Plaza II is the wrong approach for global rebalancing

How should policymakers deal with global imbalances? This column argues that a return to the Plaza Accord of the 1980s with an exclusive focus on the exchange rate could well dilute the G20’s other agendas and may not even work in practice. The best solution is instead to focus on structural reforms. In many respects, the Chinese renminbi looks increasingly like the Japanese yen thirty years ago. The US Congress is in the process of passing legislation enforcing tariffs on imports from China, as US politicians blame the undervalued renminbi for their own economic problems. President Obama has openly criticised China for “having not done enough”. While the Chinese government does still try its best to avoid sharp currency appreciation, as Premier Wen has warned that the type of currency adjustment demanded by the US could lead to significant damage to China’s export sector and massive job losses, the pace of renminbi appreciation did pick up in September as external pressures mounted. For now, the risks of a trade war look manageable. Yet today’s China does resemble Japan thirty years ago in many aspects. It is the second largest economy in the world, after the US. Its economy depends heavily on export markets. It runs a large current-account surplus. Its currency is probably undervalued, and the government is very reluctant to let the currency strengthen. But China is also different from Japan in the old days in many important ways. China is an independent actor in the global stage. It is less likely for China to be pushed to make decisions simply for international political reasons. Its economy is much more flexible, in terms of economic structure, job markets and growth dynamism. While the Chinese government is particularly concerned with job implications, its economy may be more able to adjust to currency movements. Both the US and Chinese governments appear to favour multilateral frameworks for resolving the renminbi dispute. US Treasury Secretary Geithner, for instance, suggested tackling the renminbi issue at the G20 meetings. This was indeed a good suggestion as a multilateral framework should help reduce risks of direct confrontation between the US and China. After all, economic imbalances are a global issue. A critical question, however, is what specific policy approach the G20 might adopt for dealing with such problems. Memories of the Plaza Accord The world has previous experiences of multilateral policy efforts for global rebalancing. One well-known example is the Plaza Accord introduced by the G5/7 in early 1985. At its core, the Plaza Accord contains two policy subscriptions: currency appreciation in surplus countries like Japan and Germany and fiscal contraction in deficit countries like the US. But how successful was the Plaza Accord for tackling current-account imbalances? Economic data indicate that the Accord did not really eliminate the imbalances, let alone their root causes. Princeton historian Harold James puts it bluntly: “The lesson of the past clearly indicates that a more sophisticated approach is required rather than exerting massive pressure for exchange rate adjustment and looser monetary and fiscal policy” (James 2010). There is no denying that exchange rates are an important parameter determining exports, imports and, therefore, the imbalances. But the mechanisms through which the exchange rate affects the current account are much more complicated than what appears in undergraduate textbooks. For instance, during the decade preceding the subprime crisis, the US dollar exchange rate moved up and down, but the US current-account deficits continued to climb. Again, the renminbi appreciated by more than 16% from mid-2005 to mid-2008, but China’s current-account surpluses surged. These isolated examples make an important point: there are probably more important factors determining current-account imbalances of both the US and China. It would be much more effective for G20 to deal with the imbalance issues by focusing on structural reforms in respective countries. While currency adjustments by both the US dollar and renminbi should be a part of that comprehensive policy package, exclusive focus on the exchange rate could be politically difficult and practically ineffective. It might also be poisonous for the G20’s other agendas. It is therefore best for G20 to avoid a Plaza II, or a repeat of the G5/7 policy approach of the 1970s and 1980s. And this is consistent with what was agreed by G20 leaders in September 2009 in Pittsburgh (G20 2009), specifically: G20 members with sustained, significant external deficits have pledged to undertake policies to support private savings and undertake fiscal consolidation while maintaining open markets and strengthening export sectors. G20 members with sustained, significant external surpluses have pledged to strengthen domestic sources of growth. According to national circumstances this could include increasing investment, reducing financial markets distortions, boosting productivity in service sectors, improving social safety nets, and lifting constraints on demand growth. In China, for example, the large current-account surplus was caused mainly by broad distortions of the factor markets, which generally repressed cost of production and artificially improved competitiveness of China exports (Huang 2010). Exchange rate misalignment is only a part of that broad distortion picture. Relying exclusively on currency adjustment to correct the overall external imbalance requires an out-sized appreciation, which is difficult for China to accommodate at this stage, both politically and economically. Likewise, the exceedingly low saving ratio in the US before the subprime crisis was caused by a number of factors. Simply depreciating the dollar by a significant margin is unlikely to be sufficient to substantially lift the saving ratio. In addition, such currency moves within a short period are likely to destabilise the economy and financial markets. Rebalancing already underway The good news is that global rebalancing is already occurring. In the US the current-account deficit as a share of GDP has already halved from its pre-crisis peak, while in China the surplus as a share of GDP has already shrank by two-thirds. Obviously, part of the recent adjustments must be cyclical, given global economic recession. But World Bank’s Caroline Freund has discovered that the bulk of the decline in global imbalances from 2007 to 2009 was a result of countries rebalancing export and import growth, which is more likely to be sustainable (Freund 2010). Again, taking China as an example, recent adjustment of its external imbalance was, at least to a certain extent, the result of changes in domestic factor markets. Factor costs have been on the rise despite the global financial crisis. And this was most evident in labour and resource markets due to changes in both policies and demand-supply conditions. During the past year, the government has begun to reduce price distortions for most resource products in order to improve economic efficiency. The upcoming labour shortage is already pushing up wages by close to 20% a year. Hu Xiaolian, deputy governor at the People’s Bank of China, recently argued that adjustment of factor prices are an important way of changes in renminbi’s real effective exchange rate (Xiaolian 2010).Therefore, such price adjustments are bound to have important impact on China’s trade composition. Rapid rise in wages, for instance, not only directly benefits consumption but also forces industries moving towards inland provinces, another important positive factor for promoting domestic demand. It is clear that adjustments of factor prices are only just beginning. These are the policy issues that G20 leaders should focus on in Seoul in November this year. Of course, all governments will need to entertain domestic political demand. Therefore, it is important for them to coordinate on the policy agenda. It may even be possible for G20 leaders to set specific targets or guidelines for global rebalancing. But it is better to leave the decisions on choices of policy instruments and paces of implementation to national governments. Such policy strategy is likely to be more effective and lasting compared with the G5/7’s exclusive focus on exchange rate and fiscal policy. References G20 (2009), “G20 Framework for Strong, Sustainable, and Balanced Growth”, G20 Pittsburgh Summit, 24/25 September. Huang, Yiping (2010), “What caused China’s current account surplus?”, in Simon Evenett (ed.), The US-Sino Currency Dispute: New Insights from Economics, Politics and Law, A VoxEU.org Publication, Centre for Economic Policy Research. James, Harold (2010), “The history of tackling current account imbalances”, in Stijn Claessens, Simon Evenett, and Bernard Hoekman (eds.), Rebalancing the Global Economy: A Primer for Policymaking, A VoxEU.org Publication, Centre for Economic Policy Research. Freund, Caroline (2010), "Adjustment in global imbalances and the future of trade growth", in Stijn Claessens, Simon Evenett and Bernard Hoekman (eds.), Rebalancing the Global Economy: A Primer for Policymaking, A VoxEU.org Publication, Centre for Economic Policy Research, London, UK. Xiaolian, Hu (2010), “Coordinated relationship between factor price adjustments and exchange rate policy reform”, People’s Bank of China website, Beijing, China.