Currency Wars Revisited

February 9th, 2016 | By Nick Sargen

Since mid-2014, when investors began to anticipate eventual Fed tightening, the U.S. dollar has surged against most currencies.  For a while, China was one of the few holdouts that kept its currency tied to a strong dollar.  However, the Chinese authorities wavered last August, when they widened the band for the renminbi (RMB), and allowed it to depreciate by 2% against the dollar.  Reports in the media heralded it as the biggest devaluation of China’s currency in two decades, and pundits claimed that it threatened to lead to an escalation of “currency wars.”

Since then these fears have increased further as the Chinese authorities announced in December they would henceforth peg the RMB to a basket of currencies, and the RMB subsequently weakened against the dollar. This past week, moreover, the Bank of Japan surprised market participants by announcing it would begin imposing a negative 0.1 percent interest rate on any new excess reserves beginning on February 16.  The announcement caused the yen to depreciate against the dollar, and it has raised concerns that other central banks in Asia might be compelled to respond if the yen continued to weaken.

Some observers contend the situation could lead to a series of competitive depreciations such as occurred in the 1930s, when countries abandoned currency links to gold, intervened in foreign exchange markets to drive their currencies lower, and in many instances imposed restrictions on international trade.  However, my contention is the circumstances today are different in one important respect:  Namely, most countries have not been selling their currencies in the foreign exchange markets to weaken them; on the contrary, most have allowed market forces to determine the value of their currencies.

China is an outlier in this regard, as it has intervened heavily in foreign exchange markets to limit fluctuations of the RMB. In this case, however, China’s central bank has been selling foreign exchange reserves, with its holdings of foreign exchange having fallen by more than $660 billion in the past year. This action has kept the RMB from falling as much against the dollar as market forces would have allowed. The reason: China’s government is trying to counter capital flight from the country, which is estimated to have been between 700 billion dollars to one trillion dollars last year.

The Chinese authorities now find themselves in a quandary.  The economy has slowed steadily for the past five years, which would normally have been accompanied by monetary policy easing.  However, if they were to ease monetary policy now, they run the risk of being accused of trying to manipulate the country’s exchange rate. (Note: U.S. policy makers would like to see China stimulate its economy even if it means a weaker currency).  Meanwhile, Japanese officials reportedly have suggested that China should consider implementing capital controls to stem capital flight, which would allow it more flexibility to ease monetary policy.

While China has been the focal point about alleged “currency wars,” one should not lose sight of how broadly-based the dollar’s appreciation has been since mid-2014, with the dollar’s trade weighted index having risen by about 25%.  Since then, the euro and Japanese yen have each fallen by about 20% against the dollar, as the respective central banks have pursued additional rounds of quantitative easing to counter the threat of deflation. Meanwhile, the values of several prominent emerging market currencies have fallen substantially more: Depreciations for the Russian ruble, Brazilian real, Argentine peso, and South African rand, for example, fall within a range from a high of more than 50% for the ruble to 30% for the rand.

Instead of trying to defend their currencies against plummeting commodity prices, as they did in the past, many commodity-exporting countries have allowed market forces to determine the appropriate values for their currencies. The advantage of doing so is that it allows the exchange rate to cushion some of the decline in commodity prices their exporters face, as each unit of dollar exports receipts translates into more local currency revenues.  At the same time, the main risk is that large-scale currency depreciations have exacerbated inflation pressures in some countries – notably Russia and Brazil – such that their central banks have had to boost interest rates even as their economies have fallen into severe recessions.

In the end one may ask what all of this implies for the U.S. economy as we enter the election period.  My answer is that what is happening in markets today is very complex, and terms such as “currency wars” are misleading.  In the aftermath of the Global Financial Crisis, the U.S. dollar was undervalued in the period when the Federal Reserve lowered interest rates near zero and implemented several rounds of quantitative easing.  However, when the Fed signaled to the markets in mid-2014 that it was about to wind down QE and eventually tighten monetary policy, commodity prices plummeted and the dollar began to appreciate steadily.  Today, the dollar appears to be somewhat expensive, as indicated by measures of purchasing power parity, as well as by the softness in U.S. manufacturing and the challenges shale oil producers are facing.

The fate of the dollar is now closely tied to Fed policy. At the start of this year, the consensus view was that the divergence in economic performance between the United States and overseas economies would persist, and the Fed would tighten monetary policy gradually, which would likely boost the dollar further.  However, in the wake of the recent softening in the economy and the heightened volatility in financial markets, market participants are questioning whether additional tightening is likely, and the dollar gave ground last week.

Finally, from my perspective, the dollar’s rise over the past year and one half is a natural outcome of differing policy responses in the United States versus its trading partners.  In the event the U.S. economy were to slow in the balance of this year, one should be wary of politicians that blame China and other countries for manipulating their exchange rates, when movements of the dollar in fact have been closely tied to changes in monetary policies at home and abroad.

Please also refer to Nick Sargen’s original article “Currency Wars”: Real or Imagined? published on February 17, 2015.