The Eye of the Currency Storm: Currency war gives way to currency confusion

Ilene Grabel

Through much of 2010 and 2011 many of us watched the unfolding “currency war.” The currency war construct came into vogue after Brazil’s Finance Minister Guido Mantega began to complain openly in 2010 about the pressures placed on his economy and currency (and that of other rapidly-growing developing countries) by the cheap credit made available by the US Federal Reserve and other wealthy country central banks. Brazil’s President, Dilma Rousseff, joined the rhetorical fray later in 2012 by calling US President Obama and European leaders on the carpet for what she termed the “monetary tsunami” of hot money coming from rich countries.

The currency war of the last two years made for interesting bedfellows, tensions, reversals, and continuities.  As Triple Crisis readers know, policy makers in Brazil and other developing countries responded to the triple threat of currency appreciation, inflation, and asset bubbles by introducing and adjusting a range of finely calibrated capital controls. These controls sought to staunch the speculative bubbles and currency appreciation that were aggravated by surges in international capital inflows.

A few Southern policymakers took a very different course. They responded to the same triple threat by taking pains to demonstrate to investors their fidelity to Chicago School economics.  In these cases–exemplified by Mexico, Turkey and Colombia–policymakers refused to implement capital controls (though they certainly didn’t refrain from currency market interventions).

However, earlier this month Colombia’s Finance Minister, Juan Carlos Echeverry, signaled a change of heart. He blamed the peso’s “excessive” appreciation on monetary policy in the US that is “lax almost to the point of irresponsibility.” Moreover, he asserted that Colombia should learn from its neighbors and take “more aggressive action” (though he had made clear that this action involves sterilization and not capital controls).

The currency tensions of the last three years have aggravated fault lines between China and Brazil, two of the leading BRICs.  The Brazilian government leaned toward the US in US skirmishes with China on the matter of currency manipulation. Even while criticizing China, however, Brazil’s Finance Minister has emphasized the loose monetary policies in wealthy countries and the speculative flows of money unleashed by hedge funds and derivative markets as the causes of Brazil’s currency problems.

Things really began to get interesting when a group of wealthy countries found themselves facing the downside risks of being investor favorites. As the Eurozone’s crisis intensified, investors started moving funds not just to the rapidly growing developing countries but also to those wealthy countries perceived as safe havens, most notably Canada, Switzerland, Australia, New Zealand, and Singapore.

Like their counterparts in developing countries, central banks in wealthy countries responded to the challenges of significant currency appreciations in diverse ways.  The Swiss Central Bank overcame its general aversion to market interventions as it confronted what an official termed the “massive overvaluation” of the franc relative to the euro and the US dollar. Shortly thereafter, the Japanese central bank injected liquidity into its monetary system and sold yen to counter its appreciation. The strength of the Turkish lira prompted authorities to lower interest rates and sell dollars.  The central bank of New Zealand, by contrast, lived up to its reputation as an opponent of market intervention. The Canadian central bank took a similarly hands-off attitude.

True believers in the myth of the self-correcting market cite recent developments as proof that market processes rather than government interventions appear to have restored order on the currency front. Many developing country currencies have depreciated sharply this year as the global economy has continued to weaken and as growth in the most dynamic developing countries has slowed. Indeed, according to some forecasts, the second quarter of 2012 looks set to be the worst on record for developing country currencies since the East Asian crisis of 1997-98.

The recent depreciation of Brazil’s currency, the real, is perhaps the most dramatic of these turnarounds. But a more accurate reading of the Brazil story is not that “the market” has resolved its currency problems. Instead, Brazil is responding to changing conditions quickly and aggressively by reorienting fiscal, monetary, and capital control policies—once again turning a page that Eurozone and US politicians seem unable to read.

The real has depreciated by around 12% in the last quarter, and has experienced the most significant depreciation among the sixteen most traded currencies in the world. Brazil’s central bank even sold $2 billion in currency derivatives in May 2012 in efforts to stabilize the depreciating real.  The weakening of Brazil’s economy has allowed the government to lower interest rates to 8.5% (from a peak of 12.5% in August 2011), something that had long (and rightly) been a priority of the Rousseff administration. It has loosened one type of capital control (by exempting foreign loans with a duration of more than two instead of five years from a 6% tax in order to facilitate the rollover of loans by the country’s corporations and banks), reduced some types of taxes on credit and consumer goods, and increased subsidized loans to firms.

The Indian rupee and the Russian ruble have also depreciated as global and national economic conditions decelerate. Each has fallen by almost 11% in the second quarter of 2012.  Authorities in both countries have also intervened in efforts to support the currency.  The Indian central bank has also has taken other action designed to address some of the challenges now confronting the economy. It has reduced the amount of overseas income that companies can hold in foreign exchange in order to encourage them to repatriate funds and increased the ceilings of foreign investment in government bonds.

Other developing and emerging market investor favorites have also been hit by reversals of investor sentiment.  In the second quarter of 2012, the Czech crown has depreciated by 10%, the South African rand by around 9%, Poland’s zloty by 8.6%, and the Mexican peso by 6.8%.

Currency market speculators continue to fix their gaze on Switzerland and Japan, countries that have maintained their status as safe havens as developing economies have lost their appeal. Once again, Swiss authorities have made clear that they are prepared to intervene as they did in September 2011 to address the appreciation of the franc.  Taking a page from Mr. Mantega and others, the Head of the Swiss National Bank, Thomas Jordan, has even said that he is prepared to use capital controls if monetary policy and sterilization do not do the trick. Japanese authorities have also made clear that they are prepared to intervene again to bring about a depreciation of the yen (which has appreciated by 12.5% since March 2012).

What does all of this mean? Currency markets continue to reflect the underlying volatility and uncertainty in the global economy. National policymakers continue to respond to these pressures in diverse ways.  It is heartening to see that many policymakers have overcome the capture of neo-liberal ideology and have taken a more activist role.

At the moment, developing countries are enjoying a temporary reprieve from the currency pressures that threatened their export performance in 2010 and 2011. But we’d be mistaken to interpret the present calm as the end to currency wars. There is no reason to expect that fickle investors will not return in force, causing a new set of challenges.

All of this begs the question, should someone play referee in currency markets? If so, who, and what authority ought it enjoy? Some suggest that the IMF should play this role, ideally in conjunction with the WTO [Jeanne, Subramanian and Williamson, 2012]. Rodrik [2011] suggests a simple set of “traffic rules” that nonetheless respect and protect national policy autonomy. All of this will require new financial architecture, to be sure.

But as daunting as that institutional challenge may be, the bigger trick will be to discover and establish new norms that govern the authority and strategies of developing and developed countries in regards to currency values. The new norms must at once promote genuine development and economic security, while nonetheless preventing predatory currency manipulation. Failing that, we should expect further battles in the currency wars, with no telling who will suffer the greatest casualties.

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