There is a compelling need for the International Monetary Fund, finance ministers, central bankers, market analysts, and headline writers to learn the difference between the dangers of currency devaluation in an inflationary world and the benefits of currency devaluation in a deflationary world. Policy makers, far more accustomed to an inflationary world than to today’s deflationary world, have failed to make the distinction. That failure has cost Asia and now Russia dearly. Some market analysts and newspapers continue to create dangerous and unnecessary confusion about the cause of falling stock markets worldwide. Headlines are trumpeting the view that global equity markets are falling because of currency weakness. This makes no sense and seriously muddles cause and effect.
We must understand why currency devaluation has a bad reputation and yet how it can play a constructive role. In a far more typical inflationary world of excess demand, currency devaluation is perilous and often counterproductive. A sudden devaluation--like that by the British in 1967--raises the cost of foreign goods and shifts demand onto a domestic capacity that may already be over-strained. Unless a very tight monetary policy accompanies currency devaluation in a world of excess demand, the shift in demand induced by a weaker currency away from foreign producers and onto domestic producers will only push up prices even faster without reducing an external imbalance. Thus, the IMF insists on a tight monetary policy after a devaluation. A tight fiscal policy may also be required to keep the government sector from absorbing resources that are slated to produce more exports for the demand increased by devaluation.
Deflation, Devaluation, and Demand
In the less typical world of deflation that characterizes Asia, including Japan, and an increasing share of the global economy, devaluation can be more constructive. Once again, devaluation shifts demand onto domestic producers and away from foreign producers. But, with excess capacity, there is no need for a tighter monetary or fiscal policy. Pursuing such policies may be destabilizing if they reduce aggregate demand for domestic output more than a devaluation raises it. Devaluation in a region of chronic excess capacity such as Asia might do just that. And so the initial application of restrictive IMF programs in Thailand, Indonesia, South Korea, and even possibly Russia this summer produced deflationary results. With no attendant fall in currency values, the tight monetary and fiscal policies merely increased excess supply.
Given global excess capacity, devaluation is a zero-sum game: it shifts demand onto devalued currency countries and away from stable (revalued after others devalue) currency countries. Yet, in a world like today’s with strong demand growth still present in the United States and some countries of Europe, devaluations in Asia can be and have been helpful in preventing overheating in the stronger economies. Naturally, if the excess supply and deflationary pressure in one part of the world like Asia get too large, a global excess supply through large currency revaluations may result in the rest of the world. The risk of this outcome has risen significantly with Japan’s decisive movement into the excess supply camp since 1997. Japan, accounting for about one-fifth of world output, brings the share of deflationary Asia in world production to about one-third.
The beneficial shifting of demand from countries with an excess supply to those with excess demand has been reflected in equity markets. The Asian crisis and plummeting currencies have been a great plus for U.S. and European equity markets. Between October 27, 1997--the day of the 7 percent one-day equity market sell-off, when market pundits began to notice that Asian economic problems could hurt earnings growth--and July 17, 1998 (the recent peak in Western equity markets), the U.S. stock market rose by 35 percent while European equity markets, led by Germany’s DAX index rise of 65 percent, surged even more. These climbing equity markets mirrored the constructive transfer of demand away from overheating economies and onto stagnating economies, encouraged by the devaluation of the currencies of stagnating economies.
Still, in the light of this positive relationship between weak Asian currencies and strong Western stock markets, newspapers are attributing the early August drop in global equity markets to a decline of the yen and possible devaluations of the Chinese yuan, not to mention the weakness of the Russian ruble. But Asia is simply in a deflationary spiral, and the currency weakness there is a symptom of the failure to address the problem, not a cause of weak stock markets in the West. The new Japanese government has made few changes in fiscal policy while proposing virtually no proactive steps to deal with the banking crisis and the accompanying 1 trillion dollars’ worth of bad loans on bank balance sheets. Currency markets are despairing of any Japanese reflation that might alleviate the banking system problems and push up private sector spending. That is why the yen is falling.
The Currency Peg
In China and Hong Kong, financial and commodity market deflation is accelerating. Since Hong Kong chose to "do whatever is necessary" to maintain the currency peg with the dollar, the stock market has been forced down by tightening credit and higher interest rates: the market fell 65 percent from its high of last year and 15 percent between mid-July and mid-August alone. But the lack of currency adjustment and the fear of further deflationary pressures are pushing down the Hong Kong stock market.
In the midst of this perilous situation, the Hong Kong Monetary Authority decided in mid-August to treat the symptoms rather than the causes of its deflationary malaise. On August 14, the HKMA began directly to purchase Hong Kong stocks that had been plunging because of the deflationary pressure from the tenuous peg of the Hong Kong dollar to the U.S. dollar. This effort to prop up the stock market is doomed to fail since it reverses the withdrawal of liquidity from Hong Kong’s financial sector entailed in selling U.S. dollars (purchasing Hong Kong dollars) to support the Hong Kong currency peg. By directly purchasing Hong Kong stocks, the authority is protesting the deflationary impact of its own defense of the Hong Kong dollar. With the massive excess capacity in Hong Kong’s hotel, real estate, and shipping sectors, a sensible alternative would be to let the currency float down and stop the HKMA attempt to underwrite the stock market.
The obsession with pegged exchange rates as a solution to problems in emerging markets and in Asia has been costly. Ever since Thailand resisted devaluation with higher interest rates in June 1997, a parade of countries, including Indonesia, South Korea, and now Russi a, has followed the same disastrous path. The recent $22.6 billion IMF package of relief for Russia was aimed at pegging the currency and giving the Russians time to design revenue collection to pay for their bloated government expenditures. But most Russians and foreigners wanted to abandon rubles—around 50 billion dollars’ worth—and the fresh infusion of dollars from the IMF package only prompted them to move more rapidly. Simultaneously, a lack of confidence in the Russian government to collect taxes and cut expenditures led to the rapid sales of Russian stocks and bonds. With Russian assets and ruble collapsing, the Russian government August 17 declared that the ruble would be allowed to float 30ÿ40 percent above the existing range. In effect, the government defaulted on its short-term ruble-denominated obligations and imposed restrictions on currency transactions.
As the Russian situation, along with developments all over Asia, has clearly demonstrated, there are no neat and clean solutions to the serious problems confronting Asia and the emerging markets. Pretending that holding currencies stable will somehow make the problems go away has been a disastrous error, akin to treating symptoms instead of causes.
Stability the Issue?
Under most circumstances, currency stability is a desirable goal, especially for developing countries. A stable currency tends to attract capital inflows, which thereby lower the cost of capital and enhance capital formation and growth. Unfortunately, the basic problem in Asia has been too much capital formation, resulting in huge excess capacity and requisite price cutting by countries attempting to minimize the losses associated with persistent excess capacity.
South Korea is a prime example. It has virtually eliminated imports while pressing for maximum exports. Because the country has more than enough capacity to satisfy any domestic needs, South Korea is desperately attempting to use that capacity by selling more into global markets. But Korean sales of products like rolled steel at any price put extreme pressure on other producers in China and elsewhere. Hence, markets begin to expect defensive devaluations in countries like China. The Chinese resist any notion that they might devalue and back it up with intervention and, as in Hong Kong, higher interest rates. As the higher interest rates put further downward pressure on local real estate and stock prices, headlines scream the negative results in financial markets.
The realization of the extraordinary weakness of Japan’s economy and its banking system--encumbered with 1 trillion dollars’ worth of bad loans and unable to perform normal banking functions--has intensified the Asian crisis over the past several months. Japan is 60 percent of the Asian gross domestic product; with domestic demand collapsing, the weaker currency is merely a sign of the market’s assessment that the Japanese must sell more products outside Japan to avoid an even weaker equity market. Since the new Obuchi government, coming into power at the end of July, made clear the inadequacy of Japan’s response to its serious shortage of domestic demand and serious banking system problems, the Japanese yen has flagged. Therefore, the markets have anticipated the need for further depreciation of the yen as financial markets weaken worldwide. The frail yen is not a cause of the infirmity of financial markets globally. It is merely one of the symptoms of underlying forces--primarily a lack of demand in Asia, especially when weighed against the large stock of excess capacity there--that are pushing stock prices down.
Somewhat ironically, the solution to Asia’s problems will probably involve a still more debilitated yen and possibly more debilitated Chinese and Hong Kong currencies. The Japanese need desperately to reflate by aggressively printing money to a point where Japanese consumers will believe that prices will actually rise over the coming year and therefore reward them for spending more money now rather than hording. A large, reflationary increase in the Japanese money supply will shove the yen down until higher spending helps the economy to recover. A lower yen will put downward pressure on the Chinese and Hong Kong currencies.
The weaker currency scenario is preferable to the alternative approach. Like the rest of Asia, the last thing Japan needs is more of the wrong kind of investment. In Japan’s case, the wrong investment has been the objective of more than 70 trillion yen of public works expenditures over the past five years, much of it added to excess capacity in the public sector, just as Japan’s investment boom in the 1980s produced excess capacity in the private sector. Surely Japan’s elaborate system of bridges to barely populated islands and its paved streambeds are not contributing to economic strength in Japan or the rest of Asia.
The confusion over Asia’s unusual excess capacity problem--more investment is not always best--and the impact on exchange rates has been aggravated by a careless financial press. One day a major financial newspaper published a front-page story intimating that the decline of the yen was pushing global markets down; the previous day it had published an editorial suggesting that a falling yen was preferable to the alternative: "a meltdown in Japan." If a falling yen can help prevent a Japanese meltdown (which it can do), then a falling yen should not be identified as the cause of falling global markets.
The misunderstandings about exchange rates and their relationship to the deflationary environment in Asia probably stem from a misinterpretation of the role of currency devaluations of the 1930s. The Great Depression is often associated with the competitive devaluations or "beggar thy neighbor policies" followed by countries desperately attempting to increase their market share in a deflationary world of shrinking markets. But, then as now, falling exchange rates were a symptom, not a cause, of the excess supply problems that plagued many countries. Britain’s arbitrary decision to return to the gold standard in 1925 at a sterling price of gold that severely overvalued the currency triggered a deflationary cycle that spread to the United States and the rest of Europe, and culminated in the Great Depression. The British were not solely to blame for the Great Depression, but the attempts by other countries to maintain their pegs to sterling and gold contributed to the deflationary environment.
Once markets began to sense the desperate problems of excess capacity in much of Europe and eventually in the United States, currencies fell largely because of the need to increase demand. When global excess capacity exists, no fall in exchange rates, which only reallocates demand from one country to another, can eliminate the deflation problem. Hence, the 1930s saw a number of currency devaluations associated with chronic excess capacity as more and more countries joined the quest to attract shrinking global aggregate demand to their increasingly idle production facilities.
Today we seem to assume that if we do not allow the symptoms of excess supply (weak currencies) to emerge in Asia and Russia, somehow the problem of excess capacity will go away. It will not go away and can be remedied only by ratcheting up demand while limiting new additions to excess capacity. That is why support for a stable exchange rate that cuts the cost of capital and thereby helps to increase investment and growth is counterproductive in the current excess supply situation in Asia. The last thing that Asia needs is more investment. What it needs instead is more demand for the products that past investments in capacity can produce. Hence, monetary stimulus--printing money, not just ramming interest rates down--is preferable to fiscal stimulus, which often is complicated either by passive measures such as tax cuts or by pork-barrel measures such as the ridiculous construction projects pursued by the Japanese government over the past seven to eight years.
Today’s confused headline writers in the financial press should be writing that the decline of the yen and weak financial markets are all symptoms of a desperate need for monetary stimulation in Asia. Currency weakness in a deflationary world can be a plus since it defines reflation. The sooner we get over the mistaken notion of trying to divide a group of symptoms such as falling currencies and stock prices (all caused by global excess supply) into cause and effect categories, the sooner we will have a better understanding of the problems in Asia and global financial markets.
Some guidance from the U.S. Treasury along these lines would certainly be helpful and preferable to engineering more packages like July’s disastrous $22 billion IMF package for Russia. Asia needs to reflate. Robert Rubin and Alan Greenspan should stand up and say so before deflation reaches America and Europe.
John H. Makin is a resident scholar at AEI.