NO WHITE FLAG IN THIS CURRENCY WAR

By Annaly Capital Management

In recent weeks, the Plaza Accord has been receiving a lot of attention, particularly after the IMF’s annual meeting in Washington concluded without making any progress on currency issues. If you recall, the Plaza Accord is the popular name given to an agreement struck in September 1985 by the world’s finance ministers—who met at New York’s Plaza Hotel—to engage in large-scale currency intervention.

Why did they—James A. Baker III of the U.S., Noburu Takeshita of Japan, Gerhard Stoltenberg of West Germany, Nigel Lawson of the UK and Pierre Beregovoy of France—do it? In a word, imbalances. In a sentence, when Paul Volcker made liberal use of the Fed Funds rate to successfully fight inflation, some other consequences were a significant strengthening of the dollar, large trade deficits and reduced US export competitiveness, particularly vis a vis Japan. In a paragraph, the Plaza Accord itself put it best (and, for those accustomed to parsing inscrutable messages from policymakers, the language of the Plaza Accord rings as clear as a bell): “[T]here are large imbalances in external positions which pose potential problems, and which reflect a wide range of factors. Among these are: the deterioration in its external position which the U.S. experienced from its period of very rapid relative growth; the particularly large impact on the U.S. current account of the economic difficulties and the adjustment efforts of some major developing countries; the difficulty of trade access in some markets; and the appreciation of the U.S. dollar. The interaction of these factors– relative growth rates, the debt problems of developing countries, and exchange rate development– has contributed to large, potentially destabilizing external imbalances among major industrial countries…. The Ministers and Governors agreed that exchange rates should play a role in adjusting external imbalances. In order to do this, exchange rates should better reflect fundamental economic conditions than has been the case. They believe that agreed policy actions must be implemented and reinforced to improve the fundamentals further, and that in view of the present and prospective changes in fundamentals, some further orderly appreciation of the main non-dollar currencies against the dollar is desirable. They stand ready to cooperate more closely to encourage this when to do so would be helpful.”

There are many similarities between China/U.S. economic relations today and Japanese/U.S. economic relations in 1985. Both involve an undervalued currency versus the U.S. dollar, trade imbalances as a result of this valuation, and the increased rhetoric of protectionism. And the scale of the imbalances are similar. The Japanese trade deficit was about 1.1% of U.S. GDP in 1985, and the Chinese trade deficit today is about 1.6% of U.S. GDP (nominal dollars). But as the graph below points out, the trend is not America’s friend.

Was the Plaza Accord successful as policy? It may still be too early to tell, but it also depends on your perspective. The most obvious net effect of the coordinated efforts of the world’s finance ministers was a virtual doubling of the yen in dollar terms over the next two years, from 240 to 120. Viewed on that basis alone, the Plaza Accord was a success. In addition, the rising threats of American protectionism against Japan were avoided. But what about the other imbalances? As it turned out, Japanese exports to the U.S. did not decline despite the Plaza Accord and the U.S. remained a net debtor nation. Other (mostly east Asian) nations picked up manufacturing slack from Japan. The dollar was weaker, and the U.S. stock market was off on a 25-year bull run, but the Japanese, struggling to deal with a sharply and suddenly higher yen, kept their monetary policy relatively loose and fostered a bubble economy that ultimately crashed.

While policymakers at the next G-20 summit, to be held on November 12 in South Korea, will be looking at a problem that is very similar to that of 1985, it is not the same problem. As Mohamed El-Arian reminded people last week at a conference hosted by the Financial Times, while everyone in the U.S. thinks of China as the world’s 2nd largest economy, they think of themselves as being 99th in per capita income. If anyone is holding their breath waiting for the Chinese to be as cooperative today as Japan was 25 years ago, they should exhale. We believe the Chinese consider the Plaza Accord to be one of the worst economic decisions ever made by a country. It’s not likely to happen again.

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