners. In the end, the best strategy may be to wait until the U.S. election is over.

David O'Rear is the Chamber's Chief Economist. He can be reached at david@chamber.org.hk