I wrote this piece for the Diplomatic Courier back in March for their G8 issue.
There will be no currency wars. Or so the G7 tried to say February. A week later the G20 released a similar statement claiming its nations will not target their exchange rates in search of a competitive edge. Yet the message was deemed too vague by financial markets and did little to ease concerns from emerging economies that their growth will be hampered by monetary policies of major developed nations.
Emerging markets have garnered much attention in the aftermath of the 2008 financial crisis as their improving infrastructure, competitive edge and strong growth potential attracted investment from the developed world. A relatively weaker currency is a key tool for emerging economies as it makes their exports more appealing to developed nations that have stronger purchasing power.
So it was with little surprise that officials in numerous emerging economies reacted with cynicism late last year when new Japanese premier Shinzo Abe called for a weaker yen to boost his nation’s exports and revealed plans to spur growth by increasing Japan’s money supply through the purchasing of government bonds. The yen has consequently depreciated sharply across the board. The US Federal Reserve and Bank of England also utilize similar stimulus measures, albeit without directly stating their desire for a weaker currency.
Comparatively high inflationary pressures in many emerging economies prevent them from adopting comparable policies. As a result, there has been anxiety that emerging economies will react to any significant strengthening of their own currencies by launching large-scale intervention in markets to artificially manipulate exchange rates while also adopting “beggar-thy-neighbour” policies that could disrupt global growth.
The “currency war” terminology was first used by Brazil’s finance minister in 2010 regarding the Federal Reserve’s quantitative easing – the buying of bonds with newly created money. The phrase was reignited in January by the Russian central bank when it accused Japan of potentially instigating “very serious, confrontational actions”. In February, the president of China's sovereign-wealth fund advised Japan against using its neighbors as a “garbage bin” by deliberately devaluing the yen. Later, several of South Korea’s biggest companies warned that a stronger domestic currency will lead to significant deterioration in profits.
Fears have been compounded by some economists cautioning that reactionary devaluations could lead to a similar scenario that occurred following the removal of the gold standard in the 1930s. At that time, nations engaged in devaluations against each other and ultimately introduced trade barriers and protectionist policies that dislocated trade and segregated the global economy. Several countries such as Brazil and South Korea have already introduced controls to reduce speculative capital flows that may strengthen their currencies.
A depreciation in currency value will be a short-term consequence of Japan’s policies and will likely have a negative impact on its smaller neighbors who trade in similar export markets. The possibility of lost jobs in manufacturing sectors is understandably difficult for political leaders in developing nations to accept. Yet despite this short-term prospect, the likelihood of a currency war scenario is exaggerated. The US, Japan and UK are not intervening in currency markets. Their monetary stimulus efforts are not direct attempts to weaken their currencies; the intention is to lower domestic lending rates and boost spending at home.
Focusing on the policies of developed nations and overstating their threat gives authorities in emerging economies an opportunity to turn attention away from difficulties at home. The outlook for the major emerging economies is not as upbeat as in previous years. With further fiscal expansion unfeasible, China is incapable of sustaining rapid growth. A drop in Chinese demand will hurt the Brazilian economy, and a relaxation in monetary policy has left Brazil vulnerable to inflation risks. And while the Indian stock market is near record highs, the country is facing rising inflation, falling growth and potential political uncertainty following elections next year. Russia has the potential to perform well, although it too has been dealing with increased inflation and a stubbornly high dependency on oil prices leaves it with a precarious economic outlook.
Looking past the alarming rhetoric, emerging economies actually have much to gain from stronger currencies. In the longer-term, buoyant major economies result in increased demand for their trading partners’ output. Stronger emerging market currencies will give the developing economies an opportunity to ease inflationary pressures while spurring domestic consumption by making imports cheaper, potentially driving companies to develop more innovative products which will spawn higher-paying jobs. Moreover, the extent of a weaker yen is unclear. The Bank of Japan will have a considerable amount of expansion to do if it is to bring the yen to a level that will have a truly lasting impact on its exports market. It would be remarkable if this year the yen weakened to its pre-2007 levels.
The G7/G8 has not done enough to help the situation. While the G7 statement in February said its nations would not target exchange rates, the message was too ambiguous as it made no reference to Japan. The group needs to clearly state that large-scale currency manipulation by its members will not be tolerated. Such measures can help dismiss currency war rhetoric, allowing leaders of emerging economies to focus on addressing their own policies.