Triangular Trouble: the Euro, the Dollar and the Renminbi

For the last several years the euro has been appreciating steadily against the U.S. dollar. Given the Chinese renminbi and other East Asian currencies are pegged to the dollar that means the euro has been appreciating steadily against all. This spells trouble for Euroland, and it suggests European policymakers should join with the U.S. to address the global problem of under-valued currencies.

The euro has now appreciated approximately seventy percent relative to its historic low against the dollar, set on October 26, 2000. This appreciation has been economically justified given Europe’s large trade surplus with the United States. That surplus peaked in 2005 and is now gradually coming down as the Euro appreciates, which is the exactly how a market based global economy is supposed to correct international financial imbalances.

Some in Europe are beginning to raise red flags regarding this appreciation, but the reality is it is still within the bounds of reasonableness. Though the euro has appreciated seventy percent against its historic low, it has only appreciated twenty percent relative to its January 1999 introductory parity.

That said, European concerns about exchange rates are justified, but the focus should be East Asia’s currencies, not the dollar. The key player is China, which has the largest surplus. Additionally, other East Asian countries are rationally reluctant to adjust their currencies absent a Chinese revaluation, as they fear losing competitiveness. This means China’s refusal to significantly revalue its currency against the dollar is forcing a lop-sided adjustment process that places the burden of rebalancing the U.S. trade deficit exclusively on Europe. That is imposing a deflationary burden on Europe that could easily undermine the European economy.

Europe is now experiencing double trouble as its surplus with the U.S. begins to fall while its deficit with China is large and growing. Between 2002 and 2006 the European Union’s deficit with China rose from 54 billion euros to 128 billion euros. At current exchange rates the 2006 deficit was 179 billion dollars, and the EU Chamber of Commerce expects that deficit to hit 260 billion dollars in 2007.

In a sense, Europe now finds itself involuntarily on the same path that the U.S. voluntarily locked itself into in the late 1990s. That path is characterized by rising trade deficits, weakened manufacturing investment spending, and loss of manufacturing jobs.

The renminbi’s under-valuation stands to lower European exports and increase imports from China as spending is redirected from European produced goods to cheaper Chinese goods. The resulting increased trade deficit will directly cost jobs, and reduced demand and profitability of European manufacturing companies will reduce investment spending. Furthermore, European manufacturers will have an incentive to close plants and shift production and new investment to China, just as happened in the U.S.

These effects are likely to be especially disruptive from a regional perspective. Whereas Germany’s high value-added capital goods exporters may still be able to prosper, the economies of Italy, Spain, and other Mediterranean countries stand to be badly impacted. Additionally, manufacturing in Central Europe’s new member states stands to be severely affected, making their integration into the European economy more difficult.

The bottom line is that by all reasonable standards China’s currency is under-valued against both the dollar and the euro. China is running huge and growing trade surpluses with both Europe and the U.S.; it has a growing global trade surplus; and on top of that it has an even larger current account surplus since its trade surplus is supplemented by massive foreign direct investment inflows.

These conditions suggest Europe and the U.S. have a common interest in closely cooperating to pressure China to adjust its currency. Yet, so far, that has not happened. One reason is that until recently the euro was under-valued so that Europe had no grounds for or interest in pressuring China to revalue. A second reason is that Europe and the U.S. are in competition for sales to China and each may fear antagonizing the Chinese government. This has triangulated Europe and the U.S. to their disadvantage and to the benefit of China. The implication is that fixing the structural problem of triangulation and remedying the failure to cooperate on the China currency question should be urgent policy priorities for both sides of the North Atlantic partnership.

Copyright Thomas I. Palley

2 Responses to “Triangular Trouble: the Euro, the Dollar and the Renminbi”

  1. euroscot Says:

    Isn’t it a much bigger problem than exchange rates?

    For example, six months ago the US, China, Japan, Saudi Arabia and the Eurozone agreed to tackle distortions that are threatening the stability of the global economy. The main worries then were the record trade deficit in the US, massive trade surpluses in Asia and oil producing states, and the need to persuade American citizens to save more. Little has happened.

    Since that time we’ve seen growing economic protectionism at national level, and sovereign wealth funds joining those wanting more security for their money than US Treasury IOU’s. And there’s more.

    It is doubtful that politics can solve the complex problem. See this piece in the ‘Telegraph’ last week by Harvard’s Niall Ferguson.

  2. Harald Says:

    There is a non declared assumption in your argument. That is, that the rest of the world should always adapt to the US monetary policy, which is designed exclusively according to the need of the US economy. Or, as Chinas leading currency expert and member of the monetary committee of the PBoC, Fang Gang, wrote (see
    ҉ۢ If we only look at the financial factors, the current problem is not
    RMB revaluation, but dollar devaluation! This is the major cause of
    the current imbalance.
    • This means that RMB revaluation will not solve the problem of US
    deficits, not only because China’s surplus is not equivalent to the US
    deficit … but also because the real root of the problem does not lie in China. US inflation continues due to the loose monetary policies of the US!”
    However you qualify this analysis, you should at least consider that maybe there are a lot of people around the globe, who simply do not have the same interest as the US policy makers and citizens. Maybe they think that the the source country of the global reserve currency should reflect the interest of the other 5,5 billion people too?