The experiences of many countries, including Sweden at the beginning of the 1990s, show that the foreign exchange market should not be deregulated until the banking system has been reformed. Could China not revalue then and adapt the exchange rate to its trade surplus without floating its currency? In my opinion, this would not be such a wise decision either. It is wrong to attribute China’s trade surplus with the US to the currency issue. The surplus is probably best explained by the cost advantages enjoyed by Chinese producers in labour-intensive goods compared with the US. China’s trade surplus can be seen as a natural consequence of the division of labour within the Pacific region where China’s position as supplier and sub-supplier of low value-added goods is highly favourable for US productivity. This is a segment in which the Chinese compete with very few US producers, which is why an exchange rate adjustment would have only a marginal impact. In actual fact, an excessively large one-off adjustment would be required to have any effect at all on the US-Chinese trade balance. Such a large correction would in turn give rise to problems for Chinese trade elsewhere. It is with the US that China enjoys a large surplus, while the trade balance is close to zero or is negative with many other areas, including the euro area. This picture is confirmed by many fundamental analyses of an equilibrium exchange rate for China, which come relatively close to China’s fixed exchange rate today.
The economic purposes of these contracts include hedging or gaining exposure to: outright interest rate risk, basis risk, cross currency risk, and interest rate volatility. Banks, pension funds, insurers and hedge funds are all heavy users of Libor derivatives. Libor is also important for the real economy in the UK, with more than £ of SME and corporate loans, around £ of Floating Rate Notes and £ of structured debt referenced to sterling Libor. Libor’s role here is typically to provide a transparent and widely accepted reference point for the floating interest payments on loans. The dominance of Libor might be taken as evidence of the overwhelming need for Libor-linked financial contracts. However I do not believe this is the case. A large part of the reason Libor is so widely used is due to what economists call network effects. Using Libor is attractive because Libor instruments are liquid. This is self-reinforcing – liquidity drives use of Libor, which drives liquidity. In many cases the use of other benchmarks would be preferable for users. For example, most users of interest rate swaps are seeking to hedge the general level of interest rates, not bank credit risk. For this, near risk-free rates would be more appropriate. However, liquidity for long-dated sterling swaps is firmly rooted in contracts referencing six-month sterling Libor, and individual participants cannot change this.