Econbrowser presents a guest contribution by Jeffrey Frankel, Harpel Professor at Harvard's Kennedy School of Government and a former member of the White House Council of Economic Advisers. An earlier version of this analysis appeared in Project Syndicate.

August 17 — Observers of international monetary economics have shifted their attention back to the exchange rates of Asian currencies amid concerns that China's yuan, Japan's yen, and Korea's won are undervalued. An undervalued currency makes a country's exports cheaper for foreign buyers and its imports costlier at home — one reason persistent undervaluation draws political fire in deficit countries such as the United States. All three countries run trade and current account surpluses at a time when the United States is running corresponding deficits. Yet given the fundamentals that keep US interest rates higher than those of the three Asian economies, foreign exchange intervention is unlikely to prove helpful.

Three Asian Currencies

Brad Setser of the Council on Foreign Relations has recently argued that "The world should not ignore China's undervalued currency", while Gita Gopinath, Pierre-Olivier Gourinchas, and Hélène Rey — two of them former chief economists of the IMF — have responded that the US-China exchange rate is not the root cause of current account imbalances and does not warrant action by other countries. Should Beijing be internationally pressured to push the yuan upward, as Donald Trump has long argued? (The People's Bank of China used to intervene in the foreign exchange market to impede appreciation; it stopped doing so in 2014 and began intervening to impede depreciation.)

Japan's yen is also said to be undervalued at the same time. For this reason, the US Treasury intervened in the foreign exchange market to boost the yen on July 31, in cooperation with the Japanese authorities — the first time that has happened in this century. The United States itself had last intervened in the currency market in 2000, acting to support the newly created euro. One could hear reverberating echoes of the Plaza Accord of 1985.

Political pressure from the US Treasury to get Asian currencies to appreciate is an old story. Among the Asian currencies the Treasury considers undervalued is the Korean won. In explaining the US participation, Treasury Secretary Scott Bessent told Nikkei on August 4 that "many Asian currencies follow the Japanese yen." Korea reportedly joined in on the coordinated intervention, buying won at the start of August.

Foreign Exchange Intervention

Does the rare three-country currency operation signal a break in the new US unilateralism? There is little left of a US-led international community that can act in the common interest in matters such as exchange rates. President Trump has seen to that — although, to be fair, the trend was already underway since the turn of the century.

True, Secretary Bessent used the language of mutual US-Japan comity in explaining the recent currency intervention. But many inferred that the US motivation was to prevent Japanese interest rates from rising, under a belief that this would force US interest rates up, which the Administration wants to avoid. That the US used euros to buy the yen rather than dollars is consistent with the stated desire to avoid an increase in the US Treasury bill interest rate. And Bessent's failure to consult with the European Central Bank on the use of its own currency belies any idea of a return to notions of multilateral cooperation or multilateral norms.

Many economists think that intervention in the foreign exchange market cannot affect the exchange rate, except to the extent that it changes the countries' money supplies. There is a lack of recent experience, because intervention by G-7 countries has been rare since the turn of the century, so the evidence on effectiveness must be drawn from further back. The most famous example is the set of coordinated interventions around the Plaza Agreement of 1985. The Plaza was successful at bringing down the dollar. Indeed, interventions in the 1980s and 1990s appear to have often accomplished their purpose of moving the exchange rate in the desired direction, at least for a while. The operations were more likely to be effective when (i) the US joined in with an international effort, (ii) they were publicly announced, and (iii) they caught the markets by surprise. The three-way intervention at the start of August met these conditions; sure enough, there was an immediate appreciation of the yen and won.

Currency Manipulation

The bi-annual US Treasury Report to Congress on Macroeconomic and Foreign Exchange Policies of Major Trading Partners of the United States has long been congressionally mandated to relay findings of possible currency manipulation. The most recent report, issued July 23, names seven Asian currencies on its Monitoring List of ten "major trading partners whose currency practices and macroeconomic policies merit close attention": China, Japan, Korea, Taiwan, Thailand, Singapore, Vietnam, Germany, Ireland, and Switzerland. No country was named an outright manipulator this time, however. The last formal designation came in August 2019, when the Treasury designated China a currency manipulator; that label was lifted the following January.

Those who worry that the yuan, yen, and won are undervalued against the dollar are usually talking about these countries' trade surpluses and current account surpluses, and the US deficits — particularly bilateral ones — all of which are indeed substantial. But bilateral trade balances are not among economists' standard criteria relevant for judging the undervaluation of a country's currency. The IMF has long considered the relevant criteria to be "protracted large-scale intervention in one direction in the exchange market," excessive international reserves, and an overall current account imbalance. Also relevant is whether the country is selling its goods at prices below the world price even after adjusting for productivity, as China was doing 20 years ago.

How to Address Current Account Imbalances

The best interpretation of the current trade imbalances is similar to diagnoses going back as far as the early 1980s and early 2000s. The fundamental reason China is running a large current account surplus is its high rate of national saving. Even assuming intervention were successful at raising the value of the yuan and reducing the current account surplus, that would just divert more of the high national saving into high investment, probably mediated by a low real interest rate. With China already in deflation, this is not what it needs.

What China needs is a set of reforms that economists, both domestic and foreign, have been recommending for some time: a shift away from manufacturing to services, a reduced reliance on investment spending and export demand, and a greater role for household consumption. The private saving rate would be more moderate if the government provided more of a social safety net, including health care and social security. Other desirable reforms include increasing the flexibility of land markets and labor markets — for example, allowing workers to migrate and yet retain social benefits.

The weak yen can also be attributed to economic fundamentals. The interest rate in Japan is very low, especially in light of recent Japanese inflation. Markets apparently expect Japan to continue to monetize its huge government debt. Instead, the Bank of Japan should probably raise the interest rate.

The fundamental reason the United States is running a large current account deficit is its low rate of national saving, especially the negative government budget balance. The national saving identity tells us that the current account balance must equal national saving minus investment: a country that does not save enough to finance its investment and government spending at home necessarily borrows from abroad. Even assuming intervention were successful at reducing the value of the dollar and subsequently improving the US current account deficit, this would crowd out investment.

The channel transmitting the crowding out of investment would probably be a high real interest rate: the Fed would have to raise interest rates more rapidly than otherwise to head off inflation. Inflation, already boosted by Trump's tariffs and the war on Iran, would be further exacerbated if the dollar depreciated. This is at odds with the US Treasury's desire to prevent rises in the US interest rate.

The bottom line is that the exchange rate is more often a symptom of economic fundamentals than an independent lever of its own. The United States ought to work on strengthening its government budget. It has exhausted much of its ability to persuade other countries to do things, and whatever such capacity is left should not be squandered on exchange rate actions of dubious benefit.

This post was written by Jeffrey Frankel.