As rhetoric on 'currency wars' heats up, escalating tensions between the US and China are casting a shadow over the world economy. Yet we must be clear on one point. No matter whether or not China is free riding on the exchange rate, the threat of a full-scale currency war will be defused only if the US takes the lead in promoting international exchange rate coordination and acts responsibly to prevent any rise of protectionism. Since the dollar is the key reserve currency, the US sets the pace on currency issues. South Korea, the host of this year's G20, is unlikely to put exchange rate coordination on the Seoul summit agenda in November unless the US is willing. The US should seize the opportunity to set a positive role model and defuse the undoubted protectionist threats overhanging the world economy.
This agenda clearly extends to the issue of quantitative easing, where it seems almost a foregone conclusion that the Federal Reserve will resort to a new round of Treasury securities purchases in early November. European as well as Asian governments and central banks will be watching closely for signs that America is moving over-aggressively in a deliberate ploy to force the dollar down further - a policy that the US of course denies it is following.
World economic uncertainty is irrefutably increasing as a result of countries' measures to use the exchange rate to rebalance their domestic economies. Domestic interests seem to be increasingly at odds with the goal of reducing global financial imbalances.
But unilateral intervention on the foreign exchange market is a sub-optimal way to deal with the dollar's malaise. For instance, despite cumulative intervention totaling an estimated $200bn, the Swiss franc has gained almost 20% against the dollar since March 2009 when these measures were first unveiled (although arguably the rise may have been even steeper if no intervention had taken place). And despite Japan's finance ministry intervening to the tune of $25bn in September, the yen has further appreciated against the dollar. The intervention was clearly ineffective and yet may generate a further round of dollar purchases to curb market expectations that the yen will continue to rise. In other words, the measure will have achieved exactly the opposite of the declared goal of reducing volatility.
Currency intervention can also undermine the multilateral dialogue on global economic and financial issues at the heart of the G20 process - as the verbal exchange between Japan and South Korea reminded us in the immediate aftermath of the IMF/World Bank annual meeting in Washington in early October. Naoto Kan, the Japanese prime minister, pointing out that efforts to depress currencies ran counter to G20 cooperation, called on South Korea and China to 'act responsibly' in foreign exchange policies.
Given the multilateral nature of the monetary tussles which then would be the appropriate action? The answer lies in the US recognising that dollar weakness is a matter for the international agenda - while the bilateral exchange rate between the dollar and the renminbi is mainly an issue between the US and China. Expansionary American monetary policies putting downward pressures on the dollar are shifting the burden of adjustment on to other countries. As a result, the US should lead efforts to co-ordinate exchange rate policies. Achieving this is difficult. But in Seoul the G20 members should aim at least to stop the race to the bottom. In current circumstances, achieving this slender aim will be a commendable result.