Suddenly the press and media were buzzed with the word ‘Currency War’. People are discussing that sooner than later all countries would go for this currency war. This got my curiosity and I decided to look into what is called as ‘currency war. I found some general things. I would like to share them with you all and discuss how it all started. But to start with, I would like to add that with much of Europe in a recession, Japan struggling with deflation, and the weak American economy potentially falling back into a recession if the automatic spending cuts go through, the global economy is fragile. The last thing the world needs is a currency war. Hehehe, anyways to start with:
Brazil’s finance minister coined the term “currency wars” in 2010 to describe how the Federal Reserve’s quantitative easing was pushing up other countries’ currencies. In mid January, 2013 Alexei Ulyukayev, the first deputy chairman of the Russian central bank, resurrected the phrase to warn of another round of competitive devaluations.
The starting-point for this skirmish was the election of Shinzo Abe as prime minister of Japan in December, and his promise to reorient economic policy. Mr. Abe stormed to an election victory in December with bold promises to end decades of intermittent growth. He wants the Bank of Japan to double its inflation target to 2% and to buy government bonds until that target is achieved. If his goal is realized, Japanese interest rates would finally become negative in real (i.e., after inflation) terms. Because of deflation, real rates have been positive for much of the past decade, even though the economy has been sluggish. That has kept the yen strong, making life more difficult for exporters.
Mr. Abe’s move has had a tremendous impact on the currency markets, pushing the yen down from 78 per dollar in October to 90. According to Alan Ruskin of Deutsche Bank, this was the fifth-fastest decline in the yen since the collapse of the Bretton Woods exchange-rate system in 1971. The yen, for instance, has fallen by about 11 percent against the dollar since the recent election in Japan of Prime Minister Shinzo Abe. The Bank of Japan, the central bank said it would pump more money into the economy via a new, open-ended commitment to buying assets beginning in 2014 — measures known as QE and intended to lift the country out of its fourth recession since 2000. Critics say those policies are aimed at lowering the value of the yen, which Mr. Abe’s government has denied, saying that the Bank of Japan is trying to end nearly 20 years of deflation — not manipulate the yen.
Even the Japanese seem to have been slightly taken aback by the yen’s fall. Japan is heavily dependent on foreign energy supplies, and Akari Amari, the economy minister of Japan, warned that excessive yen depreciation would force up import prices.
The yen’s weakness has added to the pressures on other economies. One of the strongest currencies so far in 2013 has been the euro, which has been buoyed by a feeling that a break-up of the single currency has become less likely.
President François Hollande of France proposed that euro-zone nations should adopt a policy to manage the value of the common currency to maintain the competitiveness of European goods. (The euro has appreciated about 2 percent against the dollar and nearly 10 percent against the yen this year.) Even Chancellor Angela Merkel of Germany waded into the currency debate Thursday, singling out Japan as a source of concern following the Bank of Japan’s moves.
“I don’t want to say that I look towards Japan completely without concern at the moment,” she said at the World Economic Forum in Davos. “It is known that in Germany we are of the opinion that central banks are not there to clean up political bad decisions and a lack of competitiveness.”
The euro has even risen against the Swiss franc, a currency that was so strong in 2011 and 2012 that the Swiss accumulated more foreign-exchange reserves than any other country in the world. The Swiss National Bank acquired those reserves as part of its pledge to prevent the franc from rising above 1.20 to the euro by creating unlimited amounts of francs and buying foreign currencies with the proceeds.
Developing countries like Brazil and Mexico also complain that looser monetary policy in industrialized nations can produce effects similar to currency manipulation. When central banks in countries like Japan and the United States pump more money into their financial systems, investors are driven to put their money into emerging markets where interest rates are higher. That pushes up currencies like the real and peso, making exports from those countries more expensive on the world market.
Typically, a central bank eases by lowering the short-term interest rate. When that rate is stuck at zero, it can buy bonds, i.e. conduct quantitative easing (QE), or verbally commit to keep the short rate low for longer, or it can raise expected inflation. All these conventional and unconventional actions work the same way: by lowering the real (inflation-adjusted) interest rate, they stimulate domestic demand and consumption. America, Britain and Japan are all doing this, although only Japan has explicitly sought to raise expected inflation; America and Britain have done so implicitly. This pushes the exchange rate down in two ways. First, a lower interest rate reduces a currency’s relative expected return, so it has to cheapen until expected future appreciation overcomes the unfavorable interest rate differential. This boosts exports and depresses imports, raising the trade balance. Second, higher inflation reduces a currency’s real value and thus ought to lead to depreciation. But higher inflation also erodes the competitive benefit of the lower exchange rate, offsetting any positive impact on trade.
If this were the end of the story, the currency warriors would have a point. But it isn’t. The whole point of lowering real interest rates is to stimulate consumption and investment which ordinarily leads to higher, not lower, imports. If this is done in conjunction with looser fiscal policy (as is now the case in Japan), the boost to imports is even stronger. Thus, QE’s impact on its trading partners may be positive or negative; it depends on a country’s trade intensity, the substitutability between it and its competitors’ products, and how sensitive domestic demand is to lower rates. The point is that this is not a zero sum game; QE raises a country’s GDP by more than any improvement in the trade balance.
There are other spillovers. Lower interest rates in one country will generally tend to send investors searching for better returns in another, lowering that country’s interest rates and raising its asset prices. By loosening foreign monetary conditions, that boosts growth, though this may not be welcome if those countries are already battling excess demand and inflation. Countries like Brazil and Mexico fall in this category.
Determining whether QE is good or bad for a country’s trading partners requires working through all these different channels. In 2011, the International Monetary Fund concluded the spillover of the Fed’s first round of QE onto its trading partners was significantly positive, raising their output by as much as a third of a percentage point, while the spillover of the second round was slightly positive. The IMF concludes the weaker dollar was indeed slightly negative for the rest of the world, but this was more than offset by the positive impact of lower interest rates and higher equity prices. This became a motivation for Japan’s stepped-up assault on deflation. The combined monetary boost on opposite sides of the Pacific has been a powerful elixir for global investor confidence.
Currency warriors regularly invoke the 1930’s as a cautionary tale, but they actually show something quite different. In the 1980s, Barry Eichengreen at the University of California, Berkeley and his co-authors demonstrated that the first countries to abandon the gold standard recovered much more quickly from the Depression than those that stayed on gold longer. The direct spillover of depreciation was negative, while the spillover of increased money and credit was positive, as capital outflows “helped to relax conditions in money and credit markets and moderate expected deflation in other countries.” Nonetheless, he concludes that from both calibration exercises and historical literature, the spillover effect was net negative. This might have been averted if everyone adopted the same monetary policy, i.e. quit gold at the same time:
The irony is that to the extent devaluation led to protectionism and falling trade volume, it was more due to countries that did not devalue. In an earlier paper, Mr Eichengreen and Doug Irwin of Dartmouth College note that countries that remained on gold were more likely to erect protectionist measures against imports than countries those that quit. So while imports did collapse, they fell far less for countries that abandoned gold (like Britain, whose imports rose slightly between 1928 and 1935) than for those that stayed with it, like France, whose imports fell 15%.
The key insight of Mr Eichengreen’s work was that the more countries abandoned gold, the more positive become the spillover effects: “what are now referred to as currency wars were part of the solution, not part of the problem.” The analogy for today is that countries whose currencies are rising because of easier foreign monetary policy should ease monetary policy as well, assuming they, too, suffer from weak demand and low inflation. In fact, America’s QE and the resulting upward pressure on the yen was one of the key reasons Shinzo Abe, Japan’s prime minister, demanded the Bank of Japan take a more determined assault against deflation. The fact that global stock markets have been chasing the Nikkei higher as Mr Abe’s programme is put in place suggests investors believe this is virtuous, not vicious, cycle. This also implies that the euro zone ought to respond with easier monetary policy which would both neutralize upward pressure on the euro and combat recession in the euro zone.
But Mr Eichengreen notes that unlike in the 1930’s, today there is a large group of emerging economies who did not suffer a deflationary shock and thus would not benefit from easier monetary policy. Their optimal response, he says, would be to tighten fiscal policy, which would cool demand, putting downward pressure on interest rates and their currencies. But, as in the 1930’s, he notes that there are political and institutional barriers to doing so, and instead they are opting for second-best policies such as capital controls, currency intervention, and in some cases, import restrictions. To read more about Mr Eichengreen, click on the link at the end of the article.
There’s an interesting debate over whether even intervention constitutes currency war. Economists traditionally thought such intervention had limited effect. If the central bank intervenes but does not change expectations about interest rates, investors will simply buy up all the currency that the central bank sells until expected returns were once again equal across all markets.
But Joseph Gagnon of the Peterson Institute for International Economics challenges this conventional wisdom. Studies that found intervention does not work were done in the 1980’s and 1990’s when the sums were far smaller, he says. Central bank intervention is now hundreds of times larger. He explains in an interview:
“Japan did $177 billion of intervention in 2011. When countries intervene on that magnitude, I don’t think all the hedge funds and investment banks in the world are enough to neutralize that effect. They’re not willing to gamble more than a few tens of billions. Hedge funds need differential rates of return to induce them to take opposing positions. And the riskier it is, the more they have exposed, and the higher return they need. They expect to make money because government is distorting markets in a way they think is not sustainable, but governments can distort markets longer than you can stay solvent. “
This has parallels to the debate over QE. Skeptics believe that if the central bank does not change the public’s expectations of interest rates or inflation, no amount of bond buying will alter asset values or stimulate growth. But advocates believe investors have a “preferred habitat;” they hold certain types of bonds or assets because of legal or institutional constraints, even if their returns seem too low relative to their own expectations of interest rates.
Most intervention is sterilized: the central bank is selling currency previously held by the public, so the money supply does not change. Unsterilized intervention, in which the central bank prints the currency it sells, as the Swiss National Bank has done, has different implications. It is, in practice, QE plus sterilized intervention. Imagine an investor sells Euros to the SNB and gets newly printed Swiss francs. He invests them in Swiss government bonds, buoying their prices. The result is exactly the same as if the SNB had bought Swiss government bonds with newly printed money, then sold those bonds in order to buy foreign exchange. Based on our analysis here, it is getting one thing right (the QE) and one wrong (the intervention). The SNB justified its action based on the fact that its domestic bond market was too small to accommodate QE in sufficient size. Its trading partners must have agreed, because they didn’t kick up much fuss. Or perhaps Switzerland is too small to matter. Japan should not assume it would get the same, hands-off treatment.
Should Japan’s attack on the yen move beyond rhetoric to actual intervention in the markets to drive its value down, then the rest of the world would be right to condemn it (Because If all countries were to competitively devalue their currencies, the result would be a downward spiral that would benefit no one, but could lead to high inflation.). Until that happens, other countries should avoid groundless outcries about currency wars.
The president of the European Central Bank on 14 February, 2013 cited the rising value of the euro as a possible threat to the region’s economic recovery, comments that immediately sent the euro down sharply against the dollar and yen. Mario Draghi, the E.C.B. president, denied that the central bank was trying to influence the value of the euro, no doubt mindful of provoking a currency war with Japan or the United States. But he then made statements that investors interpreted as meaning the E.C.B. could take action if the euro rose too much.
Source: Economist, The New York Times
Click here to read Barry Eichengreen Paper 🙂