In the world’s monetary system, only a few major currencies mainly the U.S. dollar and the euro dominate as units of account for the internationally liquid assets or debts of developing countries or emerging markets. The consequences of this international asymmetry among currencies are profound. It leads to the problems of original sin (the inability of a debtor country to borrow in its own currency) and conflicted virtue (the inability of a creditor country to lend in its own currency).
Any creditor country that cannot lend in its own currency cumulates a currency mismatch called conflicted virtue a concept introduced by McKinnon (2005). A country is ‘‘virtuous’’ if it has a high saving rate and tends to run surpluses in the current account of its balance of payments, that is, make loans to foreigners.Because the surplus country cannot lend in its own currency, however, it builds up claims on foreigners in foreign exchange, usually U.S. dollars. This situation has led foreign debtor governments particularly the U.S. government to complain that the surplus country’s ongoing flow of trade surpluses and official reserve accumulation of dollars is an unfair result of having an undervalued currency. Debtor governments may then try to pressure the surplus country to appreciate its currency against the dollar in the often mistaken belief that an appreciation of the surplus country’s currency will reduce its trade surplus.
The greater the foreign mercantile pressure for appreciation, the greater the concern of domestic private holders of dollar assets that they will suffer capital losses in their home currency. As holders of dollar assets switch into the domestic currency and out of dollars, the government is ‘‘conflicted.’’ An appreciation would dampen exports and, if expected to be repeated, induce serious deflation with a zero percent interest liquidity trap (a situation in which the nominal interest rate is close to zero and the country’s central bank is unable to stimulate the economy with monetary policy), as in Japan in the 1990s. But the American government may threaten trade sanctions if the creditor country under siege does not allow its currency to appreciate substantially. This is the essence of the syndrome of conflicted virtue.
Conflicted Virtue in East Asia
Conflicted virtue would not arise in creditor countries whose money is the dominant vehicle currency in international finance. In the 19th century, Britain was the largest creditor country, with large current account surpluses financed by large net capital outflows.Most of the British claims on foreigners, however, were denominated in the pound sterling, the British currency. Thus British investors were happy to accumulate large sterling claims on foreigners without provoking a depreciation of their foreign claims against their domestic ones. Similarly, for 25 years after World War II, the United States had trade surpluses and was the world’s biggest creditor. By then, however, the dollar had displaced sterling as the world’s dominant vehicle currency. Because U.S. claims on foreigners were denominated mainly in dollars, there was no internal currency mismatch in U.S. private portfolios.
The East Asian economies (and, increasingly, oil-rich Middle Eastern countries) are unusual, however, in that they are significant international creditors whose currencies are relatively little used outside their own countries. In Japan, large current account surpluses have persisted since the late 1970s. Taiwan’s and Singapore’s current account surpluses have been significant since the 1980s. Since 1998, previous debtor economies such as Korea have run current account surpluses (reflecting their ‘‘virtuously’’ high saving rates), resulting in high net capital exports. Sometimes these are offset by foreign direct investments (FDI) abroad. But the common mode of finance is to build up liquid claims either privately or as official exchange reserves in international monies such as the dollar. Japan’s current account surpluses continued into the newmillennium. By 2005, Japan’s net holdings of liquid claims on foreigners (largely in dollars) reached a new high of U.S. $1.7 trillion, of which about $830 billion were official exchange reserves (McKinnon and Schnabl 2006).
Although China’s buildup of liquid dollar claims has a much shorter history than Japan’s, it has been accentuated by large inflows of FDI relatively illiquid long-term liabilities. By the end of 2005, China’s liquid dollar-denominated assets were roughly $1 trillion, of which $819 billion were official exchange reserves a higher proportion than in Japan. The cumulative joint holding of dollar claims of all East Asian countries amounts to nearly $3 trillion. In China, household consumption, wages, and claims on financial intermediaries such as banks (deposits) and insurance companies (annuities) are mainly in yuan. Thus private Chinese households and firms will hold dollar assets only if there is a substantial business convenience in doing so, or if the interest rate on dollar assets is higher, and if the immediate threat of yuan appreciation (dollar devaluation) is absent.
Effects of Conflicted Virtue
China and other East Asian governments worry about the sudden loss of export competitiveness should their currencies be forced to appreciate. Beyond this, when the world price level measured in dollars is stable, any such appreciation would be followed by a domestic deflationary spiral as in Japan from the mid-1980s through the 1990s as a result of the erratically appreciating yen. McKinnon and Ohno (1997) describe the nature of an Americanmercantile pressure to appreciate the yen from the 1970s to the mid- 1990s, then analyze the subsequent deflationary consequences for Japan.
Governments in creditor economies with conflicted virtue may cut domestic short-term interest rates to forestall or slow the conversion of privately held dollar assets into domestic currency. Insofar as people believe that low short-term rates will persist, domestic long-term interest rates also fall. At any given exchange rate, a new portfolio equilibriumcan be found in which private agents would be willing to finance the nation’s ongoing current account surplus by building up higher yield liquid dollar claims rather than the government accumulating official exchange reserves.
Japan has the longest experience with current account surpluses, and the associated buildup of dollar claims, from the early 1980s into the new millennium. Between 1978 and 2007, the interest rates on long-term (10-year) Japanese government bonds (JGBs) averaged about 3 to 4 percentage points less than those on long-term U.S. treasuries. Short rates are more volatile, but were bid down close to zero in the mid-1990s. In November 2006, when the American interest rate on overnight federal funds was 5.25 percent, the corresponding Gensaki rate in Tokyo was just 0.25 percent. As long as interest rates on yen assets are sufficiently below those on dollar assets, the Japanese private sector banks, insurance companies, trust funds, and so on can still be persuaded to fund Japan’s ongoing current account surpluses by accumulating dollar assets with higher yields. This interest differential reflects both the expectation that the yen will appreciate on an upward trend, as was important from the late 1970s to the mid 1990s, and a negative risk premium that arises when the yen simply fluctuates against the dollar so as to make the ever-larger private holdings of dollar assetsmore risky in yen terms as was the case in the first few years of the new millennium.
But there are limits on how negative this risk premium on yen assets, and on how wide the associated interest differential, can become. When American interest rates fell to abnormally low levels, with short-term rates down to just 1 percent in early 2004, the spread was not (could not be) big enough because Japanese nominal interest rates were bounded from below by zero. Then the Japanese private sector refused to keep acquiring enough dollar assets to finance the current account surplus. Indeed, private agents in Japan started dishoarding previously accumulated dollar assets in order to acquire nearzero- yield yen assets! In 2003 4, the Bank of Japan intervenedmassively in the foreign exchangemarkets to acquire more than $330 billion mostly from private Japanese financial firms in order to prevent the yen from appreciating sharply.
Since 2004, China has run a larger current account surplus,mainly financed by a huge buildup of official exchange reserves. This buildup has led to calls from the American government for China to appreciate its currency the threat thereof leading to a fall in internal Chinese interest rates and the unwillingness of private Chinese wealth holders to acquire overseas assets. Therefore, the rapid accumulation of official exchange reserves becomes even larger. Conflicted virtue in creditor countries, with their overhangs of dollar assets, continues. See also balance of payments; Bretton Woods system; carry trade; dollar standard; dominant currency; foreign exchange intervention; global imbalances; gold standard, international; interest parity conditions; International Monetary Fund (IMF); international reserves;mercantilism; original sin; reserve currency; vehicle currency