For once the governments have got it right, and the market has not. Or so it appears if one reads the G-7 communique on currencies that was issued by G-7 in Dubai. The message was that “exchange rate flexibility is desirable in major countries or economic areas to promote smooth and widespread adjustment in the financial system, based on market mechanisms” (italics added)

The knee-jerk market has improperly seen this as an attack on the monetary authorities of Japan, and to a lesser extent, the European Union. It is a not so funny, indeed pathetic, case of "round up the usual suspects". When in doubt about correction of US trade imbalances, financial markets have jumped on the Japanese yen as the currency of choice. This has been aided and abetted by (formerly racist?) directions from US politicians. The efforts have not been in vain. From being an economic powerhouse in the eighties, Japan has been brought down to its knees for most of the last decade. Its growth rate for the 1975-85 decade was 4.2 percent per annum; then came the Plaza agreement which more than doubled the value of the yen - from 250 in 1985 to 110 in 1995. This reduced the growth rate to 3 percent per annum. The next eight years the exchange rate has been "stable" with a lot of volatility around 110 yen, but the growth rate collapsed to near zero. From miracle to wasted by the "market mechanism" led by the US government and its team of Japan bashers.

Because Japan has been a zero inflation country since the Plaza agreement of 1985 (average rate below 1 percent!), the appreciation of the real exchange rate has been somewhat less than the nominal appreciation - about 50 percent over 17 years or about 3 percent per year. Which implies that labor productivity growth in Japan has had to be in excess of 3 percent for Japan to stay still! For developed economies, annual productivity growth of 3 percent is nirvana, and Japan reached that level of growth prior to 1995 i.e. the appreciation of the yen from about 250 in May 1985 (prior to the mid- September Plaza agreement which brought Japan down) to 83 in May 1995 is an annual appreciation rate of 11 percent per annum. Even China does not show this productivity growth, and the cumulative effect of such appreciation resulted in the near zero percent growth rate that Japan has witnessed for the last eight years! Agreed that the market thinks that Japan is Superman, but even Supermen cannot fly forever.

Since 1995, the yen has depreciated at an annual rate of about 4 percent per annum. If the market is worried about the US trade imbalances being even partially caused by a crippled Japan, then it should show up in the export figures. Japan exports to the US have stayed constant at 120 billion for the last eight years! These exports were equal to 122 billion in 1995 (when the exchange rate was 85) to 120 billion in 2002 (when the exchange rate was 120). Net exports to the US show some elasticity - there is an increase of 11 billion in US trade imbalance brought about by a 40 percent depreciation of the yen. Reversing this process (as market participants believe that the yen should go back to at least 80 in order for market mechanics to be seen as working) would gain the US a reduction of 11 billion in the 500 billion trade imbalance - that is 2.2 percent. Wow - three cheers for "market mechanisms" of the old planning variety.

But the mother of all currencies, and indeed the grandmother of all undervaluations, is the Chinese yuan. Taking China and Hong Kong as one country, here are some startling statistics. First, between 1995-2002, total exports increased by 42 percent while Japan's exports increased by minus 6 percent. To the US, the corresponding numbers are $ 63 and $ 96 billion (China in 1995 and 2002) compared to $ 122 and $ 120 billion (Japan). Second, China's exports to the US today are within spitting distance of Japan's; the ratio in 1995 was half. Third, China's fixed exchange rate policy has allowed its exports to more than triple between 1990 and 2002 - from 145 billion to 459 billion; exports to the US have near quadrupled - from 25 billion to 96 billion. Of course, a fixed exchange rate does not guarantee export growth - just look at Argentina! But an undervalued fixed exchange rate is manna from heaven - and mercantilism at its richest.

No, Mr. Yen Basher, the G-7 communique was not aimed at Japan, and nor was it aimed at Europe. They had only one target in sight - China. If you have wondered why Asian currencies have been appreciating over the last six months (co-incident with the US finally seeing that neither the yen nor the Euro was the problem), don't wonder any more. I believe the major central banks of the world, led by the US, have helped co- ordinate an appreciation of the Asian currencies in order to make it easier for China to let go, just a little bit, of its humongous trade surpluses. If China's competitors have appreciated by 5 to 10 percent, surely China cannot claim to be ‘sacrificing" if it would allow the yuan to be "flexible" with an appreciation of 10 to 20 percent.

Very rarely is it the case that there is one policy which is a win-win situation for the entire world. Consider who loses by the yuan appreciation to at least 7 in the very short-term and 6 in the medium term. The Chinese economy has considerably overheated (latest industrial production growth figures are 17 percent plus!), and if a 15 percent appreciation happens, then the industrial growth rate should snap down to still the highest growth rate in the world - around 12 percent! So the economy gains. The workers in China, underpaid and over-exploited by a mercantilist exchange rate, will immediately realize a 15 percent increase in wages, and a reduction in poverty to zero. So the Chinese worker gains enormously. Nor do workers in Argentina, Brazil, Mexico, sub-Saharan Africa, Eastern Europe, India, Cambodia, Europe, Canada or the United States, as growth accelerates in all these regions. They all gain, especially those in Asia. Asian workers will also gain from the consolidation of the exchange rate appreciation that has already taken place. And those countries that have played the mercantilist game the most, appreciating relatively the most (we all know who they are - watch this space).

This is Asia's century, make no mistake about it. It's growth rate and its currencies (excluding developed OECD Japan) are destined to be the strongest. The major country the G-7 statement was aimed at was China; the "economic area" was developing Asia. The US deficit will correct, but only if China revalues. This time, the usual suspects have changed. The colored glasses of Western market wallahs prevents them from recognizing the true impact of globalization. Developed country currencies will depreciate, not with respect to each other, but with respect to China, and to a considerably lesser extent, with respect to other countries of vibrant Asia.