Hamish McRae: Shake-up on exchange rates is needed to stop trade war

Politicians can start trade wars, but can they also start currency wars? We will learn more about this in the coming months but I think the answer will turn out to be no. But we will also learn two other things. One is that the exchange rate of a country is a legitimate issue for politicians to have an interest in. And the other is that the world may be starting to move from freely floating exchange rates towards a more managed float.

The trigger for all this is of course the declaration by Donald Trump on Friday. He tweeted: “China, the European Union and others have been manipulating their currencies lower, while the US is raising rates and the dollar’s getting stronger and stronger with each passing day — taking away our big competitive edge. As usual not a level playing field…”

His critics were quick to point out that the main reason the dollar was getting stronger was his policies. The tax cut was pushing the US economy to grow faster, and at the wrong time since it was already close to full capacity.

The resulting inflationary pressures would lead to higher interest rates. And his trade war was encouraging a flight to safety. If the trade punch-up is liable to get out of hand, better to have your spare cash in dollars than in the main alternative, the euro.

Accept all that. Accept, too, that if there is going to be a global downturn in the next couple of years, far better to have an undervalued currency than an overvalued one. Now look at the charge: have China and the EU really been manipulating their currencies lower?

In China’s case, until 2005 it pegged the yuan to the dollar. Since then it has a managed float against a basket of currencies. It is true that by holding the value down it was able to use exports to drive its transformation into the world’s largest manufacturer. On present trends, it will outgrow the US in overall economic size by around 2030.

Manipulation? Well, yes in the sense that poor countries have been permitted to maintain barriers to financial flows, so have been able to hold their exchange rates down. But they also had to intervene in the markets to do so.

China built up the world’s largest stock of foreign exchange reserves, all $3 trillion of them, as a result of these interventions to keep an ultra-competitive yuan. But for the past three years that pile has been declining. The People’s Bank of China has gone into reverse. The yuan has been falling against the dollar and the Bank has been propping it up — exactly the opposite of what Donald Trump is attacking it for.

The European Union is different. Some eurozone members, notably Germany, have become ultra-competitive thanks to what for them is an undervalued currency. Germany is running a current account surplus of 8% of GDP and its output is up 12% since the 2008 crisis. But there are other members that are not competitive at all. Italy’s output is down 6%.

Yes, the euro is artificially low thanks largely to the European Central Bank still maintaining negative interest rates. But the reason for ultra-easy money is not to give an unfair bonus to Mercedes exporting cars to the US. It is to prop up Italy and to do, in those words of ECB president Mario Draghi, “whatever it takes” to save the euro.

Insofar as ECB policy “manipulates” the value of the euro, it is doing so for domestic, not international reasons. Were there flexibility in the eurozone Germany would have revalued and Italy would have devalued. But that cannot happen, at least not yet.

So at a detailed level, the Trump attack makes no sense. But the principle that the floating exchange rate system needs to be seen to work for all countries does matter. If it is not seen to work, action is taken. Back in 1985 the problem was an undervalued Japanese yen, which enabled it to flood the world with cheap exports. The Plaza Accord, agreed by the US, Japan, Germany, the UK and France, capped the rise of the dollar and pushed up the yen — the central banks agreed to intervene in the markets to do so. That averted a possible trade war.

Once the dollar fell to an acceptable level, the Plaza’s successor — the Louvre Accord in 1987 — agreed to try to hold the main exchange rates within unpublished bands. It faded, and the idea was abandoned.

But I can see pressure building that completely free-floating rates are not going to be acceptable much longer, and that some kind of loose currency agreement will come back into fashion — prodded, strange as it may seem, by that Trump tweet.