The European Union is the second largest economy in the world, but does it have a global economic strategy? 10 years after the creation of the euro, there is little evidence for it. Policymakers are more concerned with protecting narrow domestic advantages than with improving opportunities for the European economy as a whole. The Lisbon Treaty offers now a new perspective. It explicitly calls for policies that ‘encourage the integration of all countries into the world economy’ (art. 21). It will be the task of the new president of the European Council and the High Representative for Foreign Affairs in the European Commission to translate this objective into a coherent strategy that takes into account the euro as the second world reserve currency.

In November 2009, President Obama went to China and asked for a revaluation of the Chinese currency, the renminbi. President Hu Jintao refused. Two weeks later, the European trio Barroso, Junker and Trichet went to Bejing with the same request and got the same response. A common view is that China manipulates its currency to gain unfair trade advantages. However, the world benefits from China’s rapid growth and an appreciating currency could undermine such growth. China is therefore right to resist demands for a stronger currency and Europe is wrong to copy American demands. Europe needs its own foreign economic strategy.

With a market share of 11.4% China is the world’s third largest economy after the United States (20.6%) and the European Union (21.3%). Japan ranks fourth with 6.2% of world GDP. The IMF expects the Chinese economy to grow by 9% in 2010, but the euro area by only 0.3 %, less than the US (3.1%). The additional economic wealth generated by China next year is equivalent to nearly 5% of the EU’s total GDP. Clearly, China is of crucial importance for the European economy.

But so is the US economy. The financial crisis was caused by a combination of under-regulated financial systems and global imbalances, where Asian surpluses financed American deficits. No doubt, adjusting the American external deficit requires a real devaluation of the dollar. Some estimate that the value of the dollar needs to fall by 26%. But if all Asian currencies remain fixed to the dollar, this would imply a real appreciation for the euro of nearly 60% because the euro-dollar rate would have to do all the adjustment work. Growth in Europe would collapse.

Yet, if Chinese authorities gave in to western demands, they would kill their economic miracle, which is based on a combination of nearly unlimited supply of labour and undervalued and fixed exchange rates relative to major world currencies. Elastic labour supply keeps wage increases moderate, and fixed exchange rates maintain a stable environment for exporters and investors. Europeans have learned how damaging flexible exchange rates can be after the collapse of the Bretton Woods system in 1971. Within one or two years, European unit labour costs rose from 60% of the US-level to over 110%, and Europe’s miracle was over.

Greater exchange rate flexibility would not only hurt China but the whole Asian region. Trade between the emerging ASEAN economies plus China, Korea and Japan is now more important for the region than trade with the US or the EU. Exchange rate volatility between local currencies would destabilize the whole region. As Japan is the primary source of foreign direct investment in the region, Prime Minister Hatoyama is therefore right to push for stronger monetary cooperation in Asia.

Appreciating the renminbi is equivalent to a sudden and uncontrollable rise in interest rates. There are signs that some Asian asset markets are booming exuberantly. Preventing a sudden crash requires caution. It would be better to let China structurally grow out of its accelerated catch-up model. An appreciation of the renminbi will automatically come when the highly elastic labour supply from the Chinese country side will dry up. This may happen over the next five years.

In 2005, China’s rural labour force amounted to 485 million workers, 200-230 million of which have now migrated into industries or retired. The Chinese rural economy requires between 178 and 228 million workers so that the labour surplus is between 25 and 107 million workers. Approximately 50% of this labour force is over 40 years old and not adapted to migrating to cities. Hence, the Chinese development model will soon have to shift from low-cost labour intensive production to more capital intensive growth. Capital flows will then revert. Rather than being parked in Wall Street, funds will be invested in new technology imported from abroad. As an exporter of capital goods and advanced technology, Europe will benefit from rapid growth in Asia.

The dilemma for the world economy is that, at the same time, the US dollar must depreciate, Asia needs exchange rate stability, and Europe must avoid the overvaluation of the euro. But there is a solution to this problem. It requires ambitious exchange rate cooperation. Japan and Europe should agree to stabilize their exchange rate within a narrow range and allow the dollar to depreciate. China should re-peg its currency from the dollar to a basket that contains a large proportion of euros and Japanese yen at a competitive exchange rate level. This would allow the US economy to go through the necessary adjustment process while China and emerging Asia will continue to support rapid catch-up growth with stable exchange rates without threatening the euro area.

The effects of rapid Asian growth and regional integration would spill over into major industrialised countries. European consumers would benefit from cheap imports and domestic demand would be stimulated by their improved purchasing power. Asian surplus countries would have to place their foreign exchange reserves in euros and Japanese yen, which would stimulate asset markets and economic growth in these two advanced economies. Capital flows would stimulate European financial markets, which is particularly important in the present post-crisis environment. Furthermore, the stability of exchange rates within the euro-yen basket and those countries who peg to the basket would support further regional integration in East Asia.