links for 2007-08-24
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The Rhetoric of Undervaluation and Overvaluation

Felix Salmon Yves Smith of Naked Capitalism writes:

Finance Blog - Market Movers by Felix Salmon: Paulson Hoist on His Own Petard (Yuan Version) - Most analyses of the value of the yuan show it to be undervalued, some by as much as 40% relative to the dollar. Congress, unhappy about the huge trade deficit with China, has threatened to impose sanctions if China does not allow its currency to appreciate. (Aside: this desire for a rise in the yuan falls in the category of "be careful what you wish for," since a lower trade deficit also means lower capital inflows. In other words, kiss cheap foreign funding goodbye).

China responds badly to threats, so Paulson looked to the IMF to act as an honest broker. But that move has backfired spectacularly, with the IMF declaring the dollar to be overvalued. The focus was supposed to be on the yuan and how the Chinese needed to stop meddling; now it has shifted to the dollar, and by implication, our low savings rate (the Chinese have taken the position that it is we, not they, that need to get their house in order). And since the US hasn't gotten what it wanted, it is now demonizing the very organization it once touted as expert and fair.

From Bloomberg:

Treasury officials recruited the IMF to be a currency cop as China and other countries meddle with exchange rates to gain a trade advantage. Instead, the international lending organization took aim at the dollar, calling it overvalued in an Aug. 1 report.... "The U.S. Treasury has cut the legs from under the IMF before it even started the race," said Michael Mussa, the IMF's chief economist from 1991 to 2001 and now a fellow at the Peterson Institute in Washington. "This was foolish and unnecessary when they could have just said nothing."

By rejecting the IMF's analysis, the Treasury may have jeopardized its own effort to use international leverage to help narrow China's $118 billion trade surplus with the U.S. Members of Congress are threatening sanctions if the Treasury doesn't succeed in getting China to stop suppressing the value of its currency....

IMF staff economists told U.S. officials in meetings ended July 27 that their research showed the dollar was 10 percent to 30 percent overpriced, according to an account included in the 54-page Aug. 1 report...

"Overvalued" is, as I discovered at my personal lifetime analytical nadir in the summer of 1994, a delicate term of art. One first has to figure out what sustainable equilibrium long-run capital flows are and are going to be. One then has to figure out what exchange rate will in the long-run produce a current account balance that corresponds to those capital flows. Only then can one talk about overvaluation and undervaluation. In the end, perhaps, "overvaluation" means "net capital inflows should or must or will drop," and "undervaluation" means "net capital inflows should or must or will rise."

The problem, I think, is that the IMF worries about "global imbalances," and imbalances always have two sides. The Bush administration thought it could use the IMF to do some China-bashing, and then use that to appease Congress and so discourage Congress from doing any serious China-bashing.