Rifts reappear less than a fortnight after G-20 pact

After meeting in Seoul two weeks ago, governments from the G-20 group of the world’s 19 largest economies plus the EU agreed to halt competitive currency devaluation in hopes of allaying fears of an all-out currency war. The G-20 finance ministers vowed to address tensions in the currency markets.

The Seoul Summit was only the latest in a series of such meetings and aimed to provide a forum for heads of government from the member countries, central bankers, finance ministers and institutions such as International Monetary Fund (IMF) to discuss key issues like fighting poverty and building global financial safety nets. In addition to the G8 members, G20 also boasts an expanded membership list that includes emerging economies such as China and Russia. Against the backdrop of growing unease over the potential impact of a currency war, the leaders of the twenty member countries agreed to a broad goal of containing the rise of large current account deficits or surpluses.

The agreement seemed then to be a temporary truce and now, less than two weeks since the warm hand-shakes and smiles, several governments have resumed ‘talking down’ the price of their currencies, with a potential view towards further monetary easing. The “Seoul Action Plan” was reminiscent of many previous, toothless, international monetary agreements with its promise to “pursue the full range of policies conducive to reducing excessive imbalances.” The pledge made during the Pittsburgh G-20 summit last year had a similar ring to it, and countries have yet to uphold it with concrete policies. Now in the aftermath of the financial crisis, politicians are even less likely to muster the political will to implement policies to address trade imbalances for the fear of angering domestic exporters.

Furthermore, unlike supranational organizations like the World Bank, the G-20 has no real power to back its promises. While countries can agree on a vague sense of direction such as “correcting the trade imbalances”, they cannot lay out specific policies to be implemented in order to achieve a measurable outcome. The US, for example, has proposed “indicative guidelines” for current account balances. This move immediately came under attack from ministers in countries such as Germany and China, which have large surpluses.

The costs of inaction are high: if countries across the board cheapen their currency at the same rate, no one will gain an advantage over others but everyone will face inflationary pressures that will threaten their economy. Devaluation will also have a net negative impact on the economy as importers suffer from higher prices of goods denominated in foreign currencies. The countries are now trapped in a classic ‘Prisoners’ Dilemma’: while every country will gain if the promises are kept, the high payoff gained from unilateral devaluation will eventually cause a race to become the first country to resume lowering its currency value. This prompts other countries to react with similar measures, and everyone will be worse off as a result.

Moreover, emerging countries that stood by the market mechanisms rather than resorting to currency control will be hard pressed to stem the upward spiral of their currency. As the value of US Dollars weakened due to the Federal Reserve’s quantitative easing measures, capital flowed elsewhere as investors looked for higher yields. The destinations of such capital outflow are mainly the emerging economies, destabilising their economy by causing currencies to appreciate.

Unless the Federal Reserve eases the downward pressure on it currency, the pressure on other nations for debasement is unlikely to abate. Even though the US government claimed that it would never seek to weaken the US Dollars as a tool to gain competitive advantage, the effects of its monetary policy will be keenly felt elsewhere, especially since the Federal Reserve embarked on another round of money printing a few weeks ago.

On the other hand, the G-20 is not completely impotent when it comes to stopping the currency war. The meeting promotes a global network of key policy makers and their staff, which can contribute greatly to the coordination of macroeconomic policies, especially at times of great uncertainty. There is a growing consensus amongst the G-20 leaders that international economic cooperation is necessary given the growing interdependence of the countries. France, the next chair of the group, is optimistic that it will have growing clout as the main platform for international governmental co-ordination.

It remains to be seen how effective the G20 summit will be at tackling the issue of trade imbalances. By actively involving the emerging economies in multilateral dialogue, it may have the highest chance of establishing a global framework for monetary policies since Bretton Woods in 1944. However, international agreements of this kind on their own rarely mean much. Only when the G-20 makes real progress on cooling the current currency conflicts will it earn any credibility as a body capable of solving global economic problems.