Currency wars – the beginning
For the last several months, international currency markets have experienced tremendous volatility. Several currencies have gained in value, led by the US dollar and the Swiss franc, while many currencies have depreciated, the most important being the Japanese Yen; while the Venezuelan bolivar has fallen spectacularly. The Swiss franc appreciated by nearly 40% in a day earlier in the year, while the Venezuelan currency slumped 55% in the last month. Such pronounced volatility is surprising given the quiet years following the Financial Crisis of 2008.What has caused this sudden roller coaster ride?
The Back Story
The story actually begins years ago, in the aftermath of the 2008 Financial Crisis. International banking was in a mess and even sound institutions were in trouble. At that time the received wisdom was that credit and more credit was necessary to keep the wheels of commerce churning. In this scenario, the US Federal Reserve and the European Central Bank opened the credit tap. This was the first Quantitative Easing or QE. In simple terms it meant that the two banks along with the Bank of England and the Bank of Japan would buy bonds of dubious value, at their full prices, to prevent banks from collapsing. Earlier these banks had invested heavily in bonds and new investment products like derivatives. There is nothing wrong in innovation even in the financial space. The point was that quality of these new assets was vague and completely opaque in most cases. Amongst other assets, what lay behind such assets were the housing loans doled out to the American poor.
When defaults of these loans, referred to as ‘sub-prime assets’ started to creep up, the value of these assets also became suspect. This meant that the value of these investments became junk overnight and more importantly banks found that they were unable to sell these assets even at discounted prices to raise cash for their regular business needs. Fearing that the entire banking system would jam up, leading to a collapse of the real economy, the central banks began to buy these assets at their notional or full value, without enquiring about the real value of these assets. This gave banks, both good and bad, a much needed lifeline. Slowly the banks began to recover, but not before several big names failed and some others nearly went under.
The money for this huge purchase was and continues to be raised by a simple mechanism; printing money. Other avenues were issuing bonds and tax revenues but these have limits. As the central banks competitively print more money to keep their economies afloat, the intrinsic value of these currencies tend to sag, since there is now that much more money supply.
At last, after some years, as the US economy began to recover, the Federal Reserve announced in the summer of 2013, that it would stop QE by that year’s end. This immediately set the markets in a tizzy. Since there would be fewer dollars in the market in the future while there would be substantial numbers of euros and yens and other currencies sloshing around the world, the USD started to rise in value. In this environment, countries which maintained a benchmark to other currencies (Swiss franc was pegged to the euro) were forced to buy the bonds denominated in that currency to keep the value of their own currency at the right level. Once this became impossible currency values either tumbled or surged overnight.
In India, the rupee value fell dramatically and the RBI under the new Governor Raghuram Rajan took several emergency measures to stop the free fall of the rupee and institute a sense of confidence in the currency. Since then this sword of Damocles of the US stopping the QE has been hanging over the world. The dollar has gained in strength while most other currencies have weakened.
As a currency weakens, that country’s exports become cheaper in dollar terms. Thus countries with weak currencies get an export advantage. This has meant that countries are now competitively making monetary policies that would weaken their currencies so that they can protect their export markets.
“The government and the Bank of Japan are employing expansionary fiscal and monetary policies respectively, which traditionally tend to be currency negative.” (Financial Times 25th March 2015). This month, the Japanese yen’s exchange rate against the US dollar fell below ¥125, a 13-year low, before rebounding to nearly ¥122 following a statement by Bank of Japan Governor Haruhiko Kuroda that he did not expect further depreciation.(Gulf Times 25th June 2015).
The Japanese Yen has fallen almost 20% against the dollar since 2012. Similarly the Indonesian Rupiah has plunged 25%. However in the case of the rupee we see a strange variance. Despite high inflation and unprecedented fiscal deficits, the rupee is holding its own against the dollar while a host of other currencies are depreciating. Now, to stimulate exports and to protect our export markets India will have to do something to allow the rupee to fall so as to be in line with the values of other currencies.
The set of policies to be followed to achieve this, which are being competitively practised by governments and central banks, is called currency war.
The Way Forward
“The key to ensuring a satisfactory exchange-rate balance is for countries to pursue policies aimed at ensuring a desirable combination of domestic inflation and employment. If, for example, meeting domestic inflation and employment targets requires greater monetary expansion – which will place downward pressure on the local currency, bolstering the economy’s international competitiveness – other countries may have to pursue their own monetary expansion to maintain optimal domestic inflation and employment rates,” writes Koichi Hamada in the Gulf Times (25th June, 2015).
Yet there is some scepticism about whether countries and central banks will follow a path of reconciliation and moderation in their policies, as they rush to protect their markets, their industries and employment levels. What is needed is policy clarity and firm action on a global scale, or at least by the major economies. Countries must learn to allow their currencies to reflect international market values.