THE world may be on the brink of a currency war, if not already engaged in covert hostilities. Japan’s new government has done much to foster the idea that competitive devaluation is the order of the day, by bullying the Bank of Japan to achieve 2 per cent inflation. But even before it came to power, there were complaints from emerging economies that policies of extreme monetary easing, especially in the US, were destabilising foreign exchanges.
Some say a currency war can’t be underway because no major central bank has intervened on the foreign exchanges. Yes, the Swiss National Bank (SNB) staged an intervention after September 2011 to restrain the Swiss franc’s appreciation against the euro. But the SNB was not unilaterally seeking a trade advantage.
But policymakers have developed more subtle ways of influencing exchange rates. Since domestic demand is much less responsive to macroeconomic policies than before the financial crisis, monetary measures may be deployed to influence exchange rates with minimal risk of unwanted consequences. Further, the power of central bankers to influence exchange rates through statements seems to be much enhanced. Other market participants are now too constrained to launch any challenge.
It might also seem that there can be no winners in a currency war. After all, if one central bank weakens its currency’s exchange rate, others may take action to reverse that gain. But there are dangers. When a central bank sets its currency on a weaker course, it is relying on retaliation to provide a safety net. The risk is that market dynamics take the exchange rate far lower than the central bank might wish. If it can bank on competitors taking counter-measures to ensure their own currencies do not become too strong, the chances of a destabilising currency collapse may be minimal.
The danger is that the central bank miscalculates. Competitor central banks may not respond as promptly as it expects, or the measures they take may be ineffective. Then, currency collapse, with attendant losses from mismatched currency positions, may become a threat to global stability. This is a dramatic scenario and, in practice, there may be only a small chance that it would play out.
More substantial is the chance that central banks would resort to capital controls. And increasing impediments to the free flow of capital would lower the growth rate of the world economy.
Even if capital controls were avoided, and no exchange rates collapsed, a currency war would still almost certainly bring about an increase in exchange rate volatility. As one central bank and then another brought downward pressure on its currency, exchange rates would fluctuate more violently. The result is that companies operating across currency borders would need to build into their calculations wider margins to account for the increased possibility of exchange losses. Exporters would raise prices.
And this would be the wrong sort of inflation from policymakers’ point of view – the sort that eats into customers’ spending power.
Stephen Lewis is chief economist at Monument Securities.