chapter  7
20 Pages

External adjustment failure and cross-currency speculation: Can China be affected?

ByHEINER FLASSBECK AND MASSIMILIANO LA MARCA

External imbalances have become a major source of systemic risk to the global economy. They can have adverse repercussions in the short and long term on both surplus and deficit economies due to the potentially disruptive effect of a sudden adjustment (UNCTAD, 2004, 2005, 2007). The sources, the sustainability and the possible adjustment mechanism of external imbalances have been the object of one of the liveliest and most controversial economic policy debates of the past couple of decades. Nonetheless, there is an almost universally shared belief that changes in the overall competitiveness of an economy can be a decisive factor in reversing the sign of its trade balance. Indeed, the role of the real exchange rate in the international adjustment mechanism is regaining attention from the international financial institutions (IMF, 2007). Large corrections of deficits are usually observed to go hand in hand with large devaluations of the nominal and real exchange rate (IMF, 2007; UNCTAD, 2008). This nexus between the exchange rate and trade flows is also acknowledged by those who believe that if the Chinese renminbi were allowed to float freely, it would reduce the biggest surplus in the world and the biggest deficit at the same time.