Currency conflicts come to prominence again

From the mid 1990s onwards, the US trade balance has steadily become bigger. This is a centrepiece of the problem of `global imbalances'. Starting from values of roughly zero, this got all the way to values like $70 billion a month, where the US was importing over $2 billion a day of capital to pay for the trade deficit. Here's the picture:

The US trade balance (goods+services, per month, seasonally adjusted)

This was termed as the `Bretton Woods II' configuration, where exporting countries like China gave loans to the US, in a form of suppliers' credit, and the US bought Chinese goods. This magnitude of capital import was un-sustainable for the US. Something had to give.

Warning for Indian readers: In India, the term `trade balance' pertains only to merchandise trade. In the US, the monthly trade data covers both goods and services. So it is a meaningful measure of what is going on in international trade, unlike the corresponding Indian data.

Bretton Woods II first broke down in the financial crisis. In the downturn, the mighty American consumer purchased fewer 50" television sets. The US trade deficit dropped nicely all the way to $25 billion per month. Alongside a rise in the US savings rate, this looked like a world which was rebalancing.

In recent months, this movement reversed itself and the US trade deficit once again started getting worse.   A deterioration of $20 billion per month is visible; i.e. a deterioration of $240 billion a year. Suddenly, the story of global imbalances righting themselves came under question. The present US run rate is around $40 billion a month or $0.5 trillion a year.

Alongside this, we have news that the Chinese reserves rose by $194 billion in Q3 2010. The Chinese seem to have also passed on some of their problems of exchange rate pegging upon their neighbours by purchasing Japanese, South Korean and Indonesian assets. I am not aware of such behaviour having been observed prior to this in human history. Japan, South Korea and Indonesia have taken unkindly to this behaviour. Given the opacity of the Chinese regime, one can't help wonder if similar things are going on through less visible channels - e.g. a Chinese sovereign wealth fund buys $10 billion of OTC derivatives on Nifty.

So we seem to be headed for quite some escalation of conflict over the Chinese exchange rate regime. Here are some interesting readings on the subject:

• What happens if the RMB is forced to revalue? by Michael Pettis on his blog.


• Why America is going to win the global currency battle, by Martin Wolf in the Financial Times.


• The final end of Bretton Woods 2? on Tim Duy's Fed Watch (the source of the above graph).


• The effect of RMB appreciation on the US-China trade balance, by William Thorbecke on voxEU.


• An interview with Raghuram Rajan on der Spiegel.


• Evolution of the exchange rate regime in Asia.


• How to avoid trade war: A reciprocity requirement, by Daniel Gros on voxEU, which makes a lot of sense to me as one of the least troublesome policy avenues to go down.