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Understanding the "Currency War" Talk

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World growth remains relatively stagnant. Nearly all major economies are experiencing growth rates which are either below trend, low, or in outright contraction.  This is a world of inadequate demand, and a world where capturing as much global demand as possible (whether at home or abroad) is an inevitable, if undeclared goal of much policymaking.

For now, the trading systems for much of the world remain fairly open. Countries with a high level of domestic demand (especially the United States), are for the most part adhering to their WTO commitments and not limiting foreigners’ access to their markets with overt protectionist measures such as tariffs or quotas on imports.  Yet many policies can have a trade effect, and one key area where the WTO remains toothless is that of currency manipulation.  After the 1997 Asian Financial Crisis, many affected Asian countries actively built up foreign currency reserves to protect themselves against foreign debt crises. The side effect (or perhaps main goal) of course was to suppress their currencies’ values. In 1994, China devalued the RMB from 5.8yuan-1USD to 8.7. In order to maintain this peg, the People’s Bank of China had to build up huge reserves.

Recent events in Japan have renewed discussion of the prospect of a “currency war”. Such a war could be defined as a “beggar-thy-neighbor” tit-for-tat series of moves in which various countries try to devalue their currency in an attempt to increase the competiveness of their goods on foreign markets, whilst doing the opposite for foreign goods in home markets. 

Complicating the issue are the various ways in which currencies’ values can change.  A currency peg is the simplest form, whereby a country (normally via its central bank) intervenes in foreign exchange (forex) markets to maintain a set nominal value of its currency against another (usually in the modern era the U.S. dollar). 

More subtle would be the manipulation of one’s own fiat currency value through expansive monetary policies. Often wrongly described as “printing money,” a basic explanation would suggest that an increase in supply of a currency would lower its value, “debasing” the currency if not through simple supply and demand dynamics then through the effect of lowering domestic interest rates and thus encouraging capital to leave the country in search of higher returns abroad (lowering demand compared to other countries’ currencies.)

So, has Japan started a “currency war”? Or were its recent monetary moves entirely domestic in focus?

There have indeed been rumblings of “currency wars” from many countries in recent years. Particularly loud has been Brazil, which is seeing its manufacturing sector undercut primarily by Chinese imports (boosted by what has widely been perceived as an undervalued RMB).  Switzerland has openly intervened in its currency value, trying to limit the Swiss Franc’s appreciation as funds flowed into the country due to its “safe haven” status.  Japan has also moaned about this phenomenon, and even acted to limit the rise of the Yen.  The U.S. and UK’s quantitative easing programs have been accused of being at least partly currency focused. 

Meanwhile, suggestions that Spain, Greece or Italy might better boost competiveness by leaving the Euro and then devaluing (and defaulting) rather than undergoing years of painful austerity and unemployment (boosting competiveness through resulting wage drops) continue to worry Germany.  New Zealand Central Bank Governor Graeme Wheeler has also warned that his institution may intervene to halt rises in the New Zealand Dollar.

One main difficulty in defining a currency war is that it is natural for a currency to change in value as an economy grows (or contracts) or changes, productivity increases (or falls), trade and investment patterns shift or fund inflows from a persistent trade surplus cause domestic inflation (and thus real appreciation). 

Furthermore, Japan (in particular) and other countries do have natural checks on their ability to carry out “competitive devaluations.” For example, post-Fukushima Japan, with its anti-nuclear energy policy has to import more energy from abroad, and a weaker Yen increases the costs of such imports. Eventually, consumers will have to pay for these costs. 

So despite the recent G-20 meeting’s apparent success in averting a full blown currency war, we should remember that currency manipulation is only one tactic in a much larger strategic goal of capturing as wide a share of global demand as possible. The longer a return to healthy global growth takes, the more likely such trade frictions are to emerge.  It is almost natural for every country to try and shift as much of the cost of adjustment onto others, even if the end result of such self-interest is a net loss for everyone.

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