Currency Wars and the Emerging Market Countries

Currency Wars and the Emerging Market Countries Richard Portes President, Center for Economic Policy Research; Professor, London Business School uniTEd kingdOM/ EuROpEan uniOn he headlines shout “currency wars”. The Unit- Policymakers in both DM and EM are aware of the ed States believes China engages in “currency trilemma, but they are not fully conscious of the Tmanipulation”. It hesitates to declare this to international repercussions of quantitative easing the U.S. Congress, and the secretary of the Trea- (QE) by the largest economies when they are at sury says “competitive non-appreciation” instead. the zero lower bound (ZLB) for interest rates. This China accuses the United States of excessively note will explore these issues. loose monetary policy, flooding the world with liquidity. There is some truth in both charges, but The U.S. dollar has in fact already experienced a real some exaggeration. effective exchange rate depreciation of over 10 percent since early 2009, almost bringing it back to the This is one of the key issues facing the G-20. Ex- low of early 2008. The Federal Reserve Bank of St. change rate pressures, global imbalances and re- Louis has calculated that much of this is due to QE: balancing, spillovers and the desirability of policy the Fed’s $1.725 trillion asset purchases resulted in a coordination—these are at the center of the eco- 6.5 percent depreciation of the dollar. The Bank of nomic interdependence between the developed England has estimated that its QE resulted in a 4 per- and emerging market countries (DM and EM). All cent depreciation of sterling. So domestic QE does this is in the context of a weak American recov- seem to have substantial international implications. ery from the Great Recession, the risk of deflation, and the likelihood of more quantitative easing by But the October 23, 2010 communiqué by G-20 the U.S. Federal Reserve. These domestic issues finance ministers from their meeting in Gyeongju, and the inability to get direct action on exchange South Korea, while condemning “competitive de- rates has led the United States to propose targets valuations”, avoids direct discussion of this spill- for current account imbalances. The wheel goes over of monetary policy—which some might call a around, and these proposals bear some resem- “competitive devaluation”: blance to those of Keynes at Bretton Woods, which the United States then opposed. Specifically, we will… Policies such as these cannot be assessed properly continue with monetary policy which is ap- without an underlying analytical framework. In propriate to achieve price stability… the current discussion, the furthest this has gone is evocation of the “trilemma”: the impossibility of move towards more market determined ex- simultaneously maintaining open capital markets, change rate systems that reflect underlying nominal exchange rate stability and monetary pol- economic fundamentals and refrain from icy autonomy. (We hear little of the “inconsistent competitive devaluation of currencies. Ad- quartet”, which adds trade openness to these three vanced economies, including those with —but protectionism is indeed a potential weapon reserve currencies, will be vigilant against in the currency wars, and we must not disregard excess volatility and disorderly movements that threat.) in exchange rates… Think Tank 20: Global Perspectives on the Seoul G-20 Summit 47 As long as QE does not lead to “disorderly” ex- pressure over trade competitiveness). The alterna- change rate changes, the monetary authorities tives are equally unpalatable: reverse the trend of can ignore its international effects. I will examine the past two decades toward freeing capital markets whether this view is justified. and thereby encouraging financial development; or accept exchange-rate appreciation and loss of What is happening on the ground? The Bank of Ja- competitiveness. The conventional prescription is pan has intervened to limit appreciation of the yen to permit the appreciation—after all, it raises real and may do further QE. The Bank of England is ac- incomes and competitiveness is underpinned by tively considering additional QE beyond the £200 rapid productivity growth—and switch away from billion asset purchases it has already made. The export-led growth to more reliance on domestic European Central Bank seems reluctant to expand demand. But many countries, China most vocally, its balance sheet still further, but it may be forced are concerned that significant appreciation will hit to buy more Greek, Portuguese, Irish and Spanish marginal exporters, slow growth and create unem- bonds if the markets turn against any or all of these ployment. sovereign debtors. And if the euro were to appreciate substantially against the dollar, threatening In this context, we now explore the implications of the weak European recovery, the political pressure QE, first in a small open economy (SOE), then for on the ECB for some form of intervention would a big country, then for a set of big countries. We be hard to resist. Meanwhile, the only uncertainty assume the interest rate is constrained at the zero about further QE by the Fed is how much and at lower bound, there is a “liquidity trap”, economic what speed. activity is weak and there is some threat of deflation. China, for its part, continues to resist both political and market pressures for more rapid nominal In the SOE, when the central bank brings the inter- appreciation of the yuan. The East Asian countries est rate to the ZLB, the exchange rate depreciates. that have effectively pegged to its currency (or At the ZLB, the monetary authorities can threaten nominally to the U.S. dollar) stand firm. Others to intervene or actually do so to keep the exchange have experienced substantial appreciation (Indo- rate down. In this case, the weak currency is not nesia, Malaysia, Thailand and Korea). Brazil had “competitive devaluation”—it is just a normal part a massive appreciation in 2009 and imposed a of an easy monetary policy. In any case, for a SOE, transactions tax on capital inflows, which has just there is little effect on the rest of the world (RoW). been raised. Since the inflows have continued, in- And if the monetary easing raises domestic de- tervention has accumulated large reserves, mon- mand, including demand for imports, that is good etary aggregates are rising rapidly, while inflation- for the RoW. Hence, there is no beggar-thy-neigh- ary pressures have led to interest rate increases. bor aspect of policy. Thailand has also imposed a tax on foreign holders of domestic securities, and Indonesia is consid- Now consider a single large open economy. The ering capital controls. Singapore has widened its analysis is due to McCallum (2000) and Svens- exchange rate band. Countries from Israel to In- son (2001)—the latter proposed the “Foolproof dia and South Africa are facing similar pressures: Way” of avoiding deflation and restoring growth capital inflows, exchange-rate appreciation and in- in Japan. The authorities need to create inflation- flationary risks. ary expectations, and they must accept a short-run inflation rate above their long-run target. So they Monetary expansion in the DM has confronted the should go to a price level target, with a jump: bring EM with the trilemma. If they resist currency ap- down the exchange rate, if necessary with (unsteril- preciation, they lose monetary control and get in- ized) intervention. This also expands the monetary flation and asset price bubbles (as well as political base and their holdings of (typically) short-term Think Tank 20: Global Perspectives on the Seoul G-20 Summit 48 foreign government securities (U.K. and Germa- Meanwhile, if one large economy does not par- ny). If the exchange rate does not depreciate, then ticipate (e.g., the euro zone), then its currency will the markets do not expect inflation—the policy also appreciate, with accompanying political and has failed, or the extent of intervention has been trade tensions. And volatility between exchange inadequate and should go up. It is very important rates of large countries is more harmful than if it is to note that this is not QE; the authorities are not confined to small countries. purchasing domestic long-term assets. Here, it is very important to see that simultane- There are spillovers, of course, and they are benefi- ous QE is not the same as simultaneous exchange- cial. Escaping the liquidity trap at home does not rate intervention. In the latter case, central banks hinder the RoW from achieving their monetary will typically hold reserve increments in foreign policy objectives, unless they too are in a liquidity short-run debt (as noted above). If all do this, the trap. And if they are, then expansion in the home net effect is that of domestic open-market opera- country (escape from the liquidity trap) raises the tions in short-dated government securities. At the world natural rate of interest and hence alleviates ZLB, these securities are perfectly substitutable for the RoW liquidity trap. money. There is a liquidity trap, so exchange-rate intervention at the ZLB achieves nothing—where- Now move to a world of big countries, all at the as QE does seem to have an impact on both inter- ZLB. Ideally, all should inflate in a coordinated est rates and exchange rates (see e.g. Joyce 2010). fashion, so that exchange rates are not affected. Uncoordinated policies could bring currency vola- If the large DMs do more QE, however, then the tility. This destabilizes markets, creates a highly un- flow of liquidity to the EMs may force them to certain environment for business and raises pres- respond. They may try to resist exchange-rate ap- sures for trade policy interventions. With simul- preciation by intervening in the foreign exchange taneous QE, there might not be first-order effects markets.

Load more