The Causes and Consequences of Currency Wars
The Realist understanding of international affairs is that it is a realm of competition. The competition is multi-faceted, taking place in politics and economics. It has a cultural dimension. It takes place even in the writing of history.
This competition spills over into the foreign exchange market. It did not begin with the unorthodox pursuit of monetary policy in high income countries beset with crisis. Even at Bretton Woods countries were jockeying for advantage. From the time that the dollar-gold standard of Bretton Woods became operational, the foreign exchange market was politicized. The US wanted the German mark and Japanese yen, for example, to be adjusted higher, rather than devalue the dollar. The attempt to re-start Bretton Woods with the Smithsonian Agreement was shaped by the conflict of national interest.
This has also been the history of floating rate era. The hot capital flows into Germany and Switzerland resulted in a policy response of intervention and negative interest rates in the 1970s. Some observers attribute the 1987 equity market crash in part to Treasury Secretary James Baker threatening dollar depreciation if Germany did not stimulate its domestic economy. When he was Treasury Secretary Llyod Bentsen threatened to allow the dollar to fall against the yen unless the Japanese government opened its markets more to US goods.
At times, the high income countries coordinated intervention such as under the 1985 Plaza Agreement. At other times, countries, such as Japan, were forced to act alone. Western European countries have repeatedly sought to minimize the intra-European currency fluctuations; from the Snake, through the ERM to finally getting rid of national currencies altogether.
Very few countries in the world seem to have ever felt completely comfortable with the prices that the foreign exchange market set. Indeed from Mexico’s Tequilla Crisis in 1995/95 through the Asian financial crisis in 1997-1998, a number of semi-fixed exchange rates were broken after numerous and costly attempts to defend them. The large build up of reserves in emerging market countries is largely, though not solely, a reflection of resistance to currency appreciation and the pursuit of neo-mercantilist developmental strategies. Most of the wealthy Mideast countries retain pegged currency regimes.
These days, it has become fashionable to talk of this pursuit of national self-interest over foreign exchange prices as a “currency war”. Although many seem to think it began with the unorthodox monetary policies pursued by the high income countries since the onset of the crisis, the tale of the tape tells a different story.
Many observers are confused by the metaphor. They think it is real. Currency warfare devolves into outright protectionism and, viola, Smoot-Hawley-esque protectionism, a trade war. Then a real shooting war. Q.E.D.
Typically central banks want the external value of their currencies to move in the same direction as monetary policy. Given the synchronized economic downturn in the high income countries, it is not surprising that monetary policy has become synchronized and that most officials want weaker currencies. And this is at loggerheads with the many of the leading emerging market currencies that are not willing to accept substantial currency appreciation.
At the same time that Bank of England Governor King warned against competitive devaluations this week, he suggested that sterling’s relative strength has not done the UK any favors. The Bank of Canada, whose governor will soon replace King at the helm of the BOE, noted that the persistent strength of the Canadian dollar has hurt exports. Norway and Sweden have indicated that the strength of their respective currencies could influence the course of monetary policy decisions. Switzerland, with one of the largest current account surpluses, has effectively capped its currency.
The rhetoric, much more than the action, of the new Japanese government, explicitly seeking a weaker yen, has irked many. Former Eurogroup head Juncker was off-message when he recently said the euro was dangerously high. German officials have been quick to clarify. First it was Finance Minister Schaeuble who was critical of Japan’s “false understanding” of monetary policy. Then is was BBK’s Weidmann who warned of the risks of politicizing the exchange rate. This was followed by Deputy Chairman of Merkel’s CDU who expressed concern not just at Japan’s competitive devaluation but also that if other countries follow, it could lead to a downward spiral.
Russia has recently taken exception and has threaten to raise the issue at upcoming international meetings. South Korea has threatened to take action. The industry association for US auto makers protests (as they have since there were more than 300 yen to the dollar). It is unusual for Fed officials to comment on the foreign exchange market, but the St. Louis Fed President Bullard recently expressed his concern.
Following the war metaphor, we have often found it helpful to understand intervention as an escalation ladder. The lower rungs may be different ways to verbally express displeasure at market prices. Most of the time officials stay on the lower rungs. Despite desire for weaker currencies, neither the Bank of Canada nor the Bank of England are about to intervene materially in the foreign exchange market, for example. And if some countries cut interest rates to offset their currencies’ strength, well, that is how the adjustment process is supposed to work.
The World Trade Organization also helps act like a circuit breaker of sorts. It offers a conflict resolution mechanism to prevent trade disputes from leading to exactly the downward spiral that many observers rightly fear. There is no sign that this firewall has been threatened.
When officials talk about currencies reflecting fundamentals, they often mean external balances. Japan has swung from a trade surplus to a trade deficit. In fact, on a seasonally adjusted basis, it has not recorded a monthly trade surplus since Feb 2011. Exports have fallen on year-over year basis since May 2012 (and the December report due out first thing in Tokyo on Thurs is expected to show more of the same). The OECD calculation of purchasing power parity has the yen about 14.6% over-valued at current levels.
Besides the relative size of the economies, it is not clear why the Swiss capping their currency has not drawn the same ire as the Japanese. Indeed, one could argue that the Swiss move deflected more pressure to Japan and if the SNB had not pegged its currency, the new LDP government in Japan would not be talking the yen lower.
While we do think Japanese officials would welcome a weaker yen, we see in the rhetoric an attempt to ease concern that is is seeking an endless or even protracted decline. The upcoming G20 meeting may reaffirm the commitment to market-based foreign exchange rates. The push back may impact LDP policy intentions may making it less likely that it will seek to buy foreign bonds, which would be too close to material intervention.
A real currency war remains a remote possibility. The recent clash is largely in the realm of rhetoric and does not appear substantially different than what has been seen through the floating rate area. The synchronized crisis and economic weakness has produced synchronized easing of monetary policy. Officials typically want currency to be supporting not contradicting monetary policy signals. Lastly, it is particularly noteworthy that Japan’s largest trading partner and regional rival China, appears not to have publicly protested the yen developments.