February 1, 2013 10:54 pm

Conscientious objectors unlikely in currency war

Why do countries such as China and the US manipulate their exchange rate? The answer is simple. Because they can.

And why do other countries shout about “currency wars” and complain bitterly about the manipulation? Because they cannot.

Bear this in mind when surveying the battlefield of the latest “currency wars”. Japan is making an aggressive attempt to force down its currency, the yen, which has been artificially strong ever since the credit crisis peaked in 2008. This has sparked complaints from many countries, and understandably so. A weaker yen makes Japan’s exports that much cheaper and more competitive in foreign markets.

South Korea, another important far-eastern exporter, may provide the best example. The won has appreciated a cool 30 per cent against the yen since last June. This helps explain why the Korean stock market has been one of the few to miss out on the rally of the past few weeks.

Japan is not alone, of course. The newly aggressive approach to monetary policy at the Bank of England, heralded by its incoming governor, Mark Carney, suggests that the pound may also soon be allowed to devalue. The Swiss National Bank has long been explicitly capping the rate of the Swiss franc against the euro in a bid to stop it from growing too overvalued.

Currency wars: the winner so far

Previous rounds of “currency wars” (a term coined by a Brazilian finance minister) have seen attempts to limit capital inflows by large emerging market exporters, which stand to lose most from an appreciating currency, such as Brazil and South Korea.

But Simon Derrick, currency strategist at Bank of New York Mellon in London, points out that since Japan set its current course at the end of last year there has been no complaint from the US or China. And there is good reason for this. Both have successfully manipulated their currencies in the past decade. Neither now feels the need to complain.

The chart shows the dollar’s performance against other currencies weighted by the amount of trade they do with the US, in both real (accounting for different inflation rates) and nominal terms. It shows that the US is the hands-down winner so far.

Since the 1985 Plaza Accord, when a group of leading countries agreed to intervene to weaken the dollar, the greenback has fallen 33 per cent (31 per cent in real terms). Intriguingly, it is almost impossible to distinguish between that deliberate devaluation and the devaluation that started in 2002, when the US said it wanted a “strong dollar”.

That devaluation has continued with only a brief interruption for the credit crisis. It started when the Federal Reserve under Alan Greenspan cut rates after the collapse of the dotcom bubble. Lower rates weakened the dollar by making it profitable for traders to park their cash in other currencies. Easy monetary policy since the crisis has further weakened the dollar – and enabled the quiet rebirth of US manufacturing.

Meanwhile, China explicitly held its currency, the renminbi, within a tight range against the dollar for most of the past decade. While the dollar was weakening, this automatically weakened the renminbi, bolstering China’s competitiveness against other countries.

Beijing’s reserves are so large that any move displaces currencies beyond the dollar. Thus, in 2008, when it stopped a gradual rise against the dollar but let the renminbi keep rising against other currencies, the dollar shot upwards, wrongfooting investors and policy makers across the world.

Since 2010, Mr Derrick points out, the euro’s moves have coincided exactly with shifts in China’s reserves. When these rise, China sells some dollars to buy euros – and the euro rises.

Judging by recent pronouncements, Beijing is happy to let the renminbi rise. It is making it easier for capital to flow into the country, reducing its control over the currency, and it seems to have stemmed the rise in its reserves. Because Chinese inflation is higher than that of its competitors, this has reduced its competitiveness, but that may be deliberate, as the country wants to encourage internal growth, rather than exports.

So this bout of currency wars may be different, as China and the US start from a strong position. That is good for Japan’s hopes to weaken the yen.

But the most likely long-term winners of any currency war remain those with the power to win one. The large exporting emerging markets that lack Japan’s power to push down their rates will probably suffer.

The likeliest losers are those that do not want to fight. That implies more strengthening for the euro, as the European Central Bank, alone among the big central banks, withdraws its stimulus by reducing the assets it holds.

A stronger euro would not help the eurozone’s chances of emerging from recession. The ECB may yet have to join in the currency wars before they are over.

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