Currency war can create prisoner’s dilemma

The G20 meeting of finance ministers and central bank governors, held on Oct. 22 and 23 in Gyeongju, North Gyeongsang Province, offered signs of a possible way out of the recent currency tensions that have been aggravating uncertainties over the global economy. Participants agreed to move toward a market-driven exchange rate system and to refrain from competitive devaluations so that currency values would be reflective of economic fundamentals.

Kim Tae-joon

By Kim Tae-joon

The G20 meeting of finance ministers and central bank governors, held on Oct. 22 and 23 in Gyeongju, North Gyeongsang Province, offered signs of a possible way out of the recent currency tensions that have been aggravating uncertainties over the global economy. Participants agreed to move toward a market-driven exchange rate system and to refrain from competitive devaluations so that currency values would be reflective of economic fundamentals.

The communique also included indicative guidelines for balance of payments and implementing policy tools for bringing excessive external imbalances down to sustainable levels. In addition, the International Monetary Fund (IMF) was charged with evaluating these ongoing efforts to move external balances towards sustainability, as well as evaluating fiscal, monetary and structural financial reforms and exchange rate policies.

The meeting reconfirmed the G20’s stature as the premier forum for addressing instability in the global economy. From Korea’s perspective, the fact that the “Korea initiative” ― encompassing both a development agenda related to greater support for emerging economies as well as building a global financial safety net to stem the endless cycle of financial crises ― was readily adopted as a core item on the G20 agenda was quite a meaningful outcome.

In moving from a passive rule-taker towards an active rule-maker, Korea has now taken on a leading role in shaping the global economic order and in helping ensure global economic stability.

The significant level of agreement at the Gyeongju meeting can be said to run counter to the apprehensions still felt in the global economy, in advanced and emerging market nations alike. The hope now is that the basic directions presented at the Gyeongju meeting will be fleshed out into concrete measures at the G20 summit to be held on Nov. 11 and 12 in Seoul. However, there remain serious concerns as to whether the ongoing currency tensions will die down, and whether internationally coordinated measures can be arrived at to bring relief from excessive capital flows.

This currency war has arisen as the lagging recovery in advanced nations such as the U.S. has led to renewed reliance on quantitative easing policies, with fiscal expenditures now up against deficit constraints. This has led to capital inflows into emerging markets that offer higher returns, prompting a fall in emerging market countries’ exchange rates.

The increasing movement toward the use of exchange rate policy to stimulate recovery through boosting exports ― that may be the final card in their hand for starting economic recovery ― has morphed into what may even be called a currency war. China, meanwhile, has not seen a major fall in its exchange rate from capital flows, as it has effectively fixed its currency to the dollar.

The two economic powers of the U.S. and China are thus wrangling over the size and pace of the yuan’s appreciation, and this can be said to have heated up the currency war. As this has gone on, emerging markets have also responded. Brazil has imposed a financial transaction tax of up to 6 percent, which is a form of Tobin tax, while Thailand has reintroduced a capital gains tax on foreign investment.

Meanwhile, China suddenly raised its base interest rate right before the Gyeongju meeting. Yet, as we saw during the 1930s Great Depression, if each country endeavors to competitively raise exchange rates for its own benefit, this clearly will create a kind of prisoner's dilemma in which all countries stand to lose. This makes efforts to resolve such issues with international coordination through international fora such as the G20 absolutely essential.

The global financial crisis is not yet over. And it may take more time than we anticipate for the world economy to get back to normal. And while the U.S.-China currency dispute may indeed quiet down as political pressure subsides following the U.S. midterm elections, the trade imbalances between the two countries will be hard to resolve merely through currency revaluations.

To bring down their imbalances, such revaluations must be accompanied by structural adjustments, namely China must stimulate domestic demand and the U.S. must rein in its overall spending. Further, with the Gyeongju meeting’s indicative guidelines for balance of payments that are to be assessed by the IMF, each country is expected to have far less latitude over exchange rate policies than in the past.

As such, rather than go it alone, it makes much more sense to resolve the currency issue by pursuing a solution via international coordination and cooperation through the G20. Alongside this, the G20 must no longer put off initiating discussions on a new international monetary framework appropriate for the global era so that the global economy is able to grow in a sustainable manner.