Currency Wars and the Emerging Market Countries

Richard Portes President, Center for Economic Policy Research; Professor, London Business School

UNITED KINGDOM/ he headlines shout “ wars”. The Unit- Policymakers in both DM and EM are aware of the ed States believes engages in “currency trilemma, but they are not fully conscious of the Tmanipulation”. It hesitates to declare this to international repercussions of 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 of excessively note will explore these issues. loose , flooding the world with li- quidity. There is some truth in both charges, but The U.S. dollar has in fact already experienced a real some exaggeration. effective depreciation of over 10 per- cent 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 , 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 ”: 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 . Ad- quartet”, which adds trade openness to these three vanced economies, including those with —but 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 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 appre- ciate 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 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 defla- tion. China, for its part, continues to resist both politi- cal 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. Here we do have competitive devalua- on the exchange rates between the big countries. tion—the “currency wars”. And if the EMs do not And simultaneous QE could achieve simultaneous sterilize the intervention, or if sterilization is at least expansion, which would have first-order effects on partly ineffective, then they experience inflationary the natural rate of interest, helping to restore more pressures. So capital controls look tempting—but normal monetary conditions. experience suggests they may not be very effective.

Although simultaneous QE in all big economies This is why we see statements like “the U.S. will win might wash out in exchange rates, there are also this war”; it will either inflate the rest of the world many SOEs—including the EM countries. What or force their exchange rates up against the dollar happens in such a world? Some of the additional (Wolf, 2010). But there is a potential downside for liquidity in the QE/ZLB economies flows to coun- the U.S. Substantial dollar depreciation will weak- tries with higher interest rates. Their currencies en the global position of the dollar, as it did in the appreciate, and expected appreciation attracts late 1970s (see Chinn and Frankel, 2007). more capital flows. (Yes, the carry trade is indeed profitable, uncovered interest parity is violated.) Now consider fiscal austerity at the ZLB. Suppose Global liquidity goes up, foreign exchange reserves one large economy implements a fiscal contraction rise in those smaller countries which intervene to with all countries at the ZLB. Normally, Mundell- try to resist appreciation. The big economies are Fleming would say that fiscal contraction low- exporting bubbles to the RoW. But global rebal- ers the interest rate, hence brings exchange-rate ancing should be achieved by raising consumption depreciation, hence contraction abroad (and at in the RoW, rather than investment in financial as- home too, where the increase of net exports does sets and real estate. not fully compensate for the fall in net government

Think Tank 20: Global Perspectives on the Seoul G-20 Summit 49 expenditures). But at the ZLB, there is no effect on best to achieve its mandated goal: maximum em- the interest rate, so no depreciation through that ployment with price stability, which the chairman channel. But there is still a risk premium in the un- has just defined as “about 2 percent or a bit below” covered interest parity condition. Expected depre- (Bernanke, 2010). He also observed that actual in- ciation equals the risk premium, then where this is flation was significantly lower. There is nothing in the combined risk premium on the exchange rate the mandate about effects on the RoW except inso- and on the interest rate bonds. Then all depends far as these effects might feed back onto economic on whether austerity raises confidence: does the activity and inflation in the U.S. They might, for risk premium rise or fall with expectations of fu- example, if Fed policy were to affect the currency ture economic activity, and how does austerity af- composition of EM central bank portfolios. If a fect those expectations? major further expansion of the Fed’s balance sheet were to provoke a shift out of dollar assets, U.S. If fiscal consolidation does not raise confidence in Treasuries in particular, that would indeed affect the home economy, then the RoW takes a double U.S. interest rates and the dollar exchange rate. But hit: a fall in activity in the home economy and so far, the Fed’s policymakers, including the chair- exchange-rate appreciation against it. How might man, have shown no concern for this possibility. the RoW respond? Exchange-rate intervention— another salvo in the currency wars! The markets, however, do respond. “Brazil’s bench- mark Bovespa stock index hit a new high for the So what policies may we expect, and what will be year on Friday as U.S. Fed Chairman Ben Bernan- their consequences? Bergsten (2010) and Gros ke said current economic conditions warranted (2010) have proposed “unconventional” ways in further monetary policy easing” (Reuters, Octo- which the U.S. might try to force China to allow ber 15, 2010). And if U.S. monetary policy eases faster appreciation of the yuan. Bergsten suggests further, it will get the exchange rate depreciation “countervailing currency intervention”, in which that it wants—it will indeed win the currency wars. the U.S. would buy yuan in response to Chinese The U.S. can, after all, devalue the dollar. But there purchases of dollars. But this supposes that China’s are costs: a wave of trade protectionism is not ex- capital controls can be circumvented—possible for cluded, although low probability; more likely are marginal flows, but not for the $1 billion per day capital account protectionism, in the form of EM that China is currently buying. Gros suggests that capital controls; and damaging exchange-rate vol- the U.S. and Japan, which has complained about atility, including among the large countries, if QE Chinese purchases of Japanese government bonds, is not coordinated (simultaneous). Moreover, in could “limit sales of their public debt henceforth the longer run, this could substantially weaken the to only include official institutions from countries hegemony of the dollar in the international finan- in which they themselves are allowed to buy and cial system. hold public debt”. But this could apply only in the primary market—the secondary market for U.S. John Connally, then U.S. Treasury secretary, fa- government debt is wide-ranging and anonymous, mously said the dollar is “our currency, but your not likely to be controllable in this way. And even problem.” Like most aphorisms, the obvious truth if it were feasible, the interest-rate and exchange- in this remark conceals complexities: the “exor- rate effects of such a policy, not to mention the bitant privilege” that accrues to the issuer of the response to such “financial protectionism”, are suf- major international currency is not to be conced- ficiently unclear as to make it highly risky. ed lightly. And the consequences for EM and the global economy of a shift to multi-polarity in in- The Fed will proceed with QE. It will not accept ternational finance, like the shift of weight toward foreign constraints on its monetary policy. Its EM in global growth and economic impact, will be decisions will be determined by its view of how very far-reaching.

Think Tank 20: Global Perspectives on the Seoul G-20 Summit 50 References

Bernanke, B., 2010, ‘Monetary Policy Objectives and Tools in a Low-Inflation Environment’, speech at FRB Boston conference, 15 October.

Chinn, M., and J. Frankel, 2007, ‘Will the Euro Eventually Surpass the Dollar As Leading International ?’, in G7 Current Account Imbalances: Sustainability and Adjustment, ed. R. Clarida, University of Chicago Press.

Joyce, M., et al., 2010, ‘ impact of quantitative easing’, Bank of England Working Paper 393.

McCallum, B., 2000, ‘Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates’, Journal of Money, Credit and Banking, vol. 32(4), 870-904.

Neely, C., 2010, ‘The Large-Scale Asset Purchases Had Large International Effects’, Working Paper 2010-018B, Federal Reserve Bank of St. Louis.

Svensson, L, 2001, ‘The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap’, Monetary and Economic Studies 19(S-1), 277-312,

Wolf, M., Financial Times 13 October 2010.

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