Avoiding a currency war: how a new "dual-key" exchange rate system could help the United States, Japan, the eurozone—and China—find a way out

International Economy, The, Summer, 2004 by Adam S. Posen

An explicit resetting of a target zone, on the other hand, would be subject to misinterpretation by the markets as some sort of election year deal between President Bush and Prime Minister Koizumi or to questioning as to whether it was consistent with the market's own outlook for the relative Japanese and American recoveries. A target zone that was not reset under those circumstances, however, would have been even worse: it either would have locked in a misaligned exchange rate, limiting the much-needed adjustment of surpluses between Japan and the United States, or it would have been such a wide target zone as to be meaningless.

Target zone advocates will claim that there is a loss from not having explicit boundaries, since the boundaries themselves, if credible, would limit exchange rate movements. Most recent research has shown, however, that these boundaries are only made credible through intervention and demonstrated defense of them, and that credibility has to be reestablished time and again with changes in economic circumstances and political leadership. In short, this advantage of target zones was always theoretical if not fictional, while the disadvantages of explicit exchange rate commitments (just as in adjustable pegs for emerging markets) are real.

Though appropriately modest in ambition, an agreement among the major three currencies on dual-key intervention is more than just a stop-gap response to current political pressures. It is also a useful step in the building and maintenance of the international financial architecture. The eurozone would be forced to unify its decision-making about exchange rate intervention in order to be able to speak with one voice in these discussions; such discipline would provide an important institutional precedent for the eurozone's needed unification on financial supervision and representation in the international financial institutions. The United States would be required to acknowledge the effects of its currency movements upon other countries, at least in extremis, and could get an opportunity to visibly foreswear unilateral action (in fact, comfortably doing so in an area where unilateralism usually works against it, rather than where it exercises such). Japan could claim an explicit co-equal status with the United States and the eurozone for its currency, at least in this regard, while reassuring many observers that the Chiang Mai and follow on Asian monetary agreements would be solely directed at the defense of neighboring currencies subjected to market panics or attack--and this would in no way be constrained by a dual-key G3 agreement.

Of course, the cause of much of the current exchange rate stress is the emergence of China, and its maintenance of the renminbi peg to the dollar at an undervalued rate. Although a dual-key agreement between the eurozone, Japan, and the United States would not address this directly, it would usefully nudge China towards a constructive adjustment over the longer term. First, it would make more attractive China shifting to tracking a basket of the three major currencies from a strict dollar peg, which should be more politically if not economically sustainable in the medium term. Second, it would isolate China's unilateral intervention practices, removing the example of Japan or any other major economy to point to as "they do it too." This would increase political pressure upon China to behave responsibly regarding its peg (or to float).