Currency war!

Canada must devalue too or get hurt.

CB_currency-warLast December, Shinzo Abe became Japanese prime minister with an unusual promise: to make the yen worth less. The country was frustrated after two decades of economic turmoil, and Abe argued much of that blame lay in an inflated currency that was crippling Japan’s industry. Voters liked the pitch, even though, as Abe admitted, “it’s very rare for monetary policy to be the focus of an election.”

At its most basic, Abe’s push to devalue the yen is simple to understand. Countries with expensive currencies have trouble selling their exports abroad. Fewer Americans, for example, buy Canadian exports when the loonie trades high relative to the U.S. dollar; it simply takes more of their money to buy our products.

Between late 2008, when the financial crisis hit, and November, when the Japanese government fell, the yen increased in value by 45% against the U.S. dollar, driven upward by investors who saw the yen as a safe haven during economic turmoil. Since Japan is reliant on selling cars and electronics to the world, that currency appreciation did serious damage.

Even before he was elected, Abe began to influence the exchange rate by talking down the yen. He promised “unlimited” monetary easing, which would add trillions to the currency supply to decrease the yen’s value, and put pressure on the ultra-conservative Bank of Japan to double its inflation target to 2%, prompting the early resignation of the central bank’s governor and two of his deputies. But Abe’s gambit appears to be a success. The yen dove by more than 15% against the U.S. dollar in three months. Exporters are now enjoying a sudden boost in competitiveness. “Ever since the new government took control, it feels as though Japan is filled with the spirit for economic revival,” Toyota executive Takahiko Ijichi said this month.

Guidelines put forward by the G20 allow for monetary policy directly aimed at improving the domestic economy, but not at manipulating the exchange rate. So there are two possible ways to characterize the recent behaviour of the yen. The first: Japan has made aggressive, but legitimate, policy changes to repair an economy that can better serve the world in strength. The G20 tacitly endorsed this view in a communiqué last month. “They’d like the kind of ‘war’ where no-one gets hurt,” Kit Juckes, head of foreign exchange at Société Générale, said in a note. Others think Japanese politicians are attempting to devalue the yen to poach trade from competing nations. And that’s the kind of war where there are plenty of casualties. “Everyone knows what’s going on,” says James Rickards, author of Currency Wars: The Making of the Next Global Crisis. “But there’s a great fear of speaking candidly about it, because currency wars have a history of spinning out of control and turning into trade wars.”

If a fight is upon us, Japan is hardly alone on the front lines. China has also been accused of distorting global markets, in its case by keeping the yuan undervalued. The United States pushed its currency to recession-range lows through its quantitative easing programs, which stimulate the economy by printing new money to be lent out. The British pound plunged to a 2½-year low on the treasury’s new-found appetite for inflation and monetary easing. Brazil has for months tried to depreciate its currency by restricting capital flowing across its borders. Venezuela recently devalued its currency by one-third. New Zealand’s central bank is considering direct intervention to stop the rise of the kiwi. Other countries will join the fight.

The current era bears a troubling resemblance to that of the 1930s, when a currency war deepened the Great Depression. “Then, as now, governments tried to restore growth and exports by devaluing their currencies and carving out trade blocs, risking a chain reaction around the world,” writes John Hancock, a senior counsellor at the World Trade Organization, in his column for the Canadian International Council. “Then, as now, the system was rudderless, unstable, and insecure—which persuaded countries to protect their own national interests, even at the expense of the collective good.”

History suggests that “those who don’t engage are the ones who are hurt” in currency and trade wars, says Camilla Sutton, chief currency strategist at Scotia Capital. “That would leave at risk the smaller, open economies, like Canada.” As everyone else races for the bottom, the loonie will rise. And this is one time when Canada doesn’t want to be on top.

If Japan’s swooning yen is an early warning of an oncoming currency war, the global financial elite aren’t eager to discuss it. “I urge all parties to (exercise) very, very strong verbal discipline,” European Central Bank president Mario Draghi said after recent G20 meetings in Russia. “I think the less we talk about this, the better.” In a world full of currency debasers, there are few innocents. As tensions rise, the arbiters of global finance are reluctant to even entertain the possibility that financial hostilities could escalate. But Japan has made the currency war difficult to ignore.

The Art of Currency War
What is devaluation?
Devaluation means a deliberate attempt by a government or central bank to lower the value of its currency in foreign-exchange markets. This should not be confused with depreciation, which happens when a currency loses value due to what are deemed “normal market forces.” By way of analogy, your car depreciates as it ages and wears out; you’re devaluing it when you take a sledgehammer to the bonnet.
How is devaluation accomplished?
There are numerous weird and wonderful ways to debase a currency. Historically, one popular method was to lower the precious metals content in minted coinage. As the Roman Empire waned, it faced constant threat by barbarians but lacked money to defend itself, so successive emperors reduced the silver and copper content in coins. Once fiat currencies, which derive their value based on laws rather than metallurgical content, became common, governments could simply print bank notes in large quantities. Financially wrecked following the First World War, Weimar Germany printed huge volumes of marks to cover its expenses, resulting in hyperinflation on a massive scale.
Modernity gave rise to new techniques. Some governments attempt to hold their currency at a defined level against another, usually the U.S. dollar. In countries with these fixed rates, governments can change the official exchange rate. In February, Venezuela devalued the bolivar by sharply raising its rate relative to the U.S. dollar.
The latest popular devaluation technique is called “quantitative easing.” The term refers to a central bank using newly created money to purchase government bonds and other securities. Although it’s often cast as a means of spurring domestic consumption, some economists argue the real objective is currency devaluation.
What is devaluation?
Devaluation means a deliberate attempt by a government or central bank to lower the value of its currency in foreign-exchange markets. This should not be confused with depreciation, which happens when a currency loses value due to what are deemed “normal market forces.” By way of analogy, your car depreciates as it ages and wears out; you’re devaluing it when you take a sledgehammer to the bonnet.
Why should I care?
It’s a tenet of modern monetary theory that only stable money is good money. Needless to say, a currency war undermines stability. Those nations that succeed in devaluing often experience serious inflation, particularly if they’re reliant on imports. Nations unwilling or unable to devalue their currencies, meanwhile, can suffer higher unemployment as their export sectors lose competitiveness. With such realities in mind, economist Joseph Stiglitz has written that “a currency war will make everybody a loser.”
If a society actually loses faith in its medium of exchange, a general breakdown of trust and social cohesion often ensues. Lenin, an astute observer of such matters, wrote: “There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency.”
Matthew McClearn

When an economy needs a boost, the primary tool of the central banker is the interest rate cut—it’s simple and effective. Making it cheaper to borrow money encourages spending and lifts economic activity. But when rates are already rock-bottom, as they are in much of the world right now, central banks can still influence interest rates by manipulating the money supply. For more than four years now, the U.S. Federal Reserve has tried to do just that through a security-purchasing program known as quantitative easing—also commonly referred to as “printing money.” The Fed does this not by actually firing up the presses, but by creating new money electronically and then purchasing Treasury bills and mortgage-backed securities from banks. It’s like being allowed to print money in your basement to buy savings bonds.

With the Fed actively buying securities on the open market, the additional demand means bond issuers can promise lower yields and still attract investment. Lower interest rates means more spending, but as the return for investors falls, they start looking for new places for their money. “Financial capital is very mobile and basically is looking only at rates of return,” says Chris Ragan, a professor of economics at McGill University and former adviser at the Bank of Canada. “That capital will leave the U.S. and go someplace else.” When capital exits the U.S., fewer U.S. dollars are needed for transactions at home. As the demand for dollars falls, so too does its exchange rate.

Weakening the dollar is not the primary intent of quantitative easing, Federal Reserve chairman Ben Bernanke said recently, arguing the central bank was “using domestic policy tools to advance domestic objectives.” Still, many export-focused countries hold the policy in contempt. It was Brazilian Finance Minister Guido Mantega who first uttered the words “currency war” in reference to the slide of the U.S. dollar. Over successive rounds of quantitative easing, Brazil’s currency jumped by 50% against the greenback. A weakened U.S. dollar not only hikes the value of the Brazilian real, making its products more expensive, but some of the cash flowing out of the U.S. in search of a healthy return landed in Brazil, where interest rates were higher. That influx of foreign capital pushed the domestic currency’s value upward, just as in Japan. And all that investor money looking for a new home can lead to overheated markets. “You end up with issues like a housing bubble, which ends up threatening financial stability,” says Sutton. Sound familiar?

Like the U.S., low inflation allows Canada to keep rates at extraordinary lows. To diverge substantially from U.S. rate policy would open up a difference in interest rates that would draw more capital into Canada, further appreciating an already overvalued loonie, putting us in the same situation as Brazil. On the other hand, leaving the interest rate low encourages the kind of borrowing and spending that has produced record-high levels of consumer debt in Canada and pushed housing prices into the stratosphere. U.S. monetary policy has left Carney to choose the least-bad option—currency appreciation or a debt bubble. Still, Carney says there is no place for Canada in the currency wars. “If we were to try to control the level of our exchange rate, we would have to start to close what is one of the most open and effective capital markets, money markets, in the world, in order to be successful,” Carney told a parliamentary committee this month, also warning “there would undoubtedly be a suspicion” that we were “trying to gain a competitive advantage” if we tried to control our interest rate. Competitors would probably see the move as an act of trade aggression, just as South Korea is leery of Japan’s recent conduct.

South Korea, the primary casualty of a weak yen, has yet to retaliate but is weighing an “active response to minimize any negative impacts on exports,” Bank of Korea governor Kim Choong-soo said last month, raising the possibility of South Korean devaluation. Japan’s leaders brushed off suspicion of its motives, calling the yen’s moves an appropriate “correction” to a grossly overvalued currency. Prime Minister Abe said last month that helping Japan’s exporters is “the responsibility of the government.”

The domestic incentives for influencing the exchange rate can indeed be compelling, at least in the short term. Longer term, there are risks, both in strained trade relationships and domestic economic implications. Most of the money created by quantitative easing in the United States is still sitting in the reserves of banks reluctant to lend to consumers, who are themselves reluctant to borrow. When banks start to lend that money out as the U.S. economy improves, all of that new money could lift prices substantially.

As long as countries maintain weak-currency policies, the risk of other countries resorting to competitive devaluations will remain. Jens Weidmann, president of the German central bank, said in a recent speech he fears that monetary policy will become increasingly subject to political influence. “Until now, the international monetary system got through the crisis without competitive devaluations, and I hope very much it stays that way,” he said.

That all depends on whether politicians and central bankers can resist the lure of the quick fix. When countries do succumb to the temptation of the competitive devaluation, it invites retaliation. As long as there is something to be gained from war, there will be those nations willing to wage it.