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The value of Chinese currency, in particular, has been the target of discussion in the past decade as the cause of global imbalances. This issue was first raised in 2002. The accusation was that China was manipulating its currency to increase its export competitiveness. But the fact remains that in 2003, China’s trade surplus was smaller than its surpluses in 1997 and 1998. In 1997 and 1998, during the East Asian financial crisis, China did not devalue its currency despite the devaluations of currencies of many of its neighbours - indeed, at that time, everyone said the Chinese currency was overvalued.

If in 1997-1998, China’s currency was overvalued, then its trade surplus should have been smaller than in 2003-2004. But actually, in 2003-2004, the trade surplus in China was smaller than in 1997-1998. So it seems impossible for the Chinese currency to have been undervalued in 2003 and 2004. Moreover, the Chinese trade surplus did not become particularly large until 2005. And between 2005 and 2006, the Renminbi appreciated by about 20% against the dollar. However, even this appreciation did not result in a decrease in China’s trade surplus with the US. At the same time, many developing countries were competing with China, but their trade surpluses did not decline - and again their accumulation of reserve also continued to increase.

All the hypotheses point to East Asian economies as the cause of global imbalances and the global crisis. However, the issue of global imbalance also manifests itself in the trade deficit in the US. But this deficit has been falling. The US trade deficit with East Asian economies as a percentage of its total trade deficit declined from 51% in the 1990s down to about 38% in 2007. This implies that the East Asian contribution to global imbalances declined instead of increased. Therefore, some kind of alternative hypothesis is in need to explain the trade deficit in the US.

A principal reason for the growth in China’s trade surplus with the US was the relocation of production from East Asian economies to China and the transfer of the trade surpluses from other East Asia economies to China. In 2001, China ran a huge trade deficit with other East Asian economies. So we need to have a new hypothesis that can be consistent with the evidence. And I believe the only hypothesis that can be consistent with evidence is that global imbalances and the global crisis were triggered by the current international monetary system that uses the dollar as a global reserve combined with some policy mistakes in the US.

We know that in the 1980s there was a trend towards financial deregulation in the US that allowed financial institutions to operate with high levels of leverage that resulted in an increase in liquidity. Secondly, in 2001, when the US was hit by the burst of the dotcom bubble, the US Federal Reserve deployed very loose monetary policy to help the financial system to recover. The combination of low interest rates and high leverage created excessive liquidity in the US monetary system. This excessive liquidity first aided a bubble to form in the housing market and equity market in the US. It also created huge wealth effects that fuelled household consumption. The US became a huge consumer and saved less.

At the same time, the US government, because of the Afghanistan and Iraq wars, also ran a deficit. By that time, China produced many of the goods exported to the US market, resulting in China running a large trade surplus with the US because of the high levels of consumption by the latter country. This excess of liquidity and low interest rates also encouraged speculative outflow. So in 2000, total capital outflow from the US to developing countries was $200 billion, but this figure swelled to $1.2 trillion by 2007. Large capital inflows to developing countries certainly supported the housing bubbles and investment booms in developing countries, which caused overheating in some economies.

With high levels of liquidity supporting investment, the demand for capital goods increased a lot. That contributed to capital-goods-exporting countries, such as Japan and Germany, also running large trade surpluses. Because of the boom in demand in both developing countries and some high-income countries, the demand for commodities increased, causing a commodity price boom after 2000. All the countries, except for the US, accumulated reserves because of trade surpluses and capital inflows, which they used to purchase assets in the US to earn a return for their reserves.

The hypothesis stated at the start of this article only characterises the reserve flows from the acquisitive countries back to the US. In fact, those reserves were first created in the US. So how can we prevent a similar crisis again? From my analysis, the situation only occurs because the dollar is the world’s dominant reserve currency - otherwise it would be impossible for the US to run a large current account deficit for such a long time. It was the dollar’s reserve currency status combined with financial deregulation in the 1980s and 1990s, plus the Federal Reserve’s low interest rate policy in the 2000s, that caused the bubble and trade deficit in the US.

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