Currency wars on the horizon

First published in The Korea Herald.

Brazilian Finance Minister Guido Mantega popularized the term “currency war” in 2010 to describe policies employed at the time by major central banks to boost the competitiveness of their economies through weakening their currencies. As we enter 2015, the specter of currency wars appears to be once again looming on the horizon.

In layman’s terms, currency wars are said to occur when countries seek to devalue their currency to gain a competitive advantage ― exports become more competitive while imports become more expensive, leading to a rise in aggregate demand, which helps boost economic growth and reduce unemployment.

However, if one country seeks to become more competitive through devaluation, it means other countries become less competitive. Therefore, they may respond by weakening their currency too. This leads to a situation of competitive devaluation, where each country seeks to reduce its own currency’s value. In the end, this creates global economic instability by discouraging investment and trade.

With many major economies across the world yet to fully recover from the recession, and some facing the threat of deflation, central banks are slowly but surely seeking to boost demand through exchange rates.

According to data compiled by Bloomberg recently, weak price growth is stifling economies from the euro region to Israel and Japan. Eight of the 10 currencies forecast to decline the most through 2015 belong to nations that are in deflation or pursuing policies that weaken their exchange rates.

Lowering interest rates, quantitative easing and intervention buying are some of the measures that have become more prominent in recent months, and unless the respective economies recover, we are likely to see similar actions in 2015.

Taking a brief look at the major economies, this trend is not yet fully confirmed, but the possibility remains high.

The U.S. Federal Reserve has been pursuing quantitative easing for some time, but with a gradual economic recovery, expectations for a pickup in inflation and a strong dollar, it has hinted at the possibility of policy normalization. As crude oil prices are continuing to slump to historic lows and inflation has not picked up, such a move would have to be well-timed.

In its Dec. 17 statement, the Federal Open Market Committee noted that economic activity is expanding at a moderate pace. Inflation has continued to run below its longer-run objective, partly reflecting declines in energy prices. Market-based measures of inflation compensation have declined somewhat further; survey-based measures of longer-term inflation expectations have remained stable.

“When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run,” it said in a statement.

As such, if global growth remains weak and the dollar becomes too strong, the Fed might decide to change its position and continue with monetary easing, or even accelerate it.

Meanwhile, the European Central Bank recently announced new stimulus policies, and unveiled a promise to buy asset-backed securities and covered bonds. With Europe’s fragile recovery slowing down the rest of the world and inflation running at a fraction of the ECB’s goal, President Mario Draghi has raised the prospect of large-scale asset purchases. So far, it has stopped short of full-fledged quantitative easing, but is widely expected to consider a package of broad-based asset purchases including sovereign debt this month.

With a decline in oil prices, which have led to a fall in the value of the ruble, Economists are of the opinion that Russia won’t speed up its plan to allow the ruble to trade freely next year, even though the central bank’s continued defense of the currency has cost it a lot of money.

Russia’s central bank, led by Gov. Elvira Nabiullina, has so far failed to reverse the currency plunge even after spending a fifth of its international reserves and raising its key interest rate five times since March 2014. One can expect sharper rate moves to sway the currency market.

With Japan’s Prime Minister Shinzo Abe back in the saddle, the Bank of Japan is widely expected to continue with its quantitative easing programs to get the economy back on track. At the end of 2014, it engaged in one of the largest experiments in quantitative easing and has been selling yen and buying U.S. assets. This may pick up pace, depending on the progress of its recovery.

China has long been accused of currency manipulation. Many economists also expect the People’s Bank of China to continue its monetary easing, now that GDP has slowed down. Only recently it lowered lending and saving rates and increased the ceiling for deposit rates in an effort to boost the growth rate of its economy. The country has room to ease further, which shouldn’t be disregarded if the economic situation fails to improve.

According to experts, if the risk of deflation rises amid the unwinding of its credit bubble, there’s a risk that China will follow Japan and devalue the yuan.

Xinhua news agency cited a government official as saying that monetary policy will be kept prudent ― “There will be greater focus on monetary policy being appropriately tight or loose.”

Many other emerging economies are either trying to stabilize prices or gain competitiveness by weakening their currencies as they ease their monetary policies. Everything depends on how the economies fare.

South Korea, like China, is desperately trying to fight deflationary pressures with rate cuts. Malaysia started raising rates in July 2014 and Indonesia followed suit in November. The central banks of India and Thailand are not engaging in monetary loosening right now, although their inflation rates are moderating.

In a recent note, ANZ forecast 3 percent depreciation in Asian currencies over 2015, “a similar decline to that seen in 2014,” noting that “risks are tilted toward a larger depreciation should tighter U.S. monetary policy lead to larger portfolio outflows from the region.”

The groundwork for currency wars in 2015 is clearly being laid