Currency Wars: Why are they now hitting a low note?

In the present environment of anaemic economies no one wants to be on the losing side with a “winning” strong currency

If you travel to either Buenos Aires or Bucharest, you will notice that both look something like Paris. In the last great era of globalisation from about 1870 until the First World War, Pax Britannica allowed both capital and styles to flow easily between different countries. Globalisation is not a technological imperative, but a result of coordinated trade laws. It is now under threat by a new war, a currency war.

 The probability of a currency war must be taken in context. A currency war to paraphrase Clausewitz is "nothing but the continuation of state policy with other means." The object of state policy is always to protect the state or, to be more specific, to protect the political futures of those politicians who happen to be running the state. Politicians are notoriously short-sighted, so some of the effects of the present dislocations caused by competitive currency devaluations may have longer lasting and more general effects than is currently anticipated.

 Of course a currency war is simply an aspect of a trade war. The WTO has been successful in limiting protectionism, but recently it has been rising. The beginning of a currency war is just another example of this increase. It is severe because of its size. Some $3.2 trillion worth of currencies are traded each day. Unlike trade, it is a zero-sum game. For one country's currency to rise, another country's currency must fall. In other words, there are winners and losers. In the present environment of anaemic economies no one wants to be on the losing side with a "winning" strong currency.

 Most of the strong currency losers these days belong to emerging market currencies including India's rupee, South Africa's rand, the Brazilian real and the Thai baht. Some developed countries like Israel, Switzerland and Australia are losing with strong currencies. Even the yen and the euro are on the losing side. Of course, the winning weak currencies belong to the two largest economic powerhouses in the world, the United States and China.

Many of the emerging markets have been relatively successful in avoiding much of the pain of the recession. Anticompetitive currencies are the last thing they need. Basically they have three rather poor choices. They can just do nothing and let their exchange rates appreciate, which harms their exports. Second, they can intervene by selling their local currency and accumulating unwanted dollars, but this can threaten domestic monetary stability. Finally, they can use regulations like taxes and controls to stem the massive capital inflow. Presently we were seeing examples of all three.

 Despite the variety of different methods of controlling the flood of foreign capital, they all share one thing in common. None of them work. According to Kristin Forbes at MIT there was no significant impact on the volume of capital inflows or currency appreciation. Still many of these countries, unlike the US, are highly dependent on exports and feel that they must do something to keep their exports competitive.

China has the same problem. Its premier, Wen, warned of dire consequences to any revaluation. Mr Wen stated, "If we increase the yuan by 20% or 40%, as some people are calling for… many of our exporting companies would have to close down, migrant workers would have to return to their villages." Mr Wen further warned that such economic dislocations would result in Chinese "social and economic turbulence, that it would be a disaster for the world." Of course China's undervalued currency causes dislocations as well, just not in China.

The other perpetrator and potential instigator of a global currency war is the US central bank, the Federal Reserve. The Federal Reserve in its last meeting stated that the US economy was not growing fast enough, so they have hinted that it could flood the economy with as much as a half a trillion dollars through quantitative easing. This flood of money has driven the dollar to historic lows and inflated other currencies, markets and commodities.

With the two largest economies in the world fighting tooth and nail to devalue their currencies and smaller countries anxiously trying to protect themselves with limited resources and potentially ineffectual policies, what chance is there to avoid the currency war or a larger trade war?

Sadly very little. Countries have very different markets and different circumstances, so cannot agree on a coordinated response. There are also no quick fixes for the present imbalance. As professor Pettis of Peking University notes: "China, and surplus countries such as Germany and Japan, must understand that their policies damage the rest of the world. But the world also needs to understand that these countries cannot adjust quickly without damaging internal consequences." So while China can allow its currency to appreciate they must do so slowly. And while the United States economy will ultimately grow, its recovery will also take time. In the present climate, though, no country is really willing to wait. The consequences of this impatience will no doubt hurt us all.

(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected])

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