Editor’s note: On January 7, Eswar Prasad testified before the House Ways and Means committee on how to deal with currency manipulation in the context of the Trans Pacific Partnership (TPP) trade agreement.
Congressman Levin and honorable members of the Ways and Means Committee, thank
you for the opportunity to provide my views on the issue of how to deal with currency
manipulation in the context of the Trans Pacific Partnership (TPP) trade agreement. This
note briefly summarizes my views on the subject.
The TPP is designed as a broad agreement among its members that covers a number of
areas including expanded market access, stronger labor and environmental standards,
better protection of intellectual property rights, and consistent regulatory frameworks. By
its nature, the TPP represents some important compromises. Nevertheless, if ratified and
implemented by its members in a manner that respects the principles of the agreement, it
has the potential to substantially increase trade flows within the region, benefiting the
economies of all 12 members. The agreement could also set minimum thresholds for
other trade agreements around the world, especially those that involve existing TPP
Exchange rates constitute a key relative price that affect cross-border trade flows. Hence,
it is tempting to consider including surveillance of exchange rate management practices
among TPP members as part of the agreement. However, given the broad range of
macroeconomic and other policies that influence exchange rates, this would amount to
expanding the scope of the agreement into ill-defined and possibly counterproductive
One definition of currency manipulation is tied to direct intervention by central banks in
foreign exchange markets. The TPP includes an ancillary provision calling on members
to disclose the timing and size of their foreign exchange market interventions. Such
transparency would certainly be useful in identifying sustained and substantial
intervention, which could be interpreted as a signal of a central bank attempting to defy
market forces pushing its currency’s external value in one direction or another.
However, other macroeconomic measures such as monetary and fiscal policies, as well as
policies related to the financial sector and product markets, can also be used to affect the exchange rate in lieu of direct exchange market intervention. Even in advanced
economies such as the euro zone and Japan, central bankers have made no secret of their
desire to weaken their currencies in order to stimulate exports and offset deficient
domestic demand. Whether such policies are intended to—or whether in practice they
do—work through domestic channels rather than through the external (export) channel is
difficult to identify a priority using quantitative metrics.
Emerging markets face additional changes related to exchange rate volatility as their
financial markets are underdeveloped, making it harder to absorb and cope with the
effects of such volatility. This has led many of these economies to manage their exchange
rates, both to avoid what they regard as excessive short-term volatility and to forestall
sharp swings away from exchange rate levels that they see as consistent with
macroeconomic fundamentals. Markets are also prone to overshooting in one direction or
another when there are shifts in economic fundamentals that would normally entail some
desirable changes in exchange rates.
This points to another challenge—defining the “appropriate” or equilibrium exchange
rate that is consistent with macroeconomic fundamentals. The best that existing empirical
models and techniques can do is to generate estimates of suitable levels for medium-term
exchange rates. Such estimates have large error bands around them, reflecting the degree
of uncertainty inherent in estimates derived using these techniques. The additional step of
correcting for short-term business cycle conditions in order to translate such mediumterm
concepts into evaluating the suitable level of the exchange rate on a real-time basis
is fraught with even more conceptual and analytical pitfalls.
In short, it is a seductive but unrealistic notion that an agreement can lay down clear
markers for when a country’s economic policy interventions are designed solely or
expressly to counter market forces and weaken a currency’s value in order to gain a
competitive advantage in export markets.
This is certainly a worthwhile policy objective from the broader perspective of
international financial stability and there are forums such as the IMF through which this
should be pursued. But an already ambitious and sprawling trade agreement such as the
TPP could end up being hobbled rather than strengthened by trying to include currency
issues within its ambit.
 For two lucid pieces laying out some of these and related arguments, see Kemal Derviş,
2015, “Can Trade Agreements Stop Currency Manipulation,” Project Syndicate, and
Jeffrey Frankel, 2015, “The Chimera of Currency Manipulation,” Project Syndicate.