Macro

"Currency Wars": Real or Imagined?

February 17th, 2015 | By Nick Sargen

Highlights

  • Based on newspaper headlines, people may have the impression central banks today are pursuing actions similar to "beggar-thy-neighbor" policies during the Great Depression, when a series of currency devaluations culminated with protectionism and trade wars.
  • The situation today, however, is quite different. While monetary policy easing in Japan, the eurozone, and other countries has weakened their respective currencies, officials from the Group of 20 recently endorsed these actions as helping to boost the global economy. In this respect, currency depreciations that result from monetary policy easing are not viewed as a zero-sum game.
  • At the same time, there are limits to the effectiveness of quantitative easing (QE), and currency depreciation appears to be the primary channel for jump starting the Japanese and eurozone economies.
  • If so, investors need to assess when U.S. officials will object to a stronger dollar. My take is the dollar is fairly valued and will not be viewed as a problem as long as the economy grows satisfactorily and unemployment stays low. Therefore, the path of least resistance is for the dollar to continue to trend higher in 2015.

What Does "Currency Wars" Mean?

The term "currency wars" has become standard jargon today, as stories in newspapers and periodicals abound about the effects that monetary policy easing have on weakening a country's currency. It has been alluded to ever since Guido Mantega, Brazil's finance minister, used it in 2010 to complain that QE by the Federal Reserve was weakening the dollar, thereby contributing to excessive strength of the Brazilian real and other emerging market currencies.

More recently, the term has been used to describe the steep decline in the Japanese yen and the euro that accompanied QE by the Bank of Japan (BOJ) and the European Central Bank (ECB). While both currencies have plummeted against the U.S. dollar, other countries-notably, Switzerland, Denmark, and Sweden - have lowered official interest rates below zero to lessen pressures on their currencies to appreciate.

Some observers are concerned the current situation is unstable and could deteriorate into what transpired during the Great Depression. At that time, countries abandoned the gold standard and devalued their currencies, while also pursuing "beggar-thy-neighbor" policies, in which they sought to gain an advantage versus their trading partners by imposing tariffs and other restrictions on imports. Such mercantilist policies sought to achieve gains for one country at the expense of another, and they resulted in trade wars between countries.

The current situation, however, is different in several respects. First, monetary policy easing in Japan, the eurozone, and other countries is being implemented to boost domestic demand as well as to counter the threat of deflation, or falling prices. Second, while a consequence of the policy easing is a weaker currency, the policies are not being formulated with the objective of targeting a trade surplus.

At the latest Group of 20 (G-20) meeting, the world's top finance leaders backed currency depreciation as a tool for promoting growth by signaling strong support for aggressive monetary policy easing to bolster domestic demand. In situations where countries are experiencing weak growth and low or negative inflation, finance ministers and central bankers from the largest economies, in effect, are saying it is acceptable to pursue aggressive monetary policies, even if they result in currency depreciations. The rationale is that whereas competitive currency depreciations are a zero-sum game, widespread easing in monetary policies is supportive of global growth.


Limits to Quantitative Easing

A rebuttal to this line of argument is that there are also limits to the effectiveness of quantitative easing. The success of QE in the United States is largely attributed to its large and deep capital markets, in which large scale bond purchases by the Federal Reserve enabled corporations to gain access to cheap financing while households benefited from positive wealth effects. By comparison, the principal source of financing in Japan and Europe is via the banking system, and banks are already sitting on large holdings of excess reserves. Consequently, the primary channel for bolstering growth in Japan and Europe is via the exchange rate mechanism.

In these circumstances, investors need to consider when U.S. officials may change their tune and object to further weakness of the yen and the euro. For example, when the yen weakened from Y80 to about Y100 following the election of Prime Minster Abe in late 2012, currency traders paused in driving the yen lower, as they waited to assess the effect it would have on the Japanese economy, as well as the policy response in Japan and the U.S. Last year, the yen weakened further to Y115 – Y120, as the BOJ launched a second round of QE, and it has fluctuated in that range so far this year. At the same time, the euro weakened by about 15% against the dollar since mid-2014, when the ECB announced it was contemplating a large scale program of government bond purchases.

Thus far, U.S. officials have not objected to these moves for several reasons. First, the U.S. government is encouraging Japan and the eurozone members to do whatever they can to bolster their economies, including adopting QE. Second, it is also recognized that dollar strength stems from the U.S. economy gaining traction in 2014 while the Federal Reserve is contemplating tightening monetary policy later this year. Third, while the dollar has strengthened considerably since mid-2014, it previously had been under-valued and now appears more reasonably valued on a trade-weighted basis.

In my view, U.S. officials are not likely to express concerns about dollar strength as long as the economy continues to grow at a satisfactory pace and unemployment stays low. Therefore, I anticipate further dollar appreciation in 2015, especially if the Fed begins to tighten monetary policy.