War without end? Rich countries fire the latest shots in the global “currency war”

Ilene Grabel

I’ve written on a few occasions about the “currency wars” and the divergent responses to its macroeconomic fallout by policymakers across the developing world. (For a primer on the issue, see my earlier posts.) Until recently, the currency war garnered little global attention—likely because of its geography.  The pressures generated by appreciating currencies were largely a problem for rapidly growing developing countries. The currency war was therefore not seen as a “universal” problem that threatened global financial markets, the world economy, or relations among powerful nations. This misguided view obviously failed to acknowledge that any hope for global recovery rests with the continued growth of the larger developing economies. The other factor that kept the currency war off the global agenda was the dismal state of the US and European economies.  Economic stagnation in these countries precluded much attention there to problems abroad that policymakers in the US and Europe could only dream about—too much growth and capital inflows.

But things are changing in ways that make it impossible to ignore the issue for much longer.  While investors remain pessimistic about the prospects of the US and European economies, they are nonetheless moving funds not just to the rapidly growing developing countries but also to wealthy countries, most notably Canada, Switzerland, Australia, New Zealand, and Singapore.  The currencies of these countries are now appreciating dramatically against the euro and the dollar. The Swiss franc reached all-time highs against the US dollar and the euro this year, the Australian dollar has hit three-decade highs against the US dollar, and the Canadian dollar is approaching record levels as well. Among the 16 major currencies in the world, the Swiss franc, New Zealand dollar, Japanese yen, Brazil’s real and Singaporean dollar have gained the most against the US dollar in the past three months.  A Swiss banker put it well last week: “The franc is like the new gold.” As in the developing world, asset bubbles, currency appreciation, inflationary pressures, and risk of a sudden reversal of capital inflows are weighing heavily on policymakers, manufacturers and exporters in a growing number of safe haven countries.

What are policymakers now facing an embarrassment of riches to do? Do they intervene to slow the appreciation of their currencies? If so, through what measures? Do they risk expansionary monetary policy in the face of inflation and asset bubbles? Should they attempt to offset pressures on their currencies by purchasing dollars or euros; place restrictions on foreign investment inflows; provide support to domestic firms; and/or attempt to place restrictions on imports? All of these strategies are now in evidence (in an array of combinations), and yet all involve costs and risks of unintended consequences.

This is not to say that rich and developing country parties to the currency war now face identical challenges. After all, Switzerland’s industrial base remains vibrant and its current account performance enviable, even as the franc appreciates, while Brazil’s manufacturing and trade performance have suffered as a consequence of its high interest rates (now the second highest in the world) and the real’s dramatic appreciation.  And so we should expect divergent strategies within and across the global north and south, as policymakers confront different combinations of economic challenges.

Central banks in wealthy countries are responding to the challenges of the currency war in ways that reflect their own political economies, current economic realities, and attitudes toward currency market intervention. The Swiss Central Bank, itself not generally keen to intervene, has nevertheless been prompted into action by what an official termed the “massive overvaluation” of the franc relative to the euro and the US dollar.  It has responded by cutting interest rates, while the country’s central bankers and government officials are reportedly considering additional measures.  Shortly after the Swiss central bank’s move, the Japanese central bank injected liquidity into its monetary system and sold yen to counter the appreciation of the yen.  The strength of the Turkish lira has prompted the Turkish central bank to lower interest rates, and it also announced that it would sell dollars to banks as needed.

By contrast, the central bank of New Zealand has lived up to its reputation as a true believer in market forces.  To this point, the country’s central bank has done nothing to counter the appreciation of the currency. The Canadian central bank, too, has maintained a hands off attitude vis-à-vis its appreciating currency (thereby continuing a 13 year pattern of not intervening in the Canadian dollar). But even these central banks may be pushed away from this stance as their counterparts continue to intervene and as the political and economic costs of currency appreciations make themselves more strongly felt. Moreover, if (as seems likely) the US Federal Reserve embarks on a third round of quantitative easing, then even the most passive central banks may find it impossible not to intervene.

In taking these actions, central banks in rich safe haven countries are following a path by now well-trodden by their counterparts in the global south. Developing country central banks have been taking steps for some time now to address the US dollar’s weakness, as I’ve discussed here previously.  Recently, South Korea’s government announced that it is reviewing “all possibilities” on curbing capital inflows; officials in the Philippines say they are prepared to impose new controls (in the form of prudential limits on certain kinds of transactions by banks) to reduce the volatility in the peso after it rose to a three-year high this week; and policymakers in Brazil added to its existing array of controls a 1% tax on bets against the US dollar in the futures market, after the real reached a twelve year high. Brazilian officials are also set to provide $16 billion in tax breaks and to tighten trade barriers to protect manufacturers hurt by imports from China (which have been stimulated by the strength of the real). In response, Canadian Prime Minister Stephen Harper this week inexplicably lectured the Brazilian government on the need to dismantle its capital controls (good luck with that!). Finally, and as I’ve noted previously, in those developing countries where a commitment to the ideology of capital mobility precludes the use of capital controls (e.g., Chile and Mexico), we find central banks responding to the costs of an appreciating domestic currency through regular, large dollar purchases.

In the context of this unevenness, it is not surprising that a recent meeting in Lima of economic ministers of the twelve South American nations that are members of Unasur (the Union of South American nations) failed to produce a coordinated response to the currency war. UNASUR members continued discussions of coordination at a second meeting in Buenos Aires a few days ago.  But coordinated responses may yet be coming, as new alliances form among the diverse countries now facing the hardships attending currency appreciation.  The current crisis is exposing clearly the dangers associated with a policy free-for-all in monetary matters, and the need for a new regime of coordinated monetary and exchange rate policy. The currency war itself is in fact symptomatic of the severe institutional inadequacy of the global financial and economic architecture. The emerging currency war threatens to undermine global economic stability, economic integration, peaceable economic relations, and the possibilities of a global recovery. It is looking more likely by the day that Brazilian Finance Minister Mantega was right all along when he drew a parallel between the current period and the economic nationalism and conflict of the 1930s. The road ahead promises to be a rocky one.  Stay tuned.