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Updated Monday, March 8, 2010 10:35 am TWN, By Andrew Sheng, China Daily/Asia News Network

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Flexible exchange rates can't hide profligacy forever

This is exactly what the Greek tragedy is all about. Greece is part of the European Union, which uses the Maastricht Treaty rules to stop member countries from printing too much currency notes to ensure that the euro maintains a stable value. The Maastricht rules draw the line of the annual fiscal deficit at not more than 3 percent of GDP and total fiscal debt at 60 percent of GDP. The Greeks ran a fiscal deficit of more than 12.7 percent in 2009. Their total fiscal debt now is at 120 percent of GDP.

The Greeks hid the deficits for more than 10 years by using various tricks, including using investment bankers to do swaps. In the 1990s, leading investment banks were fined in Japan for helping Japanese companies and banks hide their losses. Now they have become bold enough to help governments hide their deficits.

Putting it bluntly, neither fixed nor flexible exchange rates can hide the fact that if a borrower, whether it's a company or a government, spends more than it earns, its day of reckoning will come soon. Fixed exchange rates are a discipline — profligacy will show up very fast.

Flexible exchange rates use a weaker currency to try and earn more exports. But if the cause of overspending is the government aided by loose monetary policy, then sooner or later foreign countries will stop lending or investing. You cannot jazz your way out of overspending. Sooner or later the music must stop.

The Greeks thought that once they were in the EU other Europeans would bail them out — that is, non-Greeks would pay for their over-spending. Since Greece cannot devalue the euro by itself, then the pain of adjustment must be done on the fiscal or employment side. In other words, a fixed exchange rate ultimately forces the structural adjustment. The Europeans are asking Greece to make that adjustment as a condition of help.

We cannot think about exchange rates as only a bilateral affair, that is, between currency A and currency B. Before the Asian financial crisis, East Asian currencies were mostly benchmarked against the U.S. dollar, some being fixed and others floating. Nevertheless, each currency had some kind of parity against each other. For example, before the crisis in 1997, the Malaysian ringgit was roughly 2.5 to US$1, and the Thai baht, Filipino peso and the Taiwanese dollar 25 to US$1.

In other words, they adjusted at roughly 1 or 10 to each other. This made it very convenient to do business across East Asian borders, especially because of trade competitiveness. The central bank of every country knew that if the rates moved out of line not only against the U.S. dollar, but also against the neighbors, trade competitive issues would arise.

This regional pattern of currencies “waltzing against each other” in a stable pattern unless disrupted by crisis was formed by the underlying “Asian global supply chain.” After the Asian financial crisis, when most currencies were floating, the same pattern emerged because the underlying needs of the “Asian supply chain” forced some competitive stability between the linked exchange rates. In sum, exchange rates ultimately reflect the underlying strength or weakness of the real economy. You can jazz all you want through flexible rates, but ultimately if you overspend, you pay.

The writer is the author of the book “From Asian to Global Financial Crisis.”

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