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THIRD WORLD RESURGENCE

Currency chaos threatens global recovery

While the global economy is still struggling to recover from the 2007-09 recession, a new threat looms as a result of the adoption by the US Federal Reserve of a policy of 'quantitative easing' (QE) which has triggered a 'currency war' with major exporting nations such as China and Brazil. While this raises the spectre of the sort of 'competitive devaluation' in the late 1920s which contributed to the Great Depression, an additional threat is posed by the huge surge of speculative capital flowing out from the US (where the yields on such investments have been lowered by the release of the flood of US dollars under the QE policy) to the emerging markets. To protect their economies from the dangers of such 'hot money', these countries have had to resort to capital controls and other measures. Martin Khor unravels this chaotic economic picture.

THE closing months of the past year witnessed 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 late 1920s and 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 World Trade Organisation (WTO) 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.

In October, Japan criticised South Korea for taking the same intervention measure to curb the appreciation of the won.

'Quantitative easing'

Second, there are concerns over the effects of the new round of 'quantitative easing' by the United States announced in November, in which the US Federal Reserve will spend $600 billion to buy up government bonds and other debts. Known as QE2, this follows the injection of $1.8 trillion in 2008-09 under the first round of quantitative easing.

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 on 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, the hard way, that sudden and large capital inflows can lead to serious problems, such as:

  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.

 The large inflow of foreign funds will build up pressures for the recipient country's currency to rise (against other currencies) significantly. The financial authorities would have to either 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.

 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 (IMF) annual meeting in Washington in October, 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).

Capital concern

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 warned that Wall Street was snapping up the assets of emerging economies. Describing the problems caused by huge inflows of capital, it asked the developing countries 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 and other measures to slow down the huge inflows of foreign capital and protect their economies (see accompanying article). The Institute of International Finance has estimated a massive flow of $825 billion to developing countries in 2010, an increase of 42% over the previous year.

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 by the US 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.                   

Martin Khor is Executive Director of the South Centre, an intergovernmental policy think-tank of developing countries, and former Director of the Third World Network.

Countering 'hot money' flows

THE low-interest-rate environment in developed countries in recent times has led investors to move their funds to other countries where yields are higher. The sudden flood of funds, however, affects the stability of the latter's currencies and markets. As such, some governments in the emerging markets have taken steps to control the flow of 'hot money' into their countries.

The following are some examples of government interventions made in the markets.

BRAZIL:

 The central bank on 14 January sold $988 million in reverse currency swaps, a derivative that effectively allows the bank to buy US dollars on the futures market.

 On 7 January the central bank announced that domestic lenders would have higher reserve requirements against foreign exchange positions to reduce speculative trade. This was Brazil's third attempt since October last year aimed at discouraging 'hot money' from chasing the real higher.

 President Dilma Rousseff on 31 December 2010 promised more aggressive measures including targeted tariff increases and tax breaks to address the effects of a strong real.

 On 18 October 2010, the government tripled tax on foreign purchases of bonds to 6% to curb inflows into the fixed income market. It also increased tax on derivatives margins to deter short-term investors.

 Sovereign wealth funds are authorised to buy dollars on the spot market.

CHILE:

 On 8 February, the Chilean central bank announced it would maintain the pace of a $12 billion foreign exchange intervention to tame the strong peso between 9 February and 8 March, and continue to buy $50 million daily. The move is expected to increase its foreign currency reserves to the equivalent of 17% of GDP.

 In January, the central bank held the benchmark interest rate steady after raising it for seven consecutive months.

 The central bank removed limits on pension funds' overseas investment.

 Chilean President Sebastian Pinera said he does not plan to impose capital controls.

COLOMBIA:

 On 17 November 2010, the Finance Ministry said it will only use external financing in 2011 to meet outside obligations to ease pressure on the peso.

 On 29 October 2010, the central bank said it was buying at least $20 million daily until at least 15 March.

 The government kept $1.5 billion abroad last year, which included $1.4 billion in government dividends from state oil firm Ecopetrol.

 There are plans to possibly hedge up to $3.7 billion in external debt service payments in 2011.

MEXICO:

  The central bank is buying $600 million per month by selling dollar put options as a means to build up its reserves.

PERU:

 The central bank bought about $9 billion on the spot market in 2010, equivalent to around 6% of GDP. The treasury also bought around $500 million.

 On 26 November 2010, banking regulator SBS said it has plans to draw up rules to curb the use of short-term derivatives called non-deliverable forwards (NDFs) to limit pressure on the sol.

  The central bank has raised deposit requirements on bank accounts.

INDONESIA:

  Analysts on 9 February said Indonesia's central bank will no longer regularly sell its six-month SBI debt in monthly auctions in an attempt to drive investment to longer-term instruments  as it seeks to counter hot money flows.

  On 3 December 2010, the central bank indicated that it will impose new measures to control inflows, including management of commercial banks' minimum reserve ratios in foreign currency bank accounts and rupiah-denominated giro accounts held by foreigners with local banks.

  In June 2010, the central bank introduced a minimum holding period of one month for its bills in a move to channel strong capital inflows away from short-term investments.

PHILIPPINES:

 The central bank approved six measures in October 2010 involving higher ceilings for residents' foreign exchange purchases and outward investments, and encouraging foreign debt prepayments by the private sector.

 The central bank said it will use measures such as building up foreign exchange reserves and additional bank regulations to deal with foreign inflows and to stay active in the currency market.

SOUTH KOREA:

 A proposal has been made to levy banks' foreign currency debt from late 2011, expected to be at a level less than 0.5%.

 The government is expected to reinstate a withholding tax on local bond holdings by foreign investors later this year, expected to be set at 14%.

 In June 2010, the government set ceilings on foreign exchange derivatives that banks can hold - 250% of equity capital for foreign bank branches and 50% for domestic banks - and these rates were to be reduced over the following months.

TAIWAN:

  On 30 December 2010, the Financial Supervisory Commission said it will investigate bank trading to see whether foreign capital is involved in speculation.

  On 27 December 2010, the central bank capped trading in non-deliverable forwards at one-fifth of a bank's total foreign exchange trading.

  The reserve requirements ratio was tightened for Taiwan dollar passbook deposits held by foreign investors.

THAILAND:

  Thailand imposed a 15% withholding tax on interest and capital gains earned by foreign investors on Thai bonds from 13 October 2010.

  On 24 November 2010, the central bank said it would consider further measures including a Tobin-style tax on international transactions.

SOUTH AFRICA:

  The central bank and the National Treasury have made a concerted attempt over the past 18 months to cap the rand's gains by selling rand and buying foreign currencies to curb rand appreciation. The central bank intervened 'aggressively' in the currency market in January, resulting in the net foreign exchange reserves rising $1.1 billion to $44.45 billion for the month.

 On 14 December 2010, South Africa eased exchange controls, allowing local institutions to invest more money abroad.

TURKEY:

  On 24 January, the central bank raised reserve requirements on one-month lira deposits by 200 basis points to 10% of the amount deposited.

  On 20 January, the central bank cut its one-week repo policy rate by 25 basis points in a surprise move.

 Increased reserve requirements were imposed for banks' short-term lira deposits, to prevent the lira from strengthening.

  However, the government is not considering a Tobin tax on hot money.

ISRAEL:

 Israel's Finance Ministry said on 27 January 2010 it is acting to annul a tax exemption for foreign investors on profit from investments in short-term government bonds and short-term Bank of Israel bills called makams.

  Effective 27 January, the Bank of Israel has imposed a 10% reserve requirement for foreign exchange swaps and forwards trades conducted by non-residents.

  The central bank on 19 January announced it will require Israelis and foreigners to report on transactions in foreign exchange swaps and forwards of more than $10 million in one day. Non-residents who perform transactions in makams and short-term government bonds of more than 10 million shekels in one day will be required to report details of the transactions and their balance of holdings of such assets.                         

(Source: various news agencies)

*Third World Resurgence No. 245/246, January/February 2011, pp 14-17
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