China's 'death grip' on the dollarDecember 14, 2010: 1:32 PM ET
Will China's addiction to dollars lead the global economy into a bruising showdown with inflation?
The head of Canada's central bank fears it may. Mark Carney, the governor of the Bank of Canada, said in a speech Monday that emerging countries accumulating massive currency reserves have a "death grip" on the dollar.
That grip, he said, prevents the global economy from adjusting to massive imbalances signified by, among other things, rising inflation in the developing world and persistently weak demand for goods and services in Western economies.
Carney spoke in Toronto on the implications of the low-rate policies being pursued by the Federal Reserve and other developed-world central banks. Without criticizing those policies, he said it is clear that the conditions are being set for an "increasingly uneasy emergence" of poorer economies.
Carney didn't name names, but it is clear he is referring first and foremost to the group beloved on Wall Street as the BRICs – Brazil, Russia, India and China.
The unease, he said, stems from the fact that growth in the developing economies tends to raise commodity prices, which pressures income in slower-growing rich countries. What's more, nations such as China continue to subsidize overseas trade by suppressing the value of their currencies, by purchasing dollars with the proceeds of their export sales.
By pursuing those policies, he said, those nations are preventing a long overdue rebalancing of the global economy. China is by far the biggest offender there: At last count it had $2.6 trillion of foreign exchange reserves, mostly in dollars – far more than the country could possibly need to deal with any financial market shock.
In doing so the emerging economies are keeping their own currencies undervalued, which props up the value of the dollar and retards job growth here, among other things.
These are not unlike the problems seen in the wake of the Great Depression, Carney said, when numerous countries pursued a so-called race to the bottom to devalue their currencies against gold.
But while those devaluations helped break the death spiral by giving countries some desperately needed flexibility, this time round the dynamic seems to be working in reverse.
With currency tensions rising, some fear a repeat of the competitive devaluations of the Great Depression. However, the current situation is actually more perverse. In the 1930s, countries left the gold standard in order to ease monetary policy, and the system became more flexible.
Today, the process is working in reverse. The international monetary system is sliding towards a massive dollar block. Over a dozen countries are now accumulating reserves at double digit annual rates, and countries representing over 40 per cent of the U.S.-dollar trade weight are now managing their currencies.
This death grip on the U.S. dollar is reducing the prospects for rebalancing global demand. As the Bank of Canada has argued elsewhere, the potential costs are huge–up to $7 trillion in lost global output by 2015.
Ultimately, excessive reserve accumulation will prove futile. Structural changes in the global economy will yield important adjustments in real exchange rates. If nominal exchange rates do not change, the adjustment will come through inflation in emerging economies and disinflation in major advanced economies.
The implication is that China and others will, at the very least, need to be vigilant about tightening their own monetary policy – though ideally they would go well beyond that and start moving toward open capital markets and free floating currencies.
Given that China only recently started allowing its currency to resume appreciating against the dollar, though, that is looking like a bit of a stretch. In the meantime, expect more interest rate hikes in India, China and the like.
"There is a need in the emerging markets to decouple from Fed policy," Bank of America chief economist Ethan Harris said Tuesday at the bank's annual year-ahead outlook press conference. "Inflation is a warning signal that there is a need for ongoing tightening."