The finance minister of Brazil has proved once more that there is nothing better than a good sound bite to capture attention. Guido Mantega said at the end of September that an international currency war has broken out. Economists, financial journalists, investment bankers and traders have latched on to this evocative phrase with the same alacrity with which they borrowed Ben Bernanke’s famous March 2009 statement about green shoots of economic recovery. We now see military metaphors dotting every discussion on exchange rate policies.
The world economy is living under the shadow of competitive devaluations, as major economies try to export their way out of trouble by making their currencies cheaper compared with the currencies of their trading partners. These are trade wars by another name, fought through exchange rates rather than tariffs. Governments have done well to avoid the overt protectionism of the 1930s— myopic policies to protect economies that eventually worsened the global depression. The currency wars that have broken out need to be watched with care because they too are driven by the mercantilist desire to push exports and limit imports.
The past few weeks has seen much action. The US Federal Reserve has already sent a strong signal that it would go in for another round of working the printing presses, in what has been dubbed QE2. Estimates of the extent of such quantitative easing range from $600 billion to $1 trillion. The extra supply of dollars should bring down the price of the US currency. Meanwhile, China continues to buy dollars to prevent an appreciation in the value of the renminbi. Its foreign exchange reserves grew by a record $195 billion in the third quarter.
The Bank of Japan has once again started intervening in the foreign exchange market, on fears that a strengthening yen will choke off the economic recovery. Many emerging markets are reacting to rising currencies. Thailand and Brazil have increased taxes on foreign capital inflows. The Reserve Bank of India has begun buying dollars from Thursday to prevent a further rise in the rupee.
The race to devalue currencies is the surest sign that the international policy coordination during the worst months of the global downturn has been blown away by the new realities. It may not yet be a case of each nation for itself, but the world is getting there. The bigger question is whether the world is headed for economic uncertainty because of the currency war.
Currency realignments can be painful, as the world saw in two similar episodes. In 1973, the system of fixed exchange rates put in place at the end of World War II unravelled. Currency values started bouncing around. The dollar fell. One result of this was that prices of assets marked in dollars—especially oil—climbed. There are many who believe that the first oil price shock was the unintended consequence of the collapse of the Bretton Woods system.
In 1985, the tussle was between the US and Japan (a role which China has stepped into today). The US put pressure on Japan and West Germany to let their currencies rise against the dollar, after a deal struck at the Plaza Hotel in New York City. The US trade deficit with Germany reduced, but its trade deficit with Japan continues till today. Once again, there is a view that this planned drop in the dollar was indirectly responsible for the great Japanese asset bubble of the late 1980s, and the subsequent economic stagnation after that bubble popped. The reason: Japanese authorities tried to minimize the economic damage from a rising yen by huge monetary easing. What followed was the boom and bust.
These two episodes provide useful clues about what could lie in store as the US rushes to push down the dollar—inflation and asset bubbles. These are possible risks rather than certainties, given that the rich nations could be in a Keynesian liquidity trap. But recent statements by Bernanke provide clear indications that the US Fed would be more comfortable with a higher inflation rate in the US. He said on Friday that the US inflation rate was too low.
The more immediate risk for emerging markets such as India is an asset bubble, as all that extra global liquidity rushes into growing economies in search of higher returns. India does not show signs of overheating as of now, as this column noted on 22 September, based on a comparison of key parameters in 2007 and today. The economy is growing at a slower rate; growth in money supply and bank credit is more muted; core inflation seems to have peaked; and market capitalization as a percentage of gross domestic product is lower. The high fiscal deficit and the growing current account deficit continue to be worries, however.
India was a closed economy in 1973 and 1985, and hence the economic effects of global currency realignments were indirect. The threat could be more direct now.
Niranjan Rajadhyaksha is managing editor of Mint. Your comments are welcome at firstname.lastname@example.org
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