What Did You Do in the Currency Wars? (Part I)

Tony Addison

The present currency turmoil is both a symptom and a cause of profound changes now underway in the global economy. In part 1 of this two-part article, we focus on Latin America and Europe. Part 2 discusses China, and will appear in the November Angle.

There is a famous British poster from 1915 of a father sitting in a comfy post-war armchair, but with an anxious face. His son is playing with toy soldiers, while his daughter is turning to him asking: ‘Daddy, what did you do in the Great War?’

It therefore seems somewhat glib to refer to disagreements over exchange rates as ‘currency wars’. No armies are on the march. Instead we have seen allegations from Latin America’s central bankers that countries are using depreciation to gain ‘unfair’ competitive advantage. Meanwhile, China and the US joust over the value of the renminbi, and Europeans patch up yet another deal to support the euro.

Yet the terminology of the currency wars has resonance: it harks back to the turmoil of the inter-war years. Our anxious father might have been worried about his job in the deflationary years of the 1920s, which were exacerbated by sterling’s return to the gold standard. The competitive devaluations undertaken in the 1930s occurred amidst a downward spiral in world trade that deepened the Great Depression.

Eventually the expansionary monetary policies behind those devaluations sparked recovery in the later 1930s—as today’s quantitative easing also might. But the ‘every nation for itself’ mentality of the 1930s seems to be back, prevailing over a more rational structure of international financial governance in which nations co-ordinate to restore global growth.

What do exchange rates do?

Shifts in currencies can dramatically alter the prospects for growth and investment, especially in the smaller and more open economies of the developing world. An appreciation of the domestic currency hits exports and makes imports cheaper relative to local products. Depreciation is more positive for the export sector and import substitutes. But it can raise the cost of intermediate inputs (capital equipment, raw materials) into both sectors. This has a bigger effect in smaller and less diversified economies (especially when they are oil importers).

Depreciation raises the cost of any foreign currency debt held by governments, companies or households. Companies can partly hedge their debt against adverse currency movements, but this is expensive. Back in 1997, it was unhedged foreign currency debt that undermined Indonesia’s economy once the rupiah entered crisis. This drove Indonesia into the hands of the IMF, and Suharto—who ruled for over 30 years—out of power. Currency crises easily become political crises, as the eurozone shows.

What is a central banker to do?

Developing countries face at least three macro-threats: slowing demand for their exports; risk aversion, which makes their debt and equity markets less attractive to foreign buyers; and higher food price inflation. Interactions abound. A sickly US and Europe, and a slowing China, puts pressure on commodity export prices, raises debt service risks, and reduces capital flow, for example.

What is a policy maker in the developing world to do? Much depends on whether the central bank governor sits in a big or small economy and whether the exchange rate is fixed or not. Governors in small economies face higher inflation and must raise interest rates to contain currency depreciation if the exchange rate is flexible (food import bills rise substantially if depreciation gets out of hand). Kenya and Uganda have both hiked rates to halt sizeable currency depreciations (Kenya’s shilling is down by a third this year).

Central bank governors in big emerging economies have a somewhat easier time. While commodities still make up a lot of their exports, they have more diversified export bases, and of course larger (and growing) domestic markets. Most are sitting on big foreign exchange reserves. They can worry less about external shocks. Their responses have therefore varied, depending on their own domestic conditions. Indonesia cut interest rates this month, while India has raised them.

So central bank governors in big emerging economies generally get more sleep than those in smaller and more open low-income economies, who risk killing growth and investment to shore up their weaker currencies. Still, central banks in the bigger economies do have to watch out because trends can quickly reverse. And their financial systems often undertake more foreign borrowing, which can make them vulnerable to currency crises. Latin America, to which we now turn, demonstrates this.

Latin America and the currency wars

Latin American policy makers started to register alarm at the dollar’s slide, and China’s policy of undervaluing the renminbi, back in 2010. Brazil’s finance ministry led the Latin American charge in the currency wars. Worried about the real's appreciation (50 per cent against the dollar from early 2009 until July this year), Brazil tightened capital controls on inward flows and eventually slapped a tax on currency derivatives (to curb speculation in the local currency futures market).

Brazil has also described currency undervaluation as a form of disguised export subsidy and one that could potentially be labelled as an unfair trading practice under WTO complaint procedures. The WTO itself has expressed alarm that currency disputes might trigger more trade protectionism.

Times change, however. What specifically changed was a deepening in the eurozone crisis over the middle of 2011. The dollar is favoured when the world takes fright. It is still the primary reserve currency, and the most liquid currency market. Traditional safe havens such as the Swiss franc became less attractive when the central bank braked hard on its appreciation in 2011 (Japan has a similar concern over the yen but less policy space than Switzerland).

Brazil’s real has depreciated since mid 2011 as the dollar changed direction, and sharply appreciated, with investors fleeing to the ‘safety’ of dollar assets and out of euros and riskier bets on gold, commodities, and developing country debt. The dollar appreciation raised the debt service of Brazilian companies, cutting their funds for investment. So while the authorities were keen to see the real’s earlier appreciation curtailed, they now need to ensure that the recent depreciation does not resume and get out of hand. This is especially so since Brazil’s own banks are taking speculative bets against the currency.

Likewise, Argentina is spending an increasing amount of its hard-won foreign exchange reserves on slowing the peso’s depreciation and the central bank is now more concerned about capital outflow than inflow.

The next shock from Europe

Dollar spikes are one shock that developing countries need to watch for. With much fanfare, eurozone politicians announced another grand plan at the end of October. Relief spread, but hard work remains to be done, not least in convincing banks to take a voluntary haircut on their loans to Greece (which also needs to achieve growth if its debt targets are to be met). So the latest plan is only a start, not the end.

If the eurozone fails to resolve its interlinked currency-debt-bank crises then a new rush of capital to dollar havens could be large and sudden. This would destabilize the bond markets in the emerging world, which have done well over the last few years (purchases of domestic currency debt surged after 2009 as investors sought out higher yields to compensate for the fall in yields on US treasuries). That in turn helped to finance governments, investment and growth in emerging economies—one reason why many folk argued that the growth of the developing world has decoupled from the developed world.

A resumption in the flight to the dollar would cut the dollar return on the domestic currency debt of the developing world, leading to a sell-off and higher yields. Many of those local debt markets are thinly traded, implying high volatility in tough times. This credit channel is one through which the European crisis—or any other crisis—can hit the developing world hard.

Hardening the armour

Developing countries would do well to look to their armour in the present currency wars. Currency swap arrangements between central banks are one way to do this. Smaller and more vulnerable economies in Africa might try and follow the lead of South Korea, which recently concluded currency swap agreements with China and Japan—countries that have large foreign exchange reserves. Those with gold deposits might strike a favourable deal since China wants more gold in its reserves; and goldbugs are abundant in China (see my article ‘Animal Spirits’ in the August Angle on this species).

So a theme for the last quarter of 2011, taking us into 2012: are the currency wars over, or just beginning? And what will you do? November’s Angle returns to the issue with a discussion on the tensions around China’s exchange rate policy.

Tony Addison is the editor of WIDER Angle. He is Chief Economist/Deputy Director of UNU-WIDER.

WIDER Angle newsletter
October 2011
ISSN 1238-9544