THE CURRENCY PUZZLE

For some time now, global powers have been engaged in a currency war, which can simply be summed up as:
mine is weaker than yours. The implicit calculation is that a cheaper currency would spur exports, making up
for the demand shortfall that has afflicted the Western economies in particular after the financial meltdown.
However, the reality is far less linear. At the centre of this battle are China, which has emerged as the second
largest economy in the world, and the US, still the numero uno of the global economic order. Outliers such as
India have a lesser stake in this battle, but are nevertheless being drawn into what is a very contentious
debate. A temporary truce was managed at the meeting of the finance ministers of the Group of 20 countries
at Gyeongju, South Korea. But nobody is willing to bet on whether the truce will hold.

To help readers understand the underlying issues, many of which are very complex and nuanced, Mint and
Project Syndicate present the expert perspectives of 12 specialists.

THE FUTURE OF THE DOLLAR by Martin Feldstein (Cambridge)

EUROPE AND THE EURO by Christine Lagarde (Paris)

A WORLD OF MULTIPLE RESERVE CURRENCIES by Barry Eichengreen (Berkeley, California)

A STERLING QUESTION by Howard Davies

Dakar - AFRICA'S MISPLACED MONETARY AMBITIONS by Sanou Mbaye

THE CARRY TRADE CARRIES ON by Hans-Joerg Rudloff & Paul Robinson

A STATE OF CONFLICT by Vijay Joshi

THE LATIN EXPERIMENT by Mario I. Blejer

DOLLAR DIPLOMACY AND JAPAN'S LOST DECADES by Takatoshi Ito

CHINA DILEMMA by Yu Yongding (Beijing)

FOR A FEW DOLLARS LESS by Jahangir Aziz (Mumbai)

STOOPING TO CONQUER by Ashok K. Lahiri

THE FUTURE OF THE DOLLAR by Martin Feldstein (Cambridge)

American economic policy aims for a dollar that is strong at home and competitive abroad. A strong dollar at
home means a dollar that retains its purchasing power, thanks to a low rate of inflation. A competitive dollar
abroad means that other countries should not implement policies that artificially depress the value of their
currencies in order to promote exports and deter imports.

The goal of a strong dollar at home has guided the US Federal Reserve (Fed) at least since Paul Volcker
crushed inflation in the early 1980s. Although the US does not have a formal inflation target, financial
markets understand that the Fed aims for an inflation rate close to 2%. And, while the law mandates the Fed
to ensure sustainable growth as well as low inflation, monetary officials recognize that sustainable growth
requires price stability.

For decades, US treasury officials have insisted that “a strong dollar is good for America“. But that slogan has
never been a guide to official US action in international markets.

The treasury does not intervene in currency markets to bolster the dollar, and the Fed does not raise interest
rates for that purpose. Instead, the US stresses to foreign governments that an effective global trading
system requires not only the removal of formal trade barriers, but also the absence of policies aimed at
causing currency values that promote large trade surpluses.

In recent years, countries around the world have accumulated very large volumes of foreign exchange,
topped by China with more than $2 trillion, but including hundreds of billions of dollars held by Korea,
Taiwan, Singapore, India and the oil-producing countries.

Most of these funds are now invested in dollar securities. The US dollar is, and will remain, these countries'
major investment currency, reflecting the depth of the US capital market and the relatively favourable
outlook for US government policies.

These large foreign exchange reserves are no longer held to buffer temporary trade imbalances. While some
of the funds serve that purpose and must be held in the most liquid form, most of these large holdings are
investment funds that will be managed to balance risk and return. That means that, over time, these
governments will seek to diversify their portfolios, moving away from the current dominance of dollar
investments.

The euro is now the primary alternative to the dollar. While the turmoil in Europe and the uncertain future of
the euro have caused a pause in the shift from dollars to euros, the rebalancing in favour of euros will
resume at some point in the future. Countries with large reserves are now overweight dollars, and their
effort to balance risks will cause the value of the euro to rise again relative to the dollar. Several other
currencies now have minor shares in those portfolios, and will continue to do so in the future.

The major risk to the sustained role of the dollar is the large and growing US national debt. After varying
between 25% and 50% of gross domestic product (GDP) for the past half-century, the recent budget deficits
have caused the debt to reach 62% of GDP. The official non-partisan Congressional Budget Office predicts
that the policies that now seem most likely could push the debt to 100% of GDP by the end of the decade.
Foreign investors might, therefore, fear that future US administrations will be tempted to reduce the real
value of that debt by allowing a higher inflation rate. But that is unlikely, given the Fed's general anti-
inflationary consensus and the very short average maturity--roughly four years--of the national debt. Higher
inflation would cause the interest rate on new debt to rise in a way that prevents the erosion of the real
value of the total debt.

But foreign investors, who hold nearly half of the US government's debt now--and are likely to hold an even
larger share in the future--could still have reason to worry that the US might someday try to reduce the value
of its debt in a way that adversely affects them but not Americans, or that affects all debt holders but relieves
the foreign-debt burden on American taxpayers. This need not mean outright default; a plan to repay
principal and interest with low-interest securities rather than cash--or to withhold income tax on interest
earned from government bonds, crediting those taxes against the obligations of American taxpayers--would
achieve the same result.

While such policies are extremely unlikely, a fear of such possibilities could cause foreign investors to shun
the dollar. The current policies and those proposed in the government's recent budget would cause the
national debt to rise rapidly, but those policies are not inevitable. The best protection of the dollar's future
role--and of the health of the US economy--will be policies that reduce the growth of the national debt.

©2010/PROJECT SYNDICATE o Martin Feldstein, a professor of economics at Harvard University, was

chairman of s former US president Ronald t Reagan's Council of Economic e Advisors, and is a former
president of the National Bureau for Economic Research. v t Comments are welcome at
feedback@livemint.com The columns that appear in this c issue were commissioned to be f delivered by 19
October.

EUROPE AND THE EURO by Christine Lagarde (Paris)

For anyone living in the 16 euro zone member states, the euro's enduring success is both a technical and an
emotional issue; both hearts and minds are involved. I consider it axiomatic that the euro is vital to Europe
and, indeed, to the world economy.

First of all, it should be recalled that the European idea began as a project for ensuring peace and democracy
among Europe's peoples. When the new currency was introduced in 1999--and even more so when European
citizens had their first opportunity to use it in January 2002--it was experienced as the most tangible, decisive
proof that European integration was a reality. As the slogan goes: euro in your wallet, Europe in your pocket.

Twenty years after the European parliament was elected by universal suffrage in 1979, the introduction of
the euro marked a logical extension of the European dream.

It should also be recalled, however, that when Slovenia entered the euro zone in 2007, many people
suggested that the country was somehow joining “Old Europe“. But Cyprus, Malta and Slovakia have since
followed suit in making the euro their currency. From Dublin on the shore of the Irish Sea to Bratislava in the
foothills of the Carpathians, the same coins and banknotes are legal tender, and they are constantly pushing
back the European Union's (EU) boundaries. Tomorrow will bring additional members, such as Estonia, which
is slated to join the euro zone on 1 January.
Europe's “founding fathers“ were right that “Europe will not be made all at once“, and neither will the euro.
Our common currency should rather be viewed as an inspiring symbol--the symbol of a Europe that is
vibrant, attractive and, above all, cohesive.

Just how cohesive Europe can be is something that we know from the experience of the past few months.
The history of the euro, not surprisingly, has turned out to represent a further stage in the ongoing saga of a
European economy that has been in a state of perpetual construction since the Treaty of Rome.

The financial support provided to Greece; the new European Financial Stability Facility, which we created to
extend guarantees to euro zone member states in need; and our efforts to achieve more effective financial
regulation are among the latest illustrations of European cohesion in practice. Admittedly, the various crises
affecting the euro zone have highlighted--sometimes starkly so--the need to reform our institutions and the
way they operate. It has been argued that Europe's institutions move forward only in times of crisis. Perhaps
the same is true of the single currency, which will derive strength and validation from the challenges that it
overcomes.

In the last few months, as it just barely emerged from the deepest economic and financial crisis in close to a
century, the euro zone experienced the worst jolts in its history, although in terms of public finance, the euro
zone as a whole has fared better than the US or Japan. Once the extent of Greece's financial crisis and the
difficulties encountered by other member states became known, the euro zone economies found themselves
on the brink of disaster.

But the EU reacted swiftly and forcefully, with a support programme for Greece and a financial guarantee
plan for the entire euro zone. In this state of emergency, a genuine European economic government, most
compellingly advocated by German Chancellor Angela Merkel and French President Nicolas Sarkozy, began to
take shape.

Following the European Council meeting in June, France and Germany jointly outlined a number of possible
reforms. Three key points emerged, concerning the need to: l Strengthen the Stability and Growth Pact,
notably through enhanced European coordination during a “European semester“ l Maintain our efforts to
expand the scope of economic surveillance to include government deficits and public as well as private sector
debt, if necessary by imposing “political penalties“ l Establish a credible crisis-resolution framework without
encroaching on the budgetary prerogatives of member states Other possible approaches are under
consideration as well. But what they all share is the recognition that the time has clearly come to stabilize
and institutionalize a European economic government. That process is already well under way. The European
Commission has made proposals, and the working group chaired by European president Herman Van
Rompuy, in which I represent France, will be submitting its own in the fall.

We all expect that the euro, which proved to be such an asset during the crisis, will be just as effective in
getting our economies back on the path to vigorous, sustainable growth. Indeed, according to Eurostat (the
EU's statistical office), by the second quarter of 2010, the euro zone was growing faster than the US, while
the euro remains the second most widely used trading currency. The euro, like the EU itself, is an exciting
adventure that must continue--and we intend to make sure that it does.

©2010/PROJECT SYNDICATE Christine Lagarde is France's minister for the economy, industry and
employment.
A WORLD OF MULTIPLE RESERVE CURRENCIES by Barry Eichengreen (Berkeley, California)

Barry Eichengreen is a professor of economics and political science at the University of California, Berkeley.

Comments are welcome at feedback@livemint.com The competition for reserve currency status is
conventionally portrayed as a winner-take-all game.

There is room, in this view, for just one full-fledged international currency.

The only question is which national currency will capture the role.

Market logic, it is argued, dictates this result. For importers and exporters, quoting prices in the same
currency--say, the dollar--as other importers and exporters avoids confusing one's customers. For central
banks , holding reserves in the same currency as other central banks means holding the most liquid asset.
With everyone else buying, selling and holding dollars, it pays to do the same, since markets in dollar
denominated assets will be the deepest.

While it is always possible that there could come a tipping point at which everyone migrates from one
currency to another, the network based nature of the international monetary system, it is said, leaves room
for only one true international unit.

But this premise is wrong, for three reasons. First, the notion that importers, exporters and bond
underwriters will want to use the same unit as other importers, exporters and bond underwriters holds less
weight in a world where everyone has a mobile phone that can compare currency values in real time. Once
upon a time, comparing prices in dollars and euros might have been beyond the capacity of all but the most
sophisticated traders and investors. Nowadays, “Currency Converter“ is one of the Apple app store's top 10
downloads.

Second, the sheer size of today's global economy means that there is now room for deep and liquid markets
in more than one currency.

Finally, the view that there can be just one international and reserve currency at any point in time is
inconsistent with history. Before 1914, there were three international currencies: the British pound, the
French franc and the German mark. The dollar and the pound then shared international primacy in the 1920s
and 1930s. Today, currencies other than the dollar account for 40% of identified international reserves.

The implication is that the dollar, the euro and the renminbi will share the roles of invoicing currency,
settlement currency and reserve currency in coming years.

To be sure, all three currencies have their critics. Willingness to hold the dollar may be undercut by concern
with America's twin fiscal and external deficits. Uncertainty about whether the European Union will hold
together could limit the use of the euro. And, although China is aggressively promoting international use of
the renminbi in trade settlements, it has a long way to go before its currency is attractive as a vehicle for
foreign investment and holding reserves.

But the very fact that there are questions about all three currencies means that none of them will obviously
dominate. There will be an international market for all three.
Some worry about the stability of this world of multiple international currencies. They shouldn't: a more
decentralized international monetary system is precisely what is needed to prevent a replay of the financial
crisis.

Countries seeking additional reserves will not be forced to accumulate only--or even mainly--dollars. No one
country will be able to run current account deficits and use foreign finance to indulge in financial excesses as
freely as the US did in recent years. This will make the world a safer place financially.

Will exchange rates between the major currencies be dangerously unstable? Will those responsible for
managing central bank reserves, seeking to maximize returns, shift erratically between those currencies?

The fear underlying such questions rests on a misunderstanding of the behaviour of central banks' reserve
managers. Reserve managers do not have the high-powered financial incentives of hedge fund managers to
seek to maximize returns. They do not have to exceed their previous high-water mark in order to draw a
paycheque. They have social responsibilities, and they know it.

This means that they have less incentive to herd--to buy or sell a currency just because everyone else is
buying or selling it. They can adopt a longer time horizon, because, unlike private fund managers, they do not
have to satisfy impatient investors.

Compared with private investors, then, central bank reserve managers are more likely to act as stabilizing
speculators. The result will be to make the exchange rates between the three international currencies more
stable, not less.

The world economy of the 21st century is becoming more multipolar. There is no reason why the same
should not be true of its international monetary system. In the end, that will be a good thing.

A STERLING QUESTION by Howard Davies

On 16 September 1992, a date that lives in infamy in the UK as “Black Wednesday“, the Bank of England
abandoned efforts to keep the pound within its permitted band in the European exchange rate mechanism.
Supporting the pound at the required exchange rate had proved prohibitively expensive for the bank and the
government. by contrast, it proved highly remunerative for George Soros.

Since then, the Bank of England has eschewed all forms of intervention in the foreign exchange markets. And
the episode served to reinforce an international consensus that monetary policy should focus on domestic
price stability while letting exchange rates float freely.

After Black Wednesday, it became conventional wisdom that it was impossible to fix both the exchange rate
and domestic monetary conditions at the same time. According to this view, in a market economy with a
convertible currency and free capital flows, the rate cannot be manipulated without consequent adjustments
to other dimensions. Seeking to influence exchange rates using capital controls or direct intervention in
currency markets were doomed to failure in anything other than the shortest term. This consensus has been
maintained through a long period in which exchange rates between the major Western currencies have been
allowed to find their own level. But it did not extend to Asia.
The Asian financial crisis of 1997-1998 convinced governments and central banks that countries that
maintained exchange controls were able to weather the storm better than countries that embraced
liberalization. It was accepted that maintaining controls required a high level of reserves. So, in much of Asia,
we have seen fixed exchange rates for the last decade or more, the maintenance of some controls on capital
flows, and a massive increase in reserves. The authorities have tolerated a somewhat greater volatility in
domestic inflation rates as a consequence.

There are now signs that the consensus reigning in Western central banks for the last two decades is being
challenged. Some economists have begun to argue central banks need not be so wary of intervening.

For example, Paul De Grauwe of the University of Leuven has proposed that the European Central Bank
intervene when exchange rate developments are out of touch with reality, in order to send a signal to the
markets. He points to the high volatility of the dollar-euro rate over the last decade, and its adverse
consequences for Europe.

Politicians, too, are concerned. French President Nicolas Sarkozy has regularly complained about the
damaging consequences of excess currency volatility, and has called for exchange rates and international
monetary conditions to be at the top of the Group of 20 (G-20) agenda when France assumes the group's
presidency this November. Sarkozy's rhetoric suggests that he hankers after new international agreements
on exchange rates, and, indeed, perhaps a new global reserve currency.

There have been actions, too, as well as words. Beginning in March 2009, the Swiss National Bank became
the first Western central bank in years to seek to influence its currency's exchange rate through intervention.
The Swiss were concerned about the franc's rise, especially against the euro, and intervened heavily in an
attempt to hold it down.

It is always difficult, even after the event, to decide how effective an intervention strategy has been. But the
Swiss reported losses of 14 billion francs in the first half of 2010, without succeeding in stemming exchange
rate appreciation. This episode, which other central banks watched with great interest, tended to reinforce
the views of those who are skeptical of monetary authorities' ability to manage exchange rates.

So where does this leave us? No doubt the debate will continue. The underlying problem remains that, while
both central banks and finance ministries are unhappy about the excessive volatility of real and nominal
exchange rates, they do not understand very well what causes it.

They may think that, in the long run, parities will reflect developments in relative unit labour costs. But the
long run can be long indeed, and the influence of speculative capital flows can be substantial and sustained.

Intervention skeptics, therefore, remain the strong majority. While they recognize Asia's experience has been
rather different, they tend to attribute that to dissimilar capital markets. They acknowledge that in some
circumstances intervention, or at least the readiness to intervene may be effective, but only if a number of
associated conditions are met.

In particular, a country planning to intervene must demonstrate it has an intimidating stockpile of foreign
exchange reserves, and the readiness to use it. There must also be a strong political commitment to
intervention, and an explicit willingness to accept the consequences for domestic monetary conditions,
which may involve an inflation rate that is higher or lower than desired, perhaps for some time. And it is
likely that there will be a need for exchange controls, certainly on short-term capital flows, whether
permanently or from time to time.

These conditions do not typically apply in Western countries. The Swiss have large reserves, but are so
interlinked with global capital markets that exchange controls are not a realistic option. Most other Western
countries, certainly the US and the UK, are in no position to invest heavily to maintain a particular exchange
rate. The London markets have waited 18 long years already for the Bank of England to appear on their
screens, and I suspect their wait will continue for some time yet.

©2010/PROJECT SYNDICATE Howard Davies, a former deputy governor of the Bank of England, is director of
the London School of Economics.

His latest book, co-authored with David Green, is Banking on the Future: The Fall and Rise of Central Banking.

Dakar - AFRICA'S MISPLACED MONETARY AMBITIONS by Sanou Mbaye

Sub-Saharan African is in the grip of currency union mania. Region- al groups of countries in eastern,
southern and western Africa are all giving priority to the idea of creating a monetary union. But haven't we
heard this all before in Africa? Indeed, today's enthusiasm for currency unions ignores the poor track record
of previous attempts on the continent to establish them through peaceful means. A common currency
requires unified and centrally agreed monetary and fiscal policies. But this necessitates political integration,
which, as the troubles of the euro this year have demonstrated, is a hard sell among nation-states.

Before the euro's arrival on the international financial scene in 1999, the only examples of countries with
common currencies were neo-colonial francophone Africa and 19th century precedents such as the Latin
American and Scandinavian monetary unions. The creation of the CFA franc, which gives France control of
65% of the CFA countries' foreign exchange reserves, combined currency convertibility with a grossly
overvalued parity--pegged first to the French franc and now to the euro--as well as trade barriers. This led
only to structural deficits, vast capital flight, and, in 1994, a 100% devaluation.

Yet, despite the difficulties that have bedevilled the CFA (and the euro of late)--indeed, despite the absence
of viable regional customs unions (except in the East African Community), let alone a single market--Africans
retain a strong allegiance to the idea of a currency union.

That allegiance is misplaced. At this stage of their economic development, with its focus on commodity
exports, the priority for Africa's countries should be long-term economic integration, not currency unions.
Here, the model to follow is not the euro, but Latin America's Southern Common Market (Mercosur) and the
Association of Southeast Asian Nations (Asean). Both regional groupings have, by lowering trade barriers,
delivered a real catalyst to economic growth.

Mercosur's member countries have adopted a strategy that prioritizes the creation of a free trade area. They
steered clear of establishing a heavy budget-fuelled bureaucracy, leaving respective ministries to handle
administering the accord. In 2008, Mercosur intra- regional exports reached $41.6 billion, up by 28.4% from
2007. The external trade of Paraguay, Argentina and Brazil within the area amounted, respectively, to 65%,
33% and 15% of their total exports.
The other major advantage of such regional groupings has been their ability to attract foreign direct
investment (FDI). Since the early 1990s, Mercosur has managed to mobilize 5.9% of world FDI in- flows. In
2008, it attracted a record $56 billion in FDI, an increase of 31.5% from 2007. Moreover, cross-investment
between Mercosur member countries has led to greater economic integration. Argentina is now Brazil's
second largest trading partner, behind the US, while Brazil is Argentina's largest trading partner, ahead of the
US.

The seven member countries of Asean decided to implement economic “road maps“ defining integration
priorities, a testimony to their determination to achieve a single economic community. A currency union,
however, is not high on the agenda. In 2009, Asean regional trade represented 24.6% of its members' total
exports and 24.3% of total imports.

by contrast, trade among African countries accounts for only about 10-12% of the continent's exports and
imports. But, partly because several African countries have escaped the hangover from the global credit
crisis, more investors are focusing on business opportunities there. by 2050, the combined gross domestic
product of the largest 11 African economies should reach more than $13 trillion, surpassing Brazil and Russia
(but not China or India).

For some analysts, the emergence of countries such as Brazil as economic powerhouses stems partly from
successful demutualization of their stock exchanges. Twenty-three bourses are currently operating in Africa,
and their combined market capitalization has soared from $245 billion in 2002 to $1 trillion (2% of the world
total) at the end of 2009--as high as the 15th largest stock exchange in the world. With a volume of $800
billion, the Johannesburg Stock Exchange alone accounts for 80% of the total and ranks 19th worldwide.
Nigeria plans to demutualize its stock exchange in order to establish it among the prime destinations for
frontier investors.

Africa stands to benefit from a massive economic turn- around, provided that the right environment for
sustainable growth and rising productivity is created. This requires consistent macroeconomic policies
focused on economic integration, food self-sufficiency, low inflation and reduced debt. It also requires
political stability, eradication of corruption, enhanced rule of law, improvement of basic levels of education
and greater use of mobile telephones and the Internet.

What it does not require is a currency union. When it comes to exchange rates, the members of Africa's
economic groupings would be better off linking their currencies in regional monetary systems to prevent
large fluctuations relative to one another.

THE CARRY TRADE CARRIES ON by Hans-Joerg Rudloff & Paul Robinson

The Bank for International Settlements recently reported that $4 trillion a day is traded in global foreign
exchange (forex) markets, up from $3.3 trillion in 2007. But, while the size of the forex business always grabs
head- lines, the way that currencies are traded also matters--and this has evolved mightily over the years.

Any introductory finance textbook will tell you that investors care about the returns of their overall portfolio,
not just its individual assets. Investors prize assets that are relatively uncorrelated, or even better, negatively
correlated with the returns of the market as a whole. Owning such assets tends to stabilize overall re- turns.
That is fine in theory, but where do such assets come from? Some stock prices are normally relatively
uncorrelated with the market.

But stock prices tend to move much more closely together at times of market dislocation. So the relationship
is liable to go wrong at the worst possible time: when a hedge would be most useful, the asset you were
relying on becomes a risk.

Many financial derivatives were developed for exactly this reason--to allow both financial and non-financial
companies to hedge their overall returns. But not all investors are able to trade derivatives.

Partly for these reasons, using currencies to hedge overall portfolios, or to have exposures that are related to
other asset markets, has be- come increasingly popular. Forex markets have two important advantages in
this respect. First, forex is all about relative prices--if the dollar appreciates, some other currency must
depreciate. So it offers natural hedges.

Second, forex markets are very liquid. Even during the worst of the recent financial crisis, when many
markets almost stopped functioning, the forex market carried on relatively normally.

Some of the more important examples of how currencies have be- come hedges involve the yen. Japanese
interest rates have been close to zero for many years--significantly lower than those in most other
economies, especially in the pre-crisis period. Low Japanese rates led to a “search for yield“ by Japanese
investors who increasingly invested their savings in foreign currencies, where they received higher interest
rates: the famous “forex carry trade“.

This was not without risk. What matters to Japanese investors is the overall return in yen terms, not simply
the difference in interest rates. If the yen were to appreciate against the currency where the money was
invested, it would be possible to get a lower return than simply keeping the money in a Japanese bank
account. Indeed, economic theory suggests that the interest rate differential should be offset on average by
depreciation of the currency with the higher interest rate, the differential thus reflecting the compensation
required by investors to hold money in relatively risky currencies.

But the carry trade has tended to produce positive returns. And in the period prior to the financial crisis, the
yen depreciated against most currencies, as well as having lower interest rates, so borrowing in yen and
investing in high-interest-rate currencies such as the Australian dollar or the Turkish lira was very profitable.
This led to increased flows into the carry trade, which for a while increased its success, because higher
inflows tended to exacerbate the weakness of the low-interest- rate currencies.

The carry trade during this period was primarily aimed at maximizing returns rather than managing risks. But
it did lead to two developments in risk management.

First, whereas in equity markets, few advocate investing in just one company's shares rather than a
diversified portfolio, that is essentially what happened in forex markets, where the traditional way of
investing in the carry trade was to use a single exchange rate. So products were developed that allowed
investors to borrow easily in several currencies at once and invest in a portfolio of high-interest-rate
currencies. This protected investors from a general sell-off of the carry trade and lessened their exposure to
idiosyncratic risks.
The second development was that the carry trade appeared to per- form strongly when other risky assets
also did well, and vice versa.

More specifically, exchange rates such as the Australian dollar-yen be- came strongly correlated with global
equity markets. This meant that an investor who was pessimistic about equities, but who might face
constraints in hedging that risk by using derivatives or selling equities short, could reduce his exposure to
equity markets by reversing the carry trade--borrowing in Australian dollars and investing in Japanese yen,
for example.

Of course, a good hedge lasts only as long as such correlations persist. But, while many financial relationships
broke down once the financial crisis started, this one actually became more pronounced, and has become a
popular strategy.

The relationship between the Chinese economy and the Australian dollar is another interesting example.
Chinese growth has been stellar, but many investors find it difficult to put their money directly in the
economy. Australia has been a particularly large beneficiary of Chinese growth, which is relatively
commodity-intensive. This has tended to in- crease metals prices, fuelling Australia's large export surplus in
metals.

That means that buying the Australian dollar is seen as a proxy for in- vesting in China. Because it is traded in
developed and liquid markets that have no capital account restrictions, many investors have bought or sold it
according to their view of China's economic prospects.

Investment strategies such as this must be entered into with caution: simply assuming that a past correlation
will persist is never a good idea.

But currency values are driven by macroeconomic developments, and therefore forex does offer natural
hedging opportunities in liquid and transparent markets. So if the correlation makes sense given the
fundamentals, it seems sensible to bet on its persistence. And it does seem likely that such strategies will
continue.

A STATE OF CONFLICT by Vijay Joshi

The basic issue concerns what is known in international economics as the (N-1) theorem.

This states that if there are N currencies, there can be, at most, (N-1) independent exchange rates. Suppose
there are only two countries, each with its own currency.

Then it is easy to see that the number of independent exchange rates can be zero or one but not two. The
first case corresponds to a float: neither country has an exchange rate target. In the second case, one of the
countries sets the exchange rate and the other is passive. The third and impossible case is where each
country wants to set the exchange rate at a different target level. In this case, there is conflict. The (N-1)
theorem simply extends this reasoning to N countries and much of the history of exchange rate regimes
concerns how the (N-1) problem is resolved. An obvious case in point is the breakdown of the post-war
Bretton Woods system in 1971. De facto, this system was a dollar standard. Each country fixed its ex- change
rate to the dollar and could change the rate if it chose to do so. The US was the passive Nth country. The
system broke down when the US wanted to alter its exchange rate. This meant the other countries giving up
their exchange rate targets, which they were reluctant to do. In the ensuing struggle the US succeeded, as it
was bound to, but only by breaking up the system.

The (N-1) theorem can be applied to any group of countries. Its relevance is sharpened if we apply it to the
group of large, key countries such as the US, the euro zone, China and Japan. A small country's choice of
exchange rate regime does not matter to other countries. Not so with a key country. Its exchange rate
arrangements and policies affect many other countries. So if the key countries have conflicting or
inappropriate exchange rate targets, this matters for global stability. The contemporary relevance of this
proposition is evident. The US is suffering from a shortage of aggregate demand and is likely to engineer a
further monetary expansion, which will depreciate the dollar. China is reluctant to see its exchange rate
appreciate because that would hurt its export industries, so it is likely to intervene in the foreign exchange
market to prevent the appreciation.

But this means the euro and the yen will appreciate a lot more than they would otherwise. That is the last
thing Europe and Japan need right now since they too are in a recession. Many emerging and developing
countries also fear that capital inflows generated by looser monetary policy in the US will appreciate their
currencies and cause an unwelcome decline in their international competitiveness, all the more so if China
refuses to let its exchange rate take some of the strain. Not surprisingly, several countries in Asia and Latin
America have already taken steps to restrict capital movements. Plainly, the probability of a disorderly
outcome of competitive devaluations, trade protection and capital controls has in- creased significantly.

Why has the world ended up in this quandary? The reason is that since the collapse of Bretton Woods, we do
not have anything that can be called an exchange rate “system“. An effort to devise one was made in the
1970s but was given up. The amendment of the IMF Articles that was agreed in 1978 established the
principle of freedom of choice in exchange rate arrangements. (The amendment also for- bade “exchange
rate manipulation“, but the term was never clearly defined and the provision became a dead letter.) This
ushered in a free-for-all based on the idea that each country should adopt any exchange rate regime that
best suits its goals and circumstances. As we saw above, from the global standpoint, this is a crazy idea,
especially when pursued by the key countries. And it will become crazier as the number of key countries
(India, Brazil, etc.) increases in the coming decades. To prevent global monetary chaos, key countries must
agree on a common exchange rate system. Only small and mi- nor countries can be allowed the luxury of
unconstrained freedom of choice.

Agreement on a system for key currencies, and on how to get there, will not be easy and will take time. A
necessary first step is agreement on the final objective. What should be the eventual shape of an ex- change-
rate system for key currencies? All alternatives have their disadvantages. A fixed exchange-rate regime would
imply a loss of monetary autonomy. It would imply adjusting to asymmetric shocks by internal wage and
price changes. That would be inefficient as well as in- tolerable. (The current strains in the euro zone
exemplify the costs of such a regime.) For the key countries, this would be a political non- starter. Another
alternative is to adopt clean floating. But this too is unlikely to be acceptable, because governments regard
the exchange rate as too important a price to be left entirely to the mercy of market forces. Unmanaged
floating can sometimes lead to exchange rate behaviour that is manifestly insane, for example, the US dollar
bubble in the mid-1980s. Many intermediate regimes can also be ruled out as unworkable. For example, a
return to Bretton Woods-style adjustable pegs would be incompatible with today's high capital mobility.
In my opinion, there is only one option that has the potential to be desirable as well as eventually acceptable.
Key countries should agree to float but with one major proviso. This is that they periodically agree on
reference exchange rates that are appropriate for international adjustment, intervention being allowed only
if it is undertaken to influence market exchange rates in the direction of reference rates. Such a scheme
would require regular dialogue between the key countries, along with some macroeconomic policy
cooperation and some willingness to abide by the rules. These are not easy requirements to satisfy, and
many details would have to be sorted out. But the impetus for agreement could come from the realization
that the status quo is clearly a recipe for disaster. Vijay Joshi is a Fellow of St John's College, Oxford, and an
Emeritus Fellow of Merton College, Oxford.

THE LATIN EXPERIMENT by Mario I. Blejer

In all cases, however, exchange rate policies have played a central role in determining these countries' overall
macroeconomic results. And today, after two turbulent decades, they seem to be converging towards a more
unified and sustainable framework.

The 1980s was a harrowing decade for most Latin American countries. The second oil shock and high
international interest rates, coupled with a lack of foreign investment, led to significant internal and external
imbalances and high levels of foreign debt. In all the major countries, this resulted in defaults, significant and
continuous exchange rate adjustments, and, by the end of the decade, a severe inflation/devaluation spiral,
bordering, in some cases, on hyperinflation.

These traumatic events set the stage for Latin America's two-decade-long currency roller coaster. That
experience was marked by the attempt to use a fixed exchange rate regime as the main policy instrument to
control inflation; that attempt's colossal failure; and the shift, over the last decade, to more flexible regimes,
freeing the exchange rate from playing a central role in controlling inflation, but not necessarily allowing a
pure float in world currency markets.

At the beginning of the 1990s, with inflation rampant, the three largest Latin American countries decided to
use the exchange rate as the centre piece of their stabilization strategies. Given that inter- national capital
flows had restarted, they did not fear immediate external constraints.

Argentina adopted the hardest peg, introducing a quasi-currency board and fixing the exchange rate by law.
Mexico and Brazil also put in place fixed exchange rates as part of broader reform policies.

The result of these experiments reminds one of the rueful saying: The operation was a success, but the
patient died. Inflation did, in- deed, come down; but the real exchange rate rapidly became over- valued.
This, together with external shocks and severe recessions, made fixed exchange rate regimes untenable, first
in Mexico, later in Brazil, and then, spectacularly, in Argentina.

During the same period, other Latin American countries, particularly Colombia and Chile, adopted an
alternative strategy. Their inflation was lower, and they oriented their policies towards maintaining a
competitive exchange rate through the adoption of a so- called “crawling band“, whereby the currency is
allowed to fluctuate within a band around a central parity.
Both countries managed to reduce inflation gradually while maintaining economic growth. Their greater
currency flexibility, however, did not prevent the recessionary impact of the Asian and Russian cri- ses of
1997-98, and Colombia did experience a financial crisis in 1999.

The collapse of Latin America's currency pegs in the financial crises of the 1990s contributed to a shift in the
world's currency paradigm. Coming from different experiences, most countries converged on the adoption of
a floating exchange rate, many in the context of inflation targeting.

But what most characterizes Latin America's experience is that, despite publicly preaching the virtues of a
floating rate, the authorities actively intervene in currency markets, this time in different and creative ways.
Thus, the exchange rate regime in Latin America to- day is one of actively managed floating.

During the first part of the decade, intervention was motivated by a desire to avoid devaluation, and
therefore to support the inflation- targeting objectives. However, in later periods the objective was to avoid
real exchange rate appreciation, and, at the same time, to ac- cumulate international reserves and
strengthen credibility.

One important lesson from Latin America's journey concerns the futility of relying on the exchange rate
regime as the main stabilization instrument. Inflation is too stubborn to be tackled without a coordinated set
of fiscal and monetary policies. Anchoring the exchange rate is likely to result in disproportionate real
appreciation, loss of competitiveness, external and financial crises, and disastrous recessions.

A second lesson is the importance of flexibility. In the 1990s, when hard pegs were in vogue, it was believed
that flexibility reduced credibility. Yet, in the end, credibility collapsed because of the lack of flexibility. Now,
in a low-inflation environment, flexibility is properly regarded as an important tool to avoid misalignments
and to shield economies from external shocks.

But flexibility is not a synonym for “pure“ floating. In a highly integrated world of highly volatile prices and
volumes, flexibility also implies the capacity to intervene and actively manage the exchange rate.

Indeed, a third lesson is that neither hard pegs nor unfettered floating facilitates the preservation of a
competitive real exchange rate, which is crucial to promoting and sustaining economic development.

Managing a floating rate has also allowed Latin American countries to accumulate a significant level of
international reserves. De- spite advice to the contrary, this has been highly stabilizing. There is little doubt
that substantial foreign reserves, together with the flexibility to float and intervene, have mitigated the
impact of the recent crisis on Latin America, and contributed to its emergence as one of the best-performing
regions in an era of deep uncertainty elsewhere. Mario I. Blejer is a former governor of the Central Bank of
Argentina.

DOLLAR DIPLOMACY AND JAPAN'S LOST DECADES by Takatoshi Ito

A spectre is haunting China's exchange rate regime: the long-running dispute between the US and Japan
throughout the 1980s and early 1990s over the value of the yen. That dispute ended only when Ja- pan's
economy entered its “lost decades“, which has made the Chinese determined not to repeat the experience.
Of course, history--particularly financial history--never repeats itself exactly. But the arguments being heard
about the renminbi today certainly give rise, at least for Japanese, to a strong sense of déjà vu.

Now, as then, the US Congress is the focal point of American anger. Today, it is preparing retaliatory
legislation against China in response to pressure from many in the US who argue that an artificially weak
renminbi is contributing to global imbalances, in particular to the US' massive bilateral trade deficit. They are
also frustrated that the US treasury has not “named and shamed” China by designating it a currency
manipulator.

But, based on Japan's experience, the Chinese do seem to have good reasons to be wary of US pressure to
revalue the renminbi. Indeed, the economists Ronald McKinnon and Kenichi Ohno have singled out US
pressure for yen appreciation as a key source of the Japanese economy's long- term deflation and stagnation-
-the so-called “lost decade“ of economic malaise that is now well into its second.

The US and China have engaged simultaneously in dispute and dialogue for several years--again reminiscent
of what Japan went through with the US in the 1980s and 1990s. Just as China has its “Strategic Dialogue“
with the US, so Japan had the “Structural Impediments Initiative“ (1989-1990) and “Framework Talks“ (1993-
1995).

And for China now, as for Japan then, the undercurrent for these discussions is US frustration with bilateral
current account deficits. Both structural factors and the exchange rate are discussed.

But the weight given to the exchange rate is higher today in the US-China dispute, because, where- as Japan
had a “managed float“ exchange rate regime in the 1980s and 1990s, the Chinese exercise much tighter
control over the renminbi.

Chinese officials agonize over the US pressure. If they yield to it, the Chinese economy, they argue, may fall
into the same deflationary trap that ensnared Japan after the yen's appreciation in the 1980s--under US
pressure--inflated a catastrophic asset-price bubble. But if they continue to resist, China may face hot trade
disputes with the US, which could be even messier.

Like Japan in the 1980s, China must defend itself from US claims that the renminbi's weakness is the source
of the imbalances between the two countries. Currency appreciation, Japan argued then and China argues
now, is unlikely to result in a significant current account adjustment, which requires addressing not only
China's high savings rate, but also low savings in the US.

How the situation will develop in the near future can be gleaned from the recent past. China instituted a
flexible exchange rate from July 2005 to the summer of 2008, and the renminbi gradually appreciated against
the dollar--cumulatively by more than 20%. Whereas the peg to the dollar was resumed during the global
financial crisis, in June China announced a return to flexibility. The renminbi fluctuated without a clear trend
until mid-September, when it appreciated sharply, apparently in response to increased US pressure
stemming from the impending Congressional vote.

In one respect, then, the dispute appears set to follow a path similar to the US-Japan case. It will be
prolonged and occasionally very tense, but eventually result in appreciation of the renminbi.
But there is a crucial distinction to be made between the two cases: Japan needs the US to ensure its
security, while China does not. Moreover, the size of China's economy will surpass that of the US in about 15
years. So time is on China's side.

But there is a more fundamental issue: the Chinese authorities, in arguing that it was a mistake to allow the
yen to appreciate, may be misinterpreting what happened in Japan--and thus overestimating the risk posed
by currency appreciation.

For Chinese officials who believe that yen appreciation was the source of Japan's chronic economic malaise,
the Plaza Accord of September 1985--a concerted effort by the US, the UK, France, West Germany, and Japan
to depreciate the dollar--is Exhibit A. The yen soared from 240 to $1 in September 1985 to 200 to $1 the
following December.

The real dilemma for Japan arrived in March 1986, when the yen neared its then record high, 178 to $1.
Japan responded by intervening in the opposite direction--dropping interest rates, selling yen, and buying
dollars. That proved decisive. Keeping interest rates low discouraged capital inflows and encouraged asset-
price inflation.

The ensuing bubble in Japanese housing and equity prices inflated and burst not because Japan succumbed
to US pressure to allow the yen to appreciate, but because Japan, in the end, resisted that pressure. So, if
China is to draw the correct lesson from the Japanese experience, it must know what really happened in
Japan back then.

What China should be carefully watching is whether there are signs of overheating in the domestic economy,
and whether asset prices are rising sharply. Allowing the renminbi to appreciate would be a good way to
prevent both.

©2010/PROJECT SYNDICATE Takatoshi Ito, a former deputy vice-minister of finance for international affairs
in Japan, is a professor of economics at the University of Tokyo.

CHINA DILEMMA by Yu Yongding (Beijing)

In June, the People's Bank of China (PBC), China's central bank, announced an end to the renminbi's 23-
month-old peg to the dollar and a return to the pre-crisis exchange rate regime adopted in July 2005. So far,
however, the renminbi's appreciation against the dollar has been slow. Will the pace of appreciation
accelerate enough to satisfy American demands? If it does, will global imbalances disappear sooner?

It is hard to argue that the renminbi is not undervalued, given China's large and persistent current account
and capital account surpluses. But, despite ending the dollar peg, faster appreciation of the renminbi seems
unlikely for the foreseeable future.

China's official position is that, to avoid the negative impact of a stronger renminbi on China's exports and
hence employment, appreciation must proceed in an autonomous, gradual and controllable manner. The
current exchange rate regime, which links the renminbi to a basket of currencies, was designed to give the
PBC leeway to control the pace of renminbi appreciation, while creating two- way fluctuations in the
exchange rate against the US dollar in order to discourage speculators from making one-way bets on the
renminbi.
Renminbi appreciation should have started earlier and at a faster pace, when China's trade surplus was much
smaller and its growth was much less dependent on exports. Delay has made current ac- count rebalancing
via renminbi appreciation costly. And now China faces a dilemma.

As a result of the global financial crisis, China's export growth in 2009 dropped by 34% compared with 2008.
In the first seven months of 2010, China's trade surplus was $84 billion, down 21.2% from January-July 2009.
This large, steady fall in the country's trade surplus makes the Chinese government hesitant to allow the
renminbi to appreciate significantly, for fear of the lagged impact on the trade balance.

But the PBC is also reluctant to buy dollars constantly. The PBC knows that rapid deterioration in America's
fiscal position and continual worsening in its external balance may create an irresistible temptation for the
US to inflate away its debt burden. The more the PBC intervenes, the larger the national welfare losses that
China may suffer in the future. The Chinese government must therefore strike a balance between protecting
China's export sector and preserving its national welfare.

The dilemma that officials face is that the impact of a fall in exports as a result of renminbi appreciation will
be felt acutely and immediately, whereas the large welfare losses due to the evaporation of the value of
China's foreign exchange reserves will be borne by society as a whole--but not immediately.

Moreover, the increase in China's overall price level--and wage levels in particular--has caused the renminbi
to strengthen steadily in real terms, reducing (to a certain extent) the need for nominal renminbi
appreciation. True, commerce ministry officials recently declared their wish to see a further fall of China's
trade surplus in 2010.

But renminbi appreciation is not the preferred instrument for achieving this goal. Thus, nothing dramatic will
happen to the renminbi ex- change rate in the near term--unless something dramatic happens.

At the same time, the effect of currency appreciation on the trade balance should not be exaggerated. The
renminbi appreciated by 18.6% in real effective terms, and by 16% in dollar terms, from June 2005 to August
2008. Yet, from 2006 to 2008, China's annual exports grew 23.4%, outpacing import growth of 19.7%.

Exchange rates are just one of many factors that affect trade balances. For China's, the income effect of
global demand is significantly larger than the price effect of the exchange rate. The fall in China's trade
surplus since late 2008 is attributable mainly to the global slowdown and the stimulus package introduced by
the Chinese government, rather than to changes in the renminbi's ex- change rate.

But if the renminbi is allowed to float, isn't a balanced trade ac- count likely? Probably not. With a fast-rising
renminbi, net capital outflows will increase, which is what Japan experienced after the Plaza Accord of 1985
pushed the yen upward. As a result, balance-of- payments equilibrium would be reached at a certain
exchange rate level, but a current account surplus (albeit smaller) would still exist.

America should not pin too much hope on a weakening dollar to correct its trade imbalances. For the US, the
fundamental cause of imbalances is not a strong dollar, but America's over-consumption and over-
borrowing. A strengthening dollar would worsen the US trade balance, but a weakening dollar could cause
panic in capital markets, which might push up risk premia on dollar-denominated assets, including US
government securities, in turn leading to an economic slowdown and a further weakening of the dollar.
Of course, renminbi appreciation may displace Chinese goods sold in the US. But if the US fails to narrow its
savings gap, its cur- rent account deficit will not disappear, regardless of where the dollar goes. Whether
America can achieve decent growth while keeping its current account deficit in check depends on whether it
can reinvigorate its ability to innovate and create, thereby restoring competitiveness and creating demand at
the same time.

For both China and the US, the renminbi-dollar exchange rate is important for achieving growth and a more
balanced current ac- count. But that dual objective requires structural change in the Chinese and US
economies.

©2010/PROJECT SYNDICATE Yu Yongding, president of the China Society of World Economics, is a former
member of the monetary policy committee of the People's Bank of China, and a former director of the
Institute of World Economics and Politics at the Chinese Academy of Social Sciences.

FOR A FEW DOLLARS LESS by Jahangir Aziz (Mumbai)

It's déjà vu all over again. Emerging market economies are once again flooded with capital inflows, struggling
to resist currency appreciation, and threatened with asset price surges. And in some emerging market
economies, such as Brazil and India, things are further complicated by inflationary pressures. Most major
emerging markets, barring India, have responded with large- scale interventions in foreign exchange markets
and intensification of capital controls.

That something like this would happen has been on the cards since earlier this year. Emerging markets have
led the current recovery, and the growth differential with developed economies is likely to widen. If any of
the developed market funds intend to recoup their losses in the crisis, increasing exposure to emerging
market assets has to hap- pen. What held them back were concerns of another October 2008 style liquidity
and redemption squeeze hitting them. The probability of such a situation arising in the near term has now
been significantly lowered: first by the ECBs liquidity support for peripheral European debt, and then, more
recently, by the US Federal Reserve announcing a second round of quantitative easing; these assurances
opened the flood gates of capital inflows into emerging markets since September.

While the currency appreciation and asset price surge are problematic, the concern that the inflows could
reverse may be over- blown. Whenever inflows come in such large magnitude, there is bound to be some
froth and some speculative flows. Some countries, such as Brazil and Korea, may be under more severe
speculative inflows than others, but, by and large, much of these flows are driven by portfolio rebalancing in
developed markets rather than currency speculation or just interest rate differentials.

This raises two issues. First, the rebalancing will continue and with that the inflows. Second--and this is the
real problem--while the rebalancing exercise from the developed market perspective is a small portfolio shift,
it will create tidal waves in emerging economies given their much smaller market size. This situation
unfortunately isn't going to change soon. So as long as the rebalancing goes on, the tidal wave will keep
pounding emerging markets.

Tweaking capital controls is not going to slow the pace of inflows as recent experience shows. These flows
aren't seeking short-term interest differential or appreciation gains. They are driven by portfolio rebalancing
and unless there are liquidity or redemption pressures in developed markets, these flows will continue. Any
substantial quantitative easing by the Fed will only reinforce that redemption pressures are unlikely to re-
emerge any time soon, thereby speeding up the rebalancing.

The other policy response, namely large-scale intervention to pre- vent the currency from appreciating, is far
less benign. Capital controls at worst will be ineffective. Interventions on the other hand run the real risk of
raising the expectations of future appreciation, there- by inviting speculative flows, adding to the already
large rebalancing related flows. And it is this nightmare that emerging markets need to avoid. Letting the
exchange rate be the shock absorber, while painful to the real economy, has been an effective way to pre-
vent speculative attacks. Can't recall the last time a floating currency was targeted by speculators.

Clearly, sudden and large appreciations are disruptive and can potentially harm the real economy. And this
has been the argument used to justify large-scale interventions. But the problem is that these countries have
not really let the exchange rate appreciate in any material manner when inflows were milder. Consequently,
when inflows surge, the size of potential currency adjustment looks scary and is intervened away. In this
regard, the Reserve Bank of India's exchange rate policy over the last 18 months has been very sensible by
letting the exchange rate absorb modest capital volatility, setting aside interventions to combat more volatile
flows.

But there is a much bigger problem: the dreaded global imbalances. With an ageing population, high fiscal
deficit, and thus low savings, developed markets will be short of savings for a long time. And emerging
markets will have to run current account surpluses and supply their excess savings to fund the developed
markets' saving shortage. Thus global imbalances are likely to remain. The issue is whether these imbalances
remain modest or blow up, threatening another disruptive adjustment in asset and foreign exchange
markets. While umpteen combinations of policy options have been suggested in the last five years, ultimately
all the potential solutions re- quire growth sacrifice on both sides. Developed markets need to consolidate
their fiscal deficits much more quickly, which will re- duce demand in their economies and, with that, growth.
Emerging markets need to let their exchange rate appreciate more markedly, which will also lower some
growth in their economies. These are not new options. The problem lies in coordinating such policy moves.

And at the heart of it lies an old problem in economics: the inability to credibly commit to policies that are
temporally inconsistent. The exchange rate adjustment is needed upfront, the fiscal consolidation, by its very
nature, is a medium-term promise. And someone will need to step up and break this impasse. Jahangir Aziz is
India chief economist at JPMorgan Chase.

STOOPING TO CONQUER by Ashok K. Lahiri

Currency markets are in the doldrums. Since April 2010, the yen has appreciated by about 12% against the
dollar. For the first time in six years, Japan unilaterally intervened in the exchange market in September
drawing adverse reactions from the US and Europe.

In China, after the June decision of allowing more rate flexibility, the renminbi has nominally appreciated
against the dollar by about 2% as of early October. Active foreign exchange purchases held the renminbi
down, while reserves surged by $194 billion in the third quarter to a record $2.65 trillion. Fred Bergsten,
director of the Peterson Institute, thinks the renminbi is under- valued by between “[at least] 25 and 40%“.
The rapid yen appreciation coincided with the deployment of a part of Chinese reserves in yen. Some allege
that intervention to hold the renminbi down is distorting the global currency system by forcing other
emerging economies to intervene and undermining recovery.

India, Indonesia, Malaysia and Thailand have experienced the strongest real effective exchange rate
appreciations so far in 2010, and their currencies were close to 10-year highs in August. In Brazil, in spite of
interventions that have pushed foreign reserves up 18% this year to a record over $280 billion, the real has
gained 38% since the end of 2008. Goldman Sachs says that the real is the most over-valued currency in the
world.

Brazilian finance minister Guido Mantega last month declared that the world was in the midst of a “currency
war“. Some suggest that the large and growing Chinese reserves hangs like “a target around the neck of
China's exchange rate regime“. War or no war, there is palpable war-like un- certainty. Will the uncertainty
reduce by November with the Federal Open Market Committee (FOMC) meeting and the Group of Twenty
nations' (G-20) summit?

On 2-3 November, the FOMC--the key committee of the US Federal Reserve System--will decide whether
monetary policy in the US should be further eased or tightened or kept unchanged.

Some quantitative easing is expected, but some residual uncertainty remains whether it will be incremental
of say roughly $100 billion per month or, follow a “shock and awe“ approach of a large upfront commitment
of $500 billion to $1 trillion.

The two-day meeting of G-20 finance ministers and central bankers, which ended last Saturday in Gyeongju,
South Korea, promised to refrain from a currency war, double the International Monetary Fund (IMF) quota
and to give fast-growing countries a greater say at the IMF. The agreement to “move toward more market-
determined exchange rate systems that reflect underlying economic fundamentals“ fell short of the US
proposal to limit the surplus or deficit on the current account to less than 4% of the gross domestic product
(GDP) by 2015. It is unlikely that the G-20 summit on 11-12 November will go far beyond this general
agreement.

Devaluation for prosperity? We seem to have come a long way. Recall the intense and wide- spread political
reaction to the 1966 devaluation of the Indian rupee. The opprobrium attached to the IMF in developing
countries came partly from its advocacy of devaluation in the face of balance of payments problems.

The wheel has turned a full circle with a proliferation of countries trying to manage their ex- change rate
down through intervention and the IMF advocating “greater exchange rate flexibility“, a coded phrase for
allowing appreciation. A weaker exchange rate makes a country's exports cheaper, and boosts a key source
of growth.

The standard recipe for a country afflicted by balance of payments problems is the pursuit of deflationary
policies. But with the dollar universally accepted for international transactions, the US does not have a
financing problem for its balance of payments deficit. Thus, it is not forced to deflate and wants the rest of
the world to inflate--including through expansionary policies and currency appreciation--to solve the US
problems, while the rest of the world wants the US to deflate and attain external balance.

The financial crisis triggered by global macroeconomic imbalances from the second half of 2007 is not quite
over. The recession in the US from December 2007 technically got over in June 2009.
Revival's green shoots, which Federal Reserve chairman Ben Bernanke saw as early as March 2009, have not
grown robustly. Unemployment in September 2010 was still as high as 9.2%.

World output, which declined by 0.6% in 2009, is projected by the IMF to increase by 4.8% in 2010. But this
growth is uneven and is being propelled mainly by emerging economies, particularly in Asia. The advanced
economies, by growing at only 2.7% in 2010 after declining by 3.2% in 2009, will still be worse off than in
2008. Emerging Asia was the growth leader with China growing by 9.1 % in 2009 and expected to grow by
10.5% in 2010. The corresponding figures for India were 5.7 % and 9.7 %, respectively.

The fundamental cause of the recent financial crisis lay in policies that resulted in over-consumption in the
US and under-consumption in China. There have been some improvements as reflected in the expected
decline in 2010 (relative to 2004-08 average, as a proportion of GDP) in the US current account deficit and
Chinese current account surplus to 3.2% (from 5.4%) and 4.7% (from 8%), respectively. But a lot more needs
to be done before declaring victory. Even after adjustments, in 2010, the savings rate in the US at only 12.4 %
is about a quarter of that in China!

In the meantime, countries are likely to try preventing their currencies from appreciating either by following
loose fiscal and monetary policies (like the US) or by intervening in the foreign ex- change markets (like
China). Will the currency war lead to a old-style trade war? Will the US, for example, impose restrictions on
imports from China, through the proposed Currency Exchange Rate Oversight Reform Act 2010? It may be
difficult to have a WTO-consistent trade remedy for an undervalued currency of a competitor.

Some recent years have seen sizeable investment flows from low-growth, low-return rich nations to faster-
growing emerging economies. The scent of future appreciation together with low interest rates in advanced
economies will accelerate these flows and exacerbate the upward pres- sure on exchange rate of emerging
economies. To contain capital inflows, Brazil imposed a financial transactions tax on foreign investments in
fixed-income securities of 2% a year ago and recently increased the tax to 6%. Such capital account measures
are likely to proliferate. Further- more, some developed countries may ban countries such as China with large
reserves investing in their government securities by allowing sales to official institutions only from countries
in which they themselves are allowed to buy and hold public debt, and thereby increase the cost of holding
reserves. Whether and when it will happen and what the reaction will be is difficult to tell. After all, the US-
China relation is a delicate one. Just as US as a debtor is too big to fail for China the creditor, China as a
creditor is too big to annoy for the US. Ashok K. Lahiri is an executive director, Asian Development Bank
(ADB), Manila. The views expressed here are personal and do not reflect those of ADB.