Is a global currency war heating up?

To drive export growth in global trade, every country strives to peg the exchange rate of its currency at low ebb. Slowly but steadily competitive devaluation is taking place around the globe mooted by advanced and emerging economies.

As Marc Chandler, Global Head of Currency Strategy at Brown Brothers Harriman & Co. says, “Most governments believe that their currencies are too important to be left to the markets”.

The collapse of fixed exchange parity in the 1970’s created earlier by the Bretton Woods system in 1944 saw   governments adopting currency manipulation and interventions to keep low currency levels to boost exports. This has become an effective arsenal in the currency strategy and has been termed as “beggar thy neighbour “policy.

The US currency management

After the 2008/2009 global economic slowdown, there was a rhetoric conflict between the United States and China over the undervaluation of the yuan otherwise known as renminbi. That the exchange rate mechanism is vital  to the surviving of an economy is emphasized by the Chinese Premier who said, “The 20 to 40% appreciation of the yuan demanded by the US would cause many bankruptcies in the Chinese owned State enterprises and cut down jobs for urban and migrant workers and eventually bring in fierce social turbulence.”

While calling the shots against Chinese pegging their currencies low, the US has been silently infusing more currency into circulation  by printing trillions of dollars out of thin air through “Quantum Easing” programme – QE1 and  QE2 resulting in a lower value of the US dollar.

Facing a tepid growth rate, high unemployment figures and the policy making Congress embroiled in tardy ideological differences, the Federal Reserve defends quantum easing as an accommodating monetary policy. The additional liquidity pumped into the system was expected to trigger consumption vis a vis investment spending and generate employment. QE1 brought in additional $1.7 trillion paper currencies into the system to ward off toxic securities. Under QE3 the Federal Reserve will buy up $600 billion of Treasuries. But with these well calculated measures, still unemployment numbers remain an Achilles Heel for the Obama administration.

But that story does not end there. The surplus dollar injected into the system out of QE in the US does not remain there but does move to other countries’ ‘financial markets’ in search of higher yields. The surge of flow into emerging markets without due care and diligence of economic fundamentals is again a source of concern. When there is a surfeit of US dollars in a receiving country, the local currencies of the receiving countries appreciate in value more than that warranted by the fundamentals.

To counter such an upward surge in the value of their currencies, the central banks intervene to buy dollars and indulge in quantitative easing to keep up with China. This economic spiral goes on and on.

But will it trigger spiraling protectionism?

The Swiss intervention

When the Swiss currency was floating high in 2011 the Swiss adopted the policy of ‘’damn the market’s mechanism ‘‘. Switzerland, a safe haven for foreign capital, plugged the rising value of its currency by fixing threshold limits by which its currency will not be allowed to appreciate further against the euro.

The Japanese intervention

In January, 2013 having seen its currency appreciate to the detriment of its exports, Prime Minister Shinzo Abe’s new government announced through its central bank the intention to launch an open bond buying programme aimed at correcting the appreciation of its currency. In fact the new Japanese government has been taking a slew of measures over the last two months and the yen weakened by more than 10% against the dollar and close to 20% against the euro.

While one need not be a financial guru or wizard to analyse the fact that while currencies can depreciate against basic economic factors like gold, land and other real estates, by logical inference not all currencies can fall against each other. This is where the exchange mechanism currently being followed is being dragged to a more complex and intriguing levels.

The Euro response

Logic and equity tell us that some must appreciate while others depreciate their currencies.  Now it seems that is the turn of the EURO Zone to be at the receiving end of other countries’ actions.  At present the euro seems to be taking the shocks. But for how long? The single currency had hit a 32 month peak against the yen a couple of weeks ago. The soaring euro is posing serious challenges to the euro bloc and is also stirring the pot in Europe.  The surge in the euro against the basket of currencies has alarmed European pundits on exchange rates amidst fear of wiping out earlier signs of recovery and expectations that the euro zone would return to growth track.

This scenario even forced France‘s President Francois Holande to call for a managed exchange rate for the euro.  But it is not easy for the Euro Zone to make a quick response as it needs the consent of 17 governments and the arsenal to clear the sovereign debts of its 17 member countries. With a contracting economy and a rising currency, Mr. Mario Draghi, the European Central Bank president has at last intervened, adding to the apprehension whether the currency war is assuming global dimensions.

Mr. Draghi’s talk down of the euro and talking up the Euro zone has sent the euro to its lowest levels against the dollar in nearly two weeks. This drew immediate accolades from foreign exchange mechanism experts like Nick Spiro, the Managing Director of Spiro Sovereign services as “Mr. Draghi pulled off quiet a strategy”. And Valentin Marinov, Currency Strategist at Citi Bank said “Investors will be mindful of the fact that that further excessive currency strength could trigger an ECB response sooner than expected.”

The Chinese roulette

Already the dramatic fall in the Japanese yen and other Asian currencies have evoked a strong policy response from the People’s Bank of China (PBoC) which has set up stronger mid points in response to a fall in the dollar’s position among a basket of currencies. In addition to midpoint mechanism the PBoC has been directly intervening in the market since early December, 2012. According to Stephen Green, an economist at Standard Chartered, ‘The PBoC is back to intervening in the FX market- to the tune of US$34 billion in 2012”
According to the analyses published by the currency strategists at RBS, as of January 2013, Indonesia, Thailand, Malaysia, Chile and Sweden are the most willing and able to intervene.

Unconventional policies of various central banks

Unlike the olden days where currency wars directly related to trade imbalances and balance of payments crisis, today’s scenario is complicated by many central banks adopting various off-setting measures in the hitherto uncharted waters to supplement policy inadequacies of relevant governments and political dysfunction as seen in the law making bodies of the developed world. As a result there are loose monetary policies like quantum easing being followed to allow currencies to weaken or limit appreciation. But there is an inherent ballooning of the global financing. The real estates of China and Argentina are heating up so also in other Asian countries. According to Mohamed El –Erian, Chief Executive of the Pacific Investment Management Co, “It is equivalent to a pharmaceutical that feels forced to bring a new medicine to the market even though it has not been properly tested”

Where is the global monetary system heading to?  Will there be positive outcome like central banks lifting the economies from their ill effects? There are divergent views. James Rickards, a veteran financier and the author of “Currency wars- The Making of Next Global Crisis” says – “I expect the international monetary system to destabilize …. There will be so much money printing by so many central banks that people’s confidence in paper money will wane and inflation will rise sharply.” And it must be remembered that there has been a dramatic regularity in breakdown of the foreign exchange system.

For the world to recover from this beggar thy neighbour policy, countries must realize that greater cross border dialogues and concerted coordinated efforts are essential. The monetary policy must be supplemented by bold and imaginative fiscal measures and efforts must be made to ensure that the heavy dosage of monetary infusion into the systems stokes domestic demand permitting a solid recovery where, the intervening powers return to adopting a sanitized exchange regime. Now the time has come for the International Monetary Fund (IMF) and the World Trade Organisation (WTO) to lend an effective role in this exchange cutting scenario.

Concerned with negative effects of this global scenario, it would be interesting to watch the outcome of the G20 summit to be held in Moscow where leaders are expected to deliberate on the issue.

Author: Srinath Sundaraju

Email: [email protected]