Currency shoot-out

Written by  //  October 15, 2010  //  Economic & Social Policy  //  7 Comments


If you believe the newspapers, the world is on the brink of global war – a global currency war. At the heart of this war is a conflict between the two largest economies of the world, each of which wants to get its own way. Both countries have the same objective – economic growth on the basis of currency depreciation – but it would seem that the world only has room for one winner. It has room enough for losers, however, as the fall-out of this conflict threatens to harm almost every other economy in the world.

This supermess has been created by superpowers refusing to take their medicine and accept necessary structural changes required of them for sustainable global development. Let’s start with the US. The financial crisis culminated in the pricking of the greatest credit bubble the world had seen in decades. The inevitable outcome of this is the deleveraging of the financial sector back to a more sustainable size. This is a painful and long-drawn out process marked by high unemployment, income stagnation, low consumer confidence, and low private investment. It is not a process for which there is much political appetite in the US.

In recent weeks, the Federal Reserve announced an inclination to embark on an extended programme of quantitative easing – essentially a strategy of pumping the US economy with as much money as it takes to revive growth. This has the impact of depreciating the dollar as well which can support American manufacturers of exports and import substitutes. I can’t quite blame the US government for wanting to protect itself, except that when the world’s largest economy goes on a printing spree, the knock-on effects reverberate all around the world.

Exchange rate appreciation against the dollar since 2009

The prospect of ultra-low interest rates in the US for the foreseeable future has encouraged investors to seek higher returns elsewhere – particularly in emerging markets. Foreign capital can theoretically finance much-needed investment in developing countries but more often than not, it causes credit-fuelled consumption booms and asset price bubbles. The domestic currency appreciates sharply, damaging export competitiveness, while encouraging big import spending. Worst of all, foreign capital can be fickle-minded; the slightest whiff of uncertainty and it disappears, leaving behind a trail of financial sector devastation and economic recession. This is not a prospect that China finds particularly appealing.


China has successfully resisted the appreciation of its currency for years through the accumulation of vast reserves of foreign assets. It currently sits on US$2.64tr in official reserves (about twice the size of the entire Indian GDP). An astonishing US$1tr of this amount was added in the last three years. One would argue that the most dynamic economy in the world ought to be the recipient of much of the world’s capital, financing a higher standard of living for the Chinese population. The PRC, however, has very different ideas about the trajectory of development of the Chinese economy. In an export-dominated growth story, currency appreciation cannot play a large role. 

Annual reserve accumulation by emerging markets

With the US trying to inflate its way out of an economic slowdown and China resisting any attempt to increase its net spending, the rest of the world is getting trampled underfoot. Economies like Brazil, South Africa, India and Indonesia are struggling to manage the vast amounts of foreign capital that have arrived at their doorstep since 2009. In 2010 alone, the World Bank predicts as much as US$800bn of capital will flow to emerging markets. Currencies in these economies have appreciated remarkably against the dollar creating a lot of political pressure at home.

Brazil, Korea and Thailand, among others, have already tried to intervene to halt the flow of capital. Unsurprisingly, they haven’t had much success so far: it’s pretty damned hard to stand up to the combined might of the US and Chinese economies. And so the political bickering has begun. The Brazilian Finance Minister declared the currency war open. China has recently been joined by Russia and even some EU policy members in terming the US quantitative easing strategy “irresponsible”. In response to its widening trade deficit with respect to China, the US House of Representatives passed a bill labeling China a “currency manipulator”. Just minutes ago, the White House stopped short of using the same language but expressed “serious concerns” with China’s currency policy. Japan has talked tough to the present G20 chair, Korea, for intervening in currency markets.

India has been very noncommittal so far but today the RBI governor made the strongest statement in favour of currency intervention. India relies on capital inflows to finance a widening current account deficit, which is possibly why policymakers are not entirely ready to take foreign investors for granted yet. The RBI may also be hoping that a little currency appreciation will restrain the continued high levels of inflation. The rupee has, however, appreciated by ten per cent since the beginning of 2009 and by 6 per cent since September 1. You’ve got to be wondering where the next bubble shows up. The RBI governor certainly is and today he sent out the strongest signal so far that the central bank may intervene as well.

The discussions at the IMF meetings in Washington last week failed to bring about any sort of compromise. The battle shifts to the G20 Seoul summit in early November. The failure to reach any sort of agreement could have far-reaching consequences for the global economy, with severe political consequences as well. The big questions will be these: will China let the renminbi rise and will the US ease up on quantitative easing? My opinion is that neither country will budge from its current position. This then begs the third question: will other economies escalate the “war” by intervening in currency markets as well? They well might, I think, but only to little effect. Make no mistake: this is the battle of two giants. Everyone else is simply caught in the crossfire.

7 Comments on "Currency shoot-out"

  1. V. Umakanth October 16, 2010 at 2:05 am ·

    Nice post that provides a comprehensive overview of the currency situation. Although the scale of this crisis could likely be quite large, I wonder whether there are any similarities or lessons to be learned from the Asian financial crisis of the late 1990s that was triggered (at least in part) by currency fluctations and collapses. This currency war will also probably demonstrate which of the economies are truly decoupled, if at all, from the major markets.

  2. Anisha October 16, 2010 at 11:31 am ·

    Hey, thanks for the comment! Lessons from the East Asian crisis: I think there is quite a strong sense of once-bitten, twice-shy in most emerging markets, especially in Asia. This is one reason they’re complaining a lot about the current US-China face-off. Korea and Thailand are already trying to limit capital inflows and Indonesia and Malaysia are considering steps as well. Obviously, unlike during the East Asian crisis, most economies no longer peg their currency to the dollar, which allows them a lot of flexibility in dealing with currency outflows. But this obviously means that currency appreciation will hurt their exports, and capital inflows on this scale can still contribute to financial fragility.

    As far as decoupling goes, you’re right in that if risk aversion suddenly rises, it will be interesting to see which of these emerging markets is going to suffer from capital outflows. The lesson from the last financial crisis is that no one was spared after the collapse of Lehman Brothers. I don’t think that’s going to change here. Also, there is no economy which is going to be spared from the initial wave of capital inflows unless they’re completely closed economies. Even for a giant like China, reserve accumulation is very expensive and will really test the central bank in terms of managing inflation.

  3. markbrownn October 19, 2010 at 11:35 am ·

    thanks for the article

  4. Ruchira November 9, 2010 at 2:19 pm ·

    Anisha, this is a great post.

    The RBI has been following the same policy as the PRC for years now. Our reserves aren’t as great as China’s but they’re going up every year. We do use it to finance our BOP but we’ve accumulated far more than we need and it is getting expensive.

    I believe China keeps threatening to convert its reserves to SDRs or at any rate, has been quietly doing so. A depreciating dollar is in no country’s interest because everyone’s reserves are in the dollar.

    Is China in a political position to take the world away from the dollar? What do you think will happen to the world economy if China makes good on this threat?

  5. Anisha November 12, 2010 at 2:49 pm ·

    Thanks, Ruchira! For what it’s worth, I don’t really think it’s fair to equate the actions of the RBI and the PBC. The scale of intervention by the PBC is really quite mindboggling, with their reserves equal to more than half of their very large GDP. It’s like a huge country! The RBI also seems to have scaled back the extent of intervention in more recent years after a more rapid acceleration in the early 2000s.

    Enormous reserves are a waste of real resources and in today’s environment where dollar denominated assets earn a pittance, they create big losses for the central bank/government. For a country like China, it’s (apparently) a worthwile cost because of the huge benefits in terms of trade.

    Would China switch to SDRs? I’m not sure. I know they dont like the fact that the US is depreciating its currency which leads to capital losses on dollar reserves, but I don’t think they can afford to switch the reserve currency independently of others. For one thing, it may bust their strategy of maintaining an undervalued exchange rate vis a vis the dollar.

    Interestingly, a shift to SDRs as reserve might force China to allow the yuan to appreciate somewhat, depending on how the terms of the restructuring are defined. So if the G20 really wants to get its act together in terms of reducing global macroeconomic imbalances, one strategy could be switching to a global “reserve currency”. Even in this case, though, I suspect a lot of countries may want to hang on to some dollars…

  6. Berneice Sutler July 18, 2011 at 2:58 am ·

    Hi I love that you are right in the mix of public “feedback” and are involved in the discussions (however banal they are). Keep up the good work and, of course, the good design!

Trackbacks for this post

  1. Carry on, Traders! The carry trade and capital controls | Critical Twenties

Comments are now closed for this article.