The global war over currencies
By Martin Wolf
Published: November 10 2010 17:02 | Last updated: November 10 2010 17:02
“Quantitative easing” breeds “quantitative tightening”. So argues HSBC, the bank, in a report.* But is monetary easing by the central banks of the high-income countries the principal force driving up the currencies of emerging countries, or is something deeper going on? Are controls on capital inflows an inevitable response?
Let us start with the path of trade-weighted real exchange rates – the best measure of overall competitiveness – during the crisis. A simple approach is to compare the real exchange rate index calculated by JPMorgan for September 2010 with the average of the same index over the long term.
When this is done for the Group of 20 leading high-income and emerging countries, we find that the following countries had high real exchange rates in September relative to their post-1990 averages: Brazil (up 73 per cent); Indonesia (up 43 per cent); Russia (up 39 per cent, relative to the average since January 1994); Australia (up 31 per cent); China (up 13 per cent); and South Africa (up 11 per cent).
On the same metric, the most depressed currencies were those of Argentina (down 27 per cent); South Korea (down 17 per cent ); the UK (down 13 per cent ); and the US (down 8 per cent). The real value of the euro and the yen were close to their averages over the past two decades.
Again, the six countries with strong currencies relative to the long-term average had also experienced substantial real appreciations since the beginning of the crisis. This is particularly true for Brazil and Indonesia. In contrast, South Korea and the UK have experienced substantial real depreciations during this period. The US dollar is roughly back to where it started, while the Japanese yen has had an extensive real appreciation over this period.
In short, a number of emerging economies, principally commodity exporters with open capital accounts, have strong currencies today and have experienced sizeable appreciations since the beginning of the crisis.
But there is little to suggest that the currencies of the big high-income economies are out of line with one another, by historical standards.
So what has been driving these shifts? The most powerful force is the desire of investors to hold both real and nominal assets in fast-growing emerging economies, most of which have relatively little private and public debt by the standards of the high-income countries. Thus, according to the Washington-based Institute for International Finance, the net flow of external private capital into emerging economies should reach $825bn this year – up from $581bn in 2009.
In addition to this longer-term shift in preferences, the monetary policies of the high-income countries are extremely aggressive: short-term interest rates are exceptionally low, while central banks, particularly the US Federal Reserve, are seeking to reduce long-term interest rates via so-called quantitative easing. With central banks buying substantial quantities of government bonds, the erstwhile private investors they displace need to purchase other assets, at home and abroad.
In sum, both private markets and central banks are trying to end the anomalous conditions of the pre-crisis era. At that time capital flowed, on a net basis, from the dynamic emerging economies, largely directed by governments, to high-income economies, particularly the US, only to be wasted in debt-fuelled personal consumption and high levels of construction.
Yet the recipients of these expanded private capital inflows dislike what is happening, as it weakens the competitiveness of their exports and domestically produced import substitutes, and encourages wasteful domestic lending and spending by the private and public sectors.
What might the recipients of these capital inflows do, in response? The obvious answer is to adopt or tighten exchange controls. The notion of the “impossible trinity” says that a country cannot have all three of a fixed exchange rate, free movement of capital and domestic monetary autonomy. If a government wants to control its exchange rate, presumably to preserve competitiveness, and retain control over domestic interest rates, to avoid credit bubbles, it has to impose controls on capital inflows.
Many emerging economies continue to have such controls, largely for this reason. Among them are China and India, the two emerging titans. With China having a heavily managed exchange rate, many countries are concerned that they will lose competitiveness against it.
HSBC notes that a number of countries have tightened controls or imposed taxes on capital inflows. Brazil is an important example, having pushed the rate on bond investments up to 6 per cent. Thailand has reinstated a 15 per cent withholding tax on purchases of government bonds, while Indonesia introduced a minimum holding period for central bank bills in June. Other governments are also considering introducing such taxes or controls.
How might this end? The process of readjustment of the global balance of payments will continue, regardless of what the G20 leaders decide. Similarly, the central banks of the high-income countries, particularly the Fed, will do whatever they can to avoid domestic deflation, whatever the results for asset prices and exchange rates. The US produces the principal global currency, but its central bank is, after all, responsible only to domestic citizens.
Many countries are unavoidably caught between the devil of US quantitative easing and the deep blue sea of Chinese intervention. The likely outcomes will include chaotic currency movements, exchange controls, sterilised currency intervention and domestic monetary expansion. The choices they face are only between unwelcome alternatives.
* Manning the Barricades, November 2 2010.