Stephen King: As currency wars wind up, will quick thrills call the shots?

Outlook: Should America print more dollars, there is a risk that demand takes off in the emerging world leading to inflation and asset bubbles

Sunday 23 October 2011 08:03

We started it. Currency wars began with the collapse of sterling back in 2008. Unlike the 1967 devaluation or the 1992 exit from the European Exchange Rate Mechanism, sterling's drop in 2008 supposedly offered opportunity rather than crisis. An opportunity to rebalance the UK economy. Less consumption. More exports. And, to top it all, a reduced dependency on credit. Yet, as more and more countries are using currency devaluation as a means of escape from domestic economic crisis, we may be witnessing the Balkanisation of the global economy.

This week, another nail will be hammered into the coffin of British domestic demand. The Government will announce savage reductions in public spending. The hope is that losses in public spending will be offset by stronger exports, helped along by sterling's earlier descent. But should exports fail to show the necessary improvement, the Bank of England is waiting in the wings, ready to switch the printing press back on. If quantitative easing works, it's through an increase in the supply of sterling in the system leading either to higher domestic inflation (of goods and services or asset prices) or, more likely, a fall in sterling's value in the world's currency markets.

Yet the UK is no longer the only country turning preparing to print. Japan's just done it. The Americans are about to do it. The reason is simple. Many Western nations are now enormously indebted. Households and companies are busily repaying debt. Governments, and their electorates, have lost the will to take on more debt. And everyone's looking for a quick way out. Currency devaluation might just do the trick.

A softer currency offers two benefits. It makes exporters more competitive, thereby improving a nation's ability to sell products to parts of the world which might not be quite so encumbered by debt. And, by boosting both economic activity and inflation, it raises the value of GDP relative to existing deficits and debts. As a share of GDP, those deficits and debts come down. In other words, the debt burden declines. It is, however, a beggar-thy-neighbour policy. If your currency drops in value, someone else's currency must be going up in value. Your competitive gain is someone else's competitive loss. Moreover, if foreigners have lent to you in your currency, your devaluation will be their loss. Measured in their currencies, the assets they've acquired from investing in your nation will now be worth less.

Put another way, quantitative easing seems to work best if it's practised in private. If everyone ends up doing it, the benefits are more difficult to pin down. Yet the incentive for everyone to follow suit is high precisely because one country's gain may be another country's loss. If your neighbour is printing money, perhaps you should follow suit or lose out.

What happens, however, if half the world is encumbered with excessive debts while the other half is relatively debt free? This is the world we now seem to be in. The West has too much debt while the emerging world – China, other Asian nations, Russia, the Middle East, parts of Latin America – has very little debt, at least compared with its sometimes-turbulent economic past. The answer you'll hear from the West is that the emerging nations should allow their currencies to rise. With its current account surplus and its ever-expanding foreign exchange reserves, China should be in the vanguard of this adjustment, encouraging its renminbi to appreciate in order to rebalance its economy. Whereas Britain and America need less consumption and more exports, China needs exactly the opposite. A stronger renminbi would peg back exports expansion. It would also make imported consumer goods cheaper.

What happens, however, if the emerging nations refuse to allow their currencies to rise too quickly? The renminbi's gains this year have, after all, proceeded at a snail's pace, much to the chagrin of US policymakers. Should the West become frustrated with this lack of progress, it can offer two veiled threats. The first is to dangle protectionist tariff of one sort of another in front of the emerging nations. On Friday, the US Treasury Department announced a delay to the publication of its Semi-Annual Report on International Economic and Exchange Rate Policies, thereby reducing the near-term risks of a public confrontation with China on currency policies. There may come a time, however, when the US Treasury Department is persuaded that China should be labelled a "currency manipulator", triggering all sorts of protectionist opportunities for a Congress which has been gradually pumping up its anti-China rhetoric. The second veiled threat is to warn the emerging nations of the consequences for their own economic stability should the US turn the printing press on. A huge chunk of the US dollars circulating around the world does little to stimulate the US economy. As the world's reserve currency, the dollar is used to finance all manner of trade and capital market transactions in far-flung parts of the world.

Should America print more dollars, there is a risk that demand takes off like a rocket in the emerging world, leading to rapidly rising inflation and the formation of asset bubbles. These nations, after all, haven't got the debt constraints which have forced central bankers in the West to think about quantitative easing in the first place. Far better, then, for the emerging nations to allow their currencies to rise against the dollar, thereby allowing them to decouple from the emergency monetary policies being adopted in the debt-ridden West.

There is, however, another option. If the West can pursue quantitative easing, logic suggests that the emerging nations could happily pursue quantitative tightening. They don't have to allow their currencies to appreciate against the dollar. They don't have to give in to "beggar-thy-neighbour" Western monetary policies. They can, instead, try to prevent excess liquidity from the West feeding through to their own countries through the adoption of "mopping-up" policies, including fiscal tightening, higher collateral requirements on loans, counter-cyclical capital ratios for banks and, most obviously, the imposition of capital and exchange controls.

The pursuit of quantitative easing is understandable but may be giving rise to unintended consequences which threaten to re-shape the world economy. We're already witnessing the outbreak of currency wars as countries try to gain the advantage from one another. But as nations increasingly strive to protect themselves from the distorting influences of unconventional monetary policies pursued elsewhere through the use of quantitative tightening, we'll slowly discover that attempts to dig ourselves out of the worst post-war economic crisis are leading to the Balkanisation of the global economy. Unconventional monetary policies are a bit like one-night stands. They may offer a quick thrill but they are no substitute for the important relationships in life. Rather than solving the world's economic problems, unconventional policies may ultimately make things worse.

Stephen King is managing director of economics at HSBC

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