A Dual Exchange Rate System

Emerging markets with large trade surpluses are reluctant to heed calls for them to help with global aggregate-demand rebalancing by appreciating their currencies. They fear harm to their export-led development and sudden reversals of capital inflows in the future. Here one of the world’s most innovative macroeconomists suggests a way to square the circle: A dual exchange-rate system that would shield their exporters while fostering imports.

Struggling developed economies – with the help of the IMF and related institutions – are escalating pressure on surplus emerging market economies to take a more active role in rebalancing global aggregate demand distribution. China is the most visible target, but the assumption is that once China concedes the others will have no choice but to fall in line.

Unfortunately, the bulk of the developed economies’ argument is self-serving. To paraphrase their argument: “We are in trouble, and you need to help!”

No surprise then that surplus emerging market economies are reluctant to follow “the mandate,” especially as evidence accumulates that a decoupled world is not a chimera. Developed economies are immersed in mediocre growth while emerging markets economies enjoy booms that feed into each other.

A better way forward?

Is there a better deal that developed economies can offer to surplus emerging market economies? I believe the answer is yes, but it requires revisiting an old and discredited policy response: Dual exchange rates (or its equivalent).

To see why, one needs to understand the perspective of the highly successful and prudent emerging market economy.

• They are experiencing massive capital inflows from disappointed developed economy investors searching for yield.
• These inflows put enormous macroeconomic pressure on emerging markets – triggering twin-fears of overheating and exposure to sudden capital flow reversals.

The classic response to the first of these fears is to let the exchange rate appreciate, which reduces domestic inflationary pressures by reallocating demand to (now cheaper) foreign goods. This is indeed the response the developed economies want and emerging markets oppose, leading to colourful “currency war” exchanges.

Why the classic prescription isn’t being followed

Why aren’t emerging markets following the classic advice and are instead opting for fighting and sterilising capital flows in order to prevent sharp nominal or real appreciations?
I believe there are two related reasons:

• The first is related to medium-term goals; many of these economies have decided to have an export-led growth strategy.

And the truth is that there are many valid “increasing returns to scale” type reasons for why it may make sense to protect an exports sector in its early stages of development. If this is not convenient for developed economies at this time, so be it.

• The second is related to short-term concerns, namely a rapid appreciation – by stressing the export sector and expanding imports – increases the potential cost of a sudden reversal in capital flows.

Given this context, a temporary and closely monitored dual exchange rate system may well offer the compromise solution.

A dual exchange rate system

For example, China could slowdown the pace of reserves accumulation and appreciate its currency quickly by 20% or so but be allowed to smooth the exchange rate faced by its export sector over five years.

• Sure, this arrangement would not please Chinese exports competitors, but it would give a big boost to those exporting goods to China.

The rebalancing role of dual exchange rates would be facilitated if complemented by a direct mechanism to assuage the fear of a sudden reversal of capital flows, and hence reduce the precautionary savings motive behind global imbalances. The IMF and the central banks of developed economies can easily do this by expanding – and making permanent – some of their contingent credit and swap facilities.

Concluding remarks

I fully appreciate the unappealing features of this proposal. Dual exchange rates introduce well-known distortions and export subsidies. In fact, a cleaner way to go is simply for the World Trade Organisation to accept temporary export subsidies for those surplus emerging market economies that implement sharp nominal appreciations. Either approach would face enormous political and technical opposition.

But what is the alternative? Trade and currency wars?

It is time to become pragmatists and stop using an idealised world as the metric. The potential costs of dogmatism have seldom been higher than they are today. Carrots and sticks, rather than just sticks, are more likely to succeed in this politically more balanced global economy.