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No haste in forex reform
By HE FAN and ZHANG BIN (China Business Weekly)
Updated: 2004-02-11 11:50

China, when drafting its foreign exchange (forex) policies, must learn from Japan and Germany. Both of those countries have experienced raising their forex rates and strong economic growth over the past several decades.

Globally speaking, a country must face the pressure of raising its forex rate when its economy takes off and begins to grow rapidly.

Deciding whether or not to properly deal with such pressure is, nevertheless, crucial if the country's economy is going to sustain its growth and maintain its competitiveness.

Japan and Germany, for example, enjoyed exceptionally high economic growth for two decades, during the post-war period, before they encountered the forex dilemma.

That is, their economies heavily relied on exports, which risked falling if their currencies were greatly appreciated.

The countries, however, adopted different strategies in dealing with the pressure, and the outcomes were in stark contrast.

The Japanese Government has been criticized for allowing the dramatic appreciation of the yen, while mishandling inflation, which resulted in stagnation.

Germany, on the other hand, focused on the stability of its domestic price levels, and appreciated its currency without sacrificing its economic growth.

Japan's lesson

Japan, for a long period after World War II, witnessed its international competitiveness increase steadily compared with its major trade partners, including the United States.

Japanese exports, as a result, outpaced imports in the early 1970s, and the country began accumulating trade surpluses.

Japan's strong export growth, accompanied by a fixed forex regime, also resulted in a steep increase in the country's forex reserves.

Most of those reserves were in US dollars.

Japan's trade surpluses eventually stoked discontent amongst its trade partners, especially the United States, which repeatedly applied pressure on the Japanese Government to revalue the yen.

In the late 1960s, the Japanese currency began to appreciate, gradually at first, but then dramatically.

In the following three decades, the yen's value more than doubled.

Meanwhile, the US dollar declined as US trade deficits ballooned and the Bretton Woods system, in which a dollar standard was established to stabilize global currencies, collapsed in the early 1970s.

Japan's monetary authorities, fearing further appreciation of the yen would harm the nation's exports, began assimilating the US dollar and selling off the yen.

Japan's central bank, the Bank of Japan, also kept domestic interest rates low to buck the dollar against the yen.

Unfortunately for Japan, the yen continued to appreciate and the nation's loose monetary controls resulted in a hyperinflation.

Japan's inflation rate, in the mid-1970s, approached a staggering 25 per cent.

The Plaza Agreement in the 1980s boosted the yen to a new high, and inflation continued.

Germany's experience

The German and Japanese economies were quite similar during the immediate post-war period.

Germany began gaining trade surpluses against the United States in the early 1960s, and the gap between its exports and imports widened after 1960.

The major difference between Germany and Japan, however, was Germany's exports were mostly to European countries instead of the United States.

The German mark had, between 1960 and 1990, appreciated 243 per cent. That exceeded the scale of the yen's increase.

German monetary authorities had to purchase US dollars to maintain Germany's fixed forex regime.

They achieved little success, however.

Germany in 1974 floated its currency, when the fixed forex regime was abolished.

The country subsequently lifted bans on cross-border capital flows and focused on maintaining independent monetary policies.

German monetary authorities, therefore, sacrificed control over the mark's forex rate for the stability of domestic prices.

Germany, between 1960 and 1990, managed to keep inflation low. The country's inflation rate, during the period, was 3.4 per cent, compared with 5.6 per cent in Japan.

Germany's gross domestic product (GDP) growth was steadier compared with Japan's, due to Germany's monetary policies.

Co-operation between European countries' monetary authorities during that period also helped Germany beat down speculation on its currency.

Speculators targetted the weaker currencies of other European countries, such as Italy and the United Kingdom, instead of the German mark.


The experiences in Japan and Germany set good examples for countries trying to deal with their currencies appreciation - as their economies grow rapidly.

Pressure on a country to hike its currency will be enormous when the country's trade surpluses increase dramatically.

The pressure will come from demands for the country to adjust its trade balance internationally and reallocate its economic resources domestically.

The best strategy for a country in this situation is to gradually adjust its forex system, including its forex rate, against those of its trade partners.

Immediate and substantial appreciation of a nation's currency will only foster investment bubbles in its economy.

A country such as China, which is in the process of reforming its forex policies, must make implementation of an independent monetary policy its top priority.

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