Global Trends by Martin Khor

Monday 18 October 2010

Currency chaos threatens global recovery

In recent weeks, the media and some political leaders have warned that a new “currency war”

has broken out.  Unless quickly resolved, it can have a severe effect on the global system.


The past few weeks have seen the emergence of global currency chaos, which is a new threat to prospects for economic recovery.

In fact the situation is being depicted by the media and even by some political leaders as a “currency war” between countries.

The general idea being conveyed by this term is that some major countries are taking measures to lower the value of their currency in order to gain a trade advantage.  If the value of a country's currency is lower, then the prices of its exports are cheaper when purchased by other countries, and the demand for the exports therefore goes up.

On the other hand, the prices of imports will become higher in the country, thus discouraging local people from buying the imports.

The result is that the country will get higher exports and lower imports, thus boosting local production and improving the balance of trade.

The problem is that other countries which suffer from this action may “retaliate” by also lowering the value of their currencies, or by blocking the cheaper imports through higher tariffs or outright bans.

Thus, a situation of “competitive devaluation” may arise, as it did in the 1930s, which can contribute to a contraction of world trade and a recession.

The present situation is quite complex and involves at least three inter-related issues.

First, the United States is accusing China of keeping the yuan at an artificially low level, which it  claims is causing its huge trade deficit with China.  A US Congress bill is asking for extra tariffs to be placed on Chinese products.  China claims such a measure would be against the WTO's rules, and that  a sudden sharp appreciation of the yuan would be disastrous for its export industries, nor would it solve the problem of the US trade deficit.

Japan, whose yen has appreciated sharply against the dollar, intervened on the currency market on 15 September by selling 2 trillion yen in order to drive its value down.

Last week, Japan criticized South Korea for taking the same intervention measure to curb the appreciation of the won.

Second, there are clear signs that the United States is preparing to lower the value of its dollar, through a new round of “quantitative easing”, in which the Federal Reserve will spend probably hundreds of billions of dollars to buy up government bonds and other debts.

This will increase liquidity in the market, which would reduce long-term interest rates (and thus contribute to a recovery). 

But this would also have two other effects.  It would weaken the US dollar further (thus opening the US to the accusation it is also engaging in competitive depreciation).

And the new liquidity would also add to a surge in capital flowing out from the US (where returns to investment are very low) to developing countries.

In the past, such surges of “hot money” would have been welcomed by the recipient countries.  But many developing countries have now learnt, through the hard way, that sudden and large capital inflows can lead to serious problems, such as:

l        The capital inflow will lead to excess money in the country receiving it, thus increasing the pressure on consumer prices, while fuelling “asset bubbles” or sharp rises in the prices of houses, other property and the stock market.  These bubbles will sooner or later burst, causing a lot of damage.

l        The large inflow of foreign funds will build up pressures for the recipient country's currency to rise (against other currencies) significantly.  Either the financial authorities would have to intervene in the market by buying up the excess foreign funds (which is known as “sterilisation”) and thus build up foreign reserves, or allow the currency to appreciate and this would have an adverse effect on the country's exports.

l        Experience (including of the Asian crisis of 1997-99) shows that the sudden capital inflows can also turn into equally sudden capital outflows when global conditions change.  This can cause economic disorder, including sharp currency depreciation, loan servicing problems and balance of payments difficulties.

At the International Monetary Fund annual meeting in Washington last week, there was a conflict of views between the United States (which accused China of deliberately suppressing the value of its yuan and not allowing it to appreciate more) and China (which accused the US of planning quantitative easing and increasing liquidity to deliberately devalue its currency).

Meanwhile, even serious Western analysts and newspapers have recognised the threat posed to developing countries by large inflows of capital coming from the developed countries in search of higher yield.

In an editorial on 15 October entitled The Next Bubble, the International Herald Tribune warns that  Wall Street is snapping up the assets of emerging economies.  Describing the problems caused by huge inflows of capital, it asked the developing counties to “pay close attention” and to “consider capital controls to slow inflows.”

This is the third recent development: some developing countries have introduced capital controls to slow down the huge inflows of foreign capital. The Institute of International Finance estimates that a massive US$825 billion will flow to developing countries this year, an increase of 42% over last year.

Brazil has doubled the tax on foreigners buying local bonds, while Thailand recently imposed a 15% withholding tax on interest and capital gains earned by foreign investors on Thai bonds and South Korea has warned of new limits on forwards, while banks are asked not to lend in foreign currency,

Finally, there are fears that if the currency chaos or currency war is not solved soon, the world faces a threat of trade protectionism, whether it takes the old form of an extra tariff, or a new form of competitive currency depreciation.

Moreover the quantitative easing that the US is now planning may exacerbate the speculative flows of funds in search of profits, and this can be destabilising to the recipient countries and the global economy overall.