Currencies

A trillion here, a trillion there...

Oct 31st 2014, 10:58 BY BUTTONWOOD
http://www.economist.com/blogs/buttonwood/2014/10/currencies
IF THE markets were suffering from withdrawal symptoms after the Fed's halting of QE on
Wednesday, they did not have to wait long for their next hit. This morning, the Bank of Japan
today announced an increase in its annual target for expansion of the monetary base from 60-70
trillion to 80 trillion. Even at 110 to the dollar, that is still a chunky $700 billion a year
increase (or about 2% of GDP). The aim is to get inflation higher; if the recent sales tax increase
is excluded, core inflation is still running at 1%, too close to deflation for comfort.
The decision, on a 5-4 vote, was a big surprise and pushed the Japanese market up sharply, with
the Nikkei 225 hitting a seven-year high. European markets, already encouraged by Wall Street's
strength yesterday, have duly pushed higher.
But perhaps the most interesting response has been in the currency markets, where the yen
dropped more than 2% against the dollar, a big move by normal standards. There is now a
genuine divergence between monetary policy in the developed economies. That creates a lot
more scope for currency volatility than in the long years when virtually all banks had their feet
on the monetary accelerator.
The talk of currency wars a few years ago was focused on emerging markets, which felt the
developed world was devaluing at their expense. In a sense, however, this was the right thing to
happen; over time, if the emerging markets are growing faster than the developed world, their
currencies should appreciate. Currency competition within the developed world, however, is a
trickier business. It may indeed be the main channel through which QE works for Japan, forcing
up import prices. But of course, it allows Japanese exporters, if they wish, to compete by
lowering prices. The effect is to export deflation to the rest of the world (this deflationary threat,
and the likelihood of a strong dollar may explain why gold continues to weaken; bullion is well
below $1,200 an ounce). The US may be strong enough to stand the strain but what about
Europe, which is competing against Japan in Asian markets? And what about China, which has
an informal peg against the dollar? A lot depends on the size of the currency move. Capital
Economics is forecasting that the yen will hit 120/$, but what if it falls to 140 or 150?
The size of the BoJ's purchase programme reinforces my longstanding view that the symbiotic
relationship between central banks and governments is now permanent. According to Capital
Economics, the Bank of Japan already owns a quarter of all government bonds, and a third of
Treasury bills; the new rate of purchases will absorb 15% a year of the remaining stock. Capital
remarks, in insouciant fashion, that

Even at the stepped-up pace of purchases (equivalent each year to 15% of the remaining stock of
JGBs not owned by the Bank), QQE could still continue for another decade. One way or another,
the policy will be halted long before the well of JGBs runs dry.
Well, maybe. The Japanese have been trying to get out of the doldruims for more than two
decades now without success. In the West, the Fed and the Bank of England may have stopped
buying bonds, but they are not selling them either; since both central banks pay the interest they
collect back to their governments, these amount to interest-free loans. For cash-strapped
politicians, that is a tough perk to give up. The British government still has a deficit of 100
billion a year but the Conservative party is talking of tax cuts and the Labour opposition of
spending increases.
Eventually, someone may decide that the whole situation is ridiculous; one part of government
owes another part of government lots of money. Just cancel the stuff and the debt will go away.
The idea was widely discussed two years ago; if deflation sets in, the concept will surely be
revived. The very suggestion would have been anathema 20 years ago. But all along, I have
argued that the debt crisis will lead to inflation, stagnation or default; if the west can't generate
inflation, then an (effective) default may be preferable to stagnation.

The Return of the Currency Wars

By DAVID WESSEL http://blogs.wsj.com/economics/2014/09/15/the-return-of-the-currency-wars/

When a countrys economy grows too slowly, the standard short-term remedies are to increase
government spending, cut taxes or reduce interest rates. When none of those options is available,
governments often resort to pushing down their currencies to make their exports more attractive
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to foreigners (and, these days, to push up import prices and thus bring inflation back up to
desired levels).
When the world economy is sputtering, and every big country increases spending, cuts taxes and
reduces interest rates, the global economy benefits from the increase in demand. Thats the
story of 2009.
But when individual countries lean heavily on pushing their currencies down, that tends to shift
demand from one place to another rather than increasing the total. That is a currency
war. And we may be on the verge of one. Last time, the emerging markets were doing the
complaining; this time, it may be the U.S. (OK, Im oversimplifying, but only a bit.)
Japan has already managed to depreciate its currency. The yen is at a six-year low against
the dollar. There is a fine line between pursuing expansionary monetary policy which
works (in part) by reducing a countrys currency, and making currency depreciation a
primary goal. The U.S. and Europe have tolerated the sinking yen largely because they saw
it as part of Prime Minister Shinzo Abes broader effort to resuscitate the Japanese
economy.
Now the spotlight is shifting to Europe. Europe is growing painfully slowly, if at
all. Unemployment in the countries that share the euro is 11.5%. Among the under-25
crowd,nearly one in four is out of work.
Standard economics, the sort pushed by the International Monetary Fund, among others,
suggests that while Europe addresses its much-discussed structural impediments to economic
growth, it also pursue low taxes, more government spending and more expansionary monetary
policy. And since short-term interest rates are already at zero, that means something akin to
the Federal Reserves quantitative easing, the purchase of huge amounts of assets by the central
bank to get more money into the economy, rekindle inflation (now at 0.3% in Europe) and nudge
investors into private-sector loans, bonds and stocks.
But what appears to be economically necessary is not politically possible. Germany is the
heavyweight in the eurozone. It wants to keep the pressure on southern Europe to reform labor
and other regulations, to work harder and to reduce their debts so it wont bless more
expansionary fiscal policy. And for those reasons, plus its historic anxiety about inflation no
matter what the circumstances, it appears opposed to more aggressive European Central
Bank action or, at the very least, it is slowing the ECBs efforts to move in that direction.
The politics are treacherous. As Europe leaders fumble and struggle to reach consensus, the
public backlash against austerity and slow growth is building. Euro-skeptic Marie Le Pen (I
dont want this European Soviet Union, she told der Spiegel Online in June) has a shot at
becoming the next president of France.
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So whats the ECB to do? Push down the euro to try to juice the eurozones exports. That
appears to be one of ECB President Mario Draghis current objectives, and its one he can
achieve with words even if he cant get his policy council to agree on printing a lot of euros. It
certainly is appealing to the French, whove long seen the currency as a useful economic
instrument.
And the markets are getting the message. The euro, which was trading above $1.38 for
most of the spring, has fallen below $1.30 and Goldman Sachs economists predict itll fall
to $1.15 by the end of 2015.
For now this isnt a big threat to the U.S. economy. The U.S. dollar has been strengthening for
some time, initially because nervous investors were looking for safety and more recently
because markets expect the Fed to begin raising interest rates from rock-bottom levels next
year, well before the ECB does.
Although there are always manufacturers complaining that the dollar is hurting their exports and
there are long-standing complaints about Chinas manipulation of its currency to favor its
exports, the dollar hasnt really been a big political or economic issue in the U.S. lately.
Perhaps because there has been so much else to worry about; perhaps because the dollars
attractiveness has helped the U.S. Treasury lure foreigners to lend billions of dollars at very low
rates. U.S. exports have been growing; they contributed 1.3 percentage points to the 4.2%
annualized increase in gross domestic product in the second quarter. But that could change if
Japan and Europe continue to nudge their currencies down as a substitute for economic policies
more friendly to global economic growth.

Will China Spark a Currency War?

OCT 8, 2014 6:03 PM
By William Pesek
Is China about to devalue? The question seems to pop up everywhere I go -- most recently in
Frankfurt, Sydney and New York. Economists here in Tokyo, too, are buzzing about the
chances of a big decline in the yuan in the next few months.
A new report from Lombard Street Research explains why all these folks may have reason for
concern. According to London-basedCharles Dumas, China's slowdown will soon drag down
gross domestic product growth below 5 percent (whether Beijing admits it or not). Dumas
joins long-time Asia investor Marc Faber in thinking China will find itself in the 4 percent
range by year end.
A continued downtrend, Dumas says, would represent "a major, slow-motion shock for the world
economy and financial markets" that will slam everything from commodities to growth rates
from Japan to Germany. Growth significantly below Beijing's 7.5 percent target also complicates
President Xi Jinping's efforts to shift China to a services-based economy from an export-andinvestment-led one.
The obvious solution: a weaker exchange rate that boosts exports and thus buys Xi time to
recalibrate growth drivers. While Chinese leaders aren't dropping clear hints of a devaluation, it's
a logical next step. Even before the 2008 global crisis, Lombard Street says, capital spending in
China had already reached an unsustainable 42 percent of GDP. Then the regime responded to
the crisis with an unprecedented investment surge, beginning with a $651 billion stimulus
package in 2009. By the end of that year, capital spending had jumped to 48 percent -- where it
remained until last year. It's simply not possible for an economy that carries a consumerspending ratio of about 36 percent to thrive long-term with an investment ratio on the cusp of 50
percent.
Since the crisis, Chinese corporate debt has also reached $14.2 trillion, topping that of the U.S.,
according to Standard & Poor's. Recently, China's central bank set out to measure activity in
Chinas $6 trillion shadow banking industry, implying that officials worry it's even bigger than
we know. And while estimates of the true size of liabilities facing local governments differ
widely, roughly $1.65 trillion of their debt is already held by major banks, including Industrial
and Commercial Bank of China and China Construction Bank. Borrowing more to gin up growth
isn't an option for a highly-indebted developing nation. Debt must be reduced.
The International Monetary Fund left no doubt of that in its latest assessment of the global
economy. Of China, the IMF said: Measures to contain local government debt, curb shadow
banking and tackle excess capacity, high energy demand and high pollution will reduce
investment and manufacturing output.

As Xi's reform process kicks in, a weaker yuan offers an obvious shock absorber. "China needs
to keep growth up while getting excessive investment down, if only to avoid delaying for too
long the moment when consumer spending comes to lead the economy, rather than -- as now -slowing less than other sources of demand," Dumas says. "The bridge to the desired result has to
be greater net exports. There is nothing else. But if a decline in the yuan worsens an already
alarming race to the bottom with other currencies, the world may find itself in shock."
As I wrote yesterday, the yuan's 11 percent surge since the start of theglobal crisis has placated
officials in Washington, who have traditionally accused China of beggar-thy-neighbor policies. It
also is helping China spread its tentacles around the globe (see this week's deal to buy New
York's iconic Waldorf-Astoria hotel for $1.95 billion). A big devaluation now would irk officials
not just in Washington, but in Tokyo and Seoul, risking another currency war that destabilizes
markets and sours relations. Ahead of the annual meetings of the IMF and World Bank this
weekend, U.S. Treasury Secretary Jacob Lewwarned: It's wrong to get into exchange-rate
competition for the purpose of promoting advantage, one over the other."
A devaluation isn't inevitable. "We still predict very gradual yuan appreciation as the currency,
rather than economic, fundamentals are still supportive," says Simon Grose-Hodge, head of
South Asia investment strategy at LGT Group in Singapore. "China is systematically moving to a
domestic-demand led economy and we don't see them diverting from that path. While a weaker
yuan may help exporters, it also stokes imported inflation, so would be a Pyrrhic victory."
Then again, if like Xi you're looking to turn China Inc. upside down without stoking social
instability, any victory might sound attractive. As the Chinese president mulls his stimulus
options in the weeks ahead, he's very likely to see a weaker yuan as a win-win.

CHINA FACES TRAP IN CURRENCY WAR

http://www.marketwatch.com/story/china-faces-trap-in-currency-war-2014-11-02?page=2
HONG KONG (MarketWatch) Last Friday, the Bank of Japan effectively tossed a grenade
into the regions currency markets with its surprise announcement of a new round of
quantitative easing sending the yen USDJPY, -0.01% to fresh lows.
The move will be particularly problematic for China, as its slow-crawling managed rate to the
U.S. dollar USDCNY, +0.20% renders it is effectively defenseless when confronted by
currency wars, in which countries try to steal growth from their trading partners through
competitive devaluations. It also comes at a time when Beijing is already battling foes on two
fronts: hot-money outflows and an economy flirting with deflation.
The consensus is that the worlds largest trading nation will resist the temptation to enter the fray
with a competitive devaluation or move to a market-based exchange rate. Yet Japans latest
actions will hurt, as they hold Beijings feet to the fire.
The decision last Friday by the Bank of Japan to boost its bond purchases by more than a third to
roughly $725 billion a year, among other actions, sent the yen tumbling to a seven-year low as
the dollar rallied to above 112. This means the currency of the worlds second-biggest
economy has now risen by roughly a third against that of the worlds third-biggest since
late 2012.
Thats a significant revaluation to swallow by any measure, all the more so as Japan and China
are increasingly competing with each other, say analysts.
According to new report by HSBC, Japan and China are already rivals in 19 manufactured
product lines, and this total is growing. Panasonic 6752, +3.28%PCRFF, +3.49% has already
said it is considering on-shoring certain production back to Japan.
The other reason Japans escalation of QE turns up the heat on China is that it risks exposing the
vulnerabilities in Beijings piecemeal approach to opening up its capital account.
If we rewind to early 2013 when Japans started it aggressive monetary-stimulus program
dubbed Abenomics, it drew rebuke from mainland Chinese officials, who warned it could fuel
inflation and asset bubbles in China.
Once again Beijing will be uncomfortable, but for different reasons as todays problems are hot
money retreating and managing the unwinding of debt.
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The market is still digesting the significance of Chinas foreign-reserves pileshrinking by $100
billion in the third quarter, and it will be watching carefully for external shocks that could
exacerbate this trend.
Chinas exchange-rate mechanism essentially a loose peg to the U.S. dollar and its official
capital controls place currency policy in a pivotal position. If capital continues to exit, authorities
must choose whether to defend the exchange rate and tighten money supply, or let the exchange
rate weaken.
The weekend brought further evidence that Chinas economy and monetary conditions are
deteriorating, as industrial activity slowed unexpectedly as shown in the official Manufacturing
Purchasing Managers Index, which dropped to 50.8 in October from 51.1 in September.
Japans latest monetary easing puts Chinas policy makers in bind, forcing them to pick
between two tough choices, writes Craig Stephen.
Deposits at Chinas largest banks are also shrinking. Four of the five biggest banks posted a drop
in deposits in their third-quarter earnings reports. ICBC1398, -0.78% IDCBF, -0.56% 601398, 0.27% the worlds largest lender by assets, saw its deposits fall by 388 billion yuan ($63 billion)
from June to 15.3 trillion yuan. For the industry, this was the first quarterly decline since at least
1999, according to central bank data.
This will reinforce fears that Chinas credit conditions are set to worsen. It also puts the Peoples
Bank of China in a policy bind. Rate cuts to stimulate growth would now be counterproductive,
as banks need to consider raising interest rates to maintain deposits.
In such circumstances, stimulus through currency depreciation might start to look increasingly
tempting to policy makers.
Yet this too comes with risks, since China loaded up on foreign debt in the last leg of its
borrowing spree, through its partially opened capital account.
Much of this was routed through Hong Kong, which Jefferies strategist Sean Darby earlier this
year referred to as an invisible carry trade that had a parabolic increase since 2010. Some
analysts put the total as high as $1.2 trillion.
The risk is that any devaluation sets up the scenario of the Asian financial crisis of debt defaults
due to a currency mismatch.
Most likely, China will muddle through for now, but there appears to be no painless solution to
this debt unwind.
If authorities allow growth to fall too sharply, this in itself could cause capital to exit and
intensify a credit crunch.
The policy choice could come down to accelerating moves to a market-determined exchange rate
and an open capital account, or moving the other way to limit capital movement.
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Meanwhile, the other swing factor in the currency trap is the prospect of continued strength in
the U.S. dollar DXY, +0.08% as the Federal Reserve has now exited from QE. This could force
Beijing to make a move on its exchange-rate regime, one way or another.

WORLD IS IN CURRENCY WAR BETWEEN US, CHINA, RUSSIA, JAPAN:

ECONOMIST Thu Oct 9, 2014
An American economist has said that the world is in a currency war between the United
States, China, Russia, and Japan, questioning the countries economic growth.
The world is unfortunately in a currency war between the US, Japan, China, and Russia,
keeping the interest rates very low and increasing the supplies of money and credit beyond
normal, sustainable limits, said Mark Thornton, senior fellow with the Ludwig von Mises
Institute in Alabama and a research fellow with the Independent Institute in California.
Thornton made the comments following a report by the International Monetary Fund that China
has overtaken the US as the worlds largest economy.
The IMF estimates that the size of the US economy is $17.4 trillion, while the Chinese economy
comes in at $17.6 trillion, Business Insider reports.
However, these figures are adjusted for the relative costs of living in both countries, known as
"purchasing power parity." Without the purchasing-power adjustment, Americas GDP will total
about $17.4 trillion, compared with Chinas $10.4 trillion, the IMF predicts.
Thornton said that economic growth in the United States during the past decade was mostly
based on the governments borrowing and spending which led to the massive national debt and
subsequent deficits.
In the US, the GDP growth has been driven largely through a process of large government
deficits and the burgeoning national debt, he said.
An unprecedented radical monetary policy of keeping interest rates very low also contributed
to an unsustainable economic growth, Thornton told Press TV on Wednesday.
The American economist said Chinas growth policies are also questionable and will not be
sustainable in the future.
They (China) have a lot of planned investment in infrastructure, housing, office space and the
building of giant skyscrapers and they have a lot of inventory of all those products and under
utilization of infrastructure investment, he noted.
China remains the biggest foreign holder of US government debt, holding an estimated
$1.27 trillion in US Treasury bonds.

The United States accuses China of lowering the price of its exports by manipulating its
currency.
Growth is a good thing, but in the case of China and the US, we have to question whether its
natural, sustainable, Thornton said.

Currency Wars: A Race to the Bottom

JEFF DESJARDINS
on August 11, 2014 at 4:11 pm
Currency Wars: A Race to the Bottom
Printing dollars at home means higher inflation in China, higher food prices in Egypt and stock
bubbles in Brazil. Printing money means that U.S. debt is devalued so foreign creditors get paid
back in cheaper dollars. The devaluation means higher unemployment in developing economies
as their exports become more expensive for Americans. The resulting inflation also means higher
prices for inputs needed in developing economies like copper, corn, oil and wheat. Foreign
countries have begun to fight back against U.S.-caused inflation through subsidies, tariffs and
capital controls; the currency war is expanding fast. Jim Rickards, Currency Wars
Many consider deliberate currency devaluation to be a tool that can help jump start a nations
economy. The aim of such a practice is to increase exports while encouraging domestic
purchases by making goods outside of the country relatively more expensive.
However, like any good prisoners dilemma, this might be the case if only one country acted in
isolation. The reality is that many major countries engage in the same policy, and the end result
as the infographic details is a race to the bottom.
So far the winner in the race is Japan. The BoJ has been rolling with the Abenomics plan for
almost two years now and the results are in

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The BoJs balance sheet has since exploded in size and they also have the highest public sector
debt in the world.

Currency Wars Evolve With Goal of Avoiding Deflation

By David Goodman, Lucy Meakin and Ye Xie Oct 22, 2014 10:23 PM GMT+0800
Bank of Japan Governor Haruhiko Kuroda said last month hed welcome a lower exchange...
Currency wars are back, though this time the goal is to steal inflation, not growth.
Brazil 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 weaker currencies. Now, many see lower exchange rates as a
way to avoid crippling deflation.
Weak price growth is stifling economies from the euro region to Israel and Japan. Eight of the
10 currencies with the biggest forecasted declines through 2015 are from nations that are either
in deflation or pursuing policies that weaken their exchange rates, data compiled by Bloomberg
show.
This beggar-thy-neighbor policy is not about rebalancing, not about growth, David Bloom, the
global head of currency strategy at London-based HSBC Holdings Plc, which does business in
74 countries and territories, said in an Oct. 17 interview. This is about deflation, exporting your
deflationary problems to someone else.
Bloom puts it in these terms because, when one jurisdiction weakens its exchange rate, anothers
gets stronger, making imported goods cheaper. Deflation is a both a consequence of, and
contributor to, the global economic slowdown thats pushing the euro region closer to recession
and reducing demand for exports from countries such as China and New Zealand.
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Biggest Declines
Bank of Japan Governor Haruhiko Kuroda said last month hed welcome a lower exchange rate
to help meet his inflation target and may extend the nations unprecedented stimulus program to
achieve that. Like his Japanese counterpart, European Central Bank President Mario Draghi has
acknowledged the need for a weaker euro to avoid deflation and make exports more competitive,
though hes denied targeting the exchange rate specifically.
After the Argentine peso, which is plunging following a debt default and devaluation, the yen
will be the biggest loser among major currencies by the end of 2015, according to median
strategist forecasts compiled by Bloomberg as of yesterday. A 6 percent decline is predicted,
which would build on a 5.5 percent slide since June.
The euro is also expected to be among the 10 biggest losers, with strategists seeing a 4.8 percent
drop. The yen traded at 107.21 per dollar 10:18 a.m. in New York, while the euro bought
$1.2658.
Spilling Over

At 0.3 percent in September, annual inflation in the 18-nation bloc remains a fraction of the
ECBs target of just under 2 percent. Gross-domestic-product growth flat-lined in the second
quarter, while Germany, Europes biggest economy, reduced its 2014 expansion forecast this
month to 1.2 percent from 1.8 percent.
Disinflationary pressures in the euro area are starting to spread to its neighbors and biggest
trading partners. The currencies of Switzerland, Hungary (HUCPIYY), Denmark, the Czech
Republic and Sweden are forecast to fall from 3.8 percent to more than 6 percent by the end of
next year, estimates compiled by Bloomberg show, partly due to policy makers actions to stoke
prices.
Deflation is spilling over to central and eastern Europe, Simon Quijano-Evans, the Londonbased head of emerging-markets research at Commerzbank AG, said yesterday by phone.
Weaker exchange rates will help them tackle the issue, he said.
Hungary and Switzerland entered deflation in the past two months, while Swedish central-bank
Deputy Governor Per Jansson last week blamed his countrys falling prices partly on rate cuts
the ECB used to boost its own inflation. A policy response may be necessary, he warned.
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Currency Pegs

While not strictly speaking stimulus measures, the Swiss, Danish and Czech currency pegs -whether official or unofficial -- have a similar effect by limiting gains versus the euro.
Measures like these are necessary because, even after a broad-based dollar rally, eight of the
Group of 10 developed-nation currencies remain overvalued versus the dollar, according to a
purchasing-power parity measure from the Organization for Economic Cooperation &
Development.
Some central banks have GDP, rather than inflation, in their sights. Thats particularly true of
exporters, for whom a lower exchange rate makes their goods cheaper.
New Zealand, where second-quarter annual inflation was the fastest in 2 1/2 years, announced
last month its biggest currency intervention in seven years, sending the local dollar to a 13-month
low.
Deflation Story

The so-called kiwi will drop 5.7 percent to 75 U.S. cents by the end of 2015, the median estimate
of 33 strategists surveyed by Bloomberg shows. That follows an 9.2 percent slide since mid-year,
the third-biggest among 31 major currencies.
Goldman Sachs Group Inc. lowered its forecast for the shekel on Oct. 6, citing the Bank of
Israels efforts to combat its first slide into deflation since 2007. Its measures have included rate
cuts and local-currency sales. Goldman Sachs sees the shekel falling to 3.9 per dollar in 12
months, from 3.7438 today and compared with a previous estimate of 3.66.
Deflation is such a major part of the story that dealing with that, by whatever means necessary,
is key, Simon Derrick, the London-based chief currency strategist at Bank of New York
Mellon Corp., said Oct. 17 by phone. If that involves getting the currency lower, then so be it.
You have to deal with it.

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Are the Currency Wars Back On?

Sun, Oct 26 2014, 22:28 GMT
by BabyPips.com FX-Men Team | BabyPips.com

Brace yourselves, forex fellas! Another round of currency wars is starting, but economies no longer seem to be
bent on gaining an advantage in trade this time. Central banks have been getting creative with monetary policy
while some have even resorted to actual intervention in an effort to keep their local currencies weak.
Currency war and trade imbalance became buzzwords a few years back, as China has been accused of
engineering yuan weakness in order to have an unfair advantage in trade. You see, local currency depreciation
makes the countrys exports relatively cheaper, thereby boosting international demand for these products.
While this is definitely good news for the exporting economy, it is actually a beggar-thy-neighbor strategy
since it winds up hurting demand for products from other countries. Think of it as Newtons Third Law of
Motion (For every action, there is an equal and opposite reaction) applied to forex price action, as currency
weakness results to relative strength for its counterparts. This became such a huge issue in 2010 that the G20
saw the need to make a coordinated effort to rebalance the global economy.
Fast forward to the present, major central banks seem to be at it again, although a different economic issue is at
the front and center of it all. This time, deflationary concerns have prompted policymakers to implement or
consider measures to weaken their local currency.
Apart from growth issues that have led some central banks to revert to a more cautious stance, falling
commodity prices and weak inflationary pressures seem to be good enough reasons to maintain an
accommodative monetary policy. After all, the prospect of cutting interest rates or increasing money supply
typically results to currency depreciation, which then boosts price levels. Thats because a weaker local
currency translates to lower purchasing power, which means that youd have to pay more units of that currency
to get the same product.
The ECB already got the ball rolling with its monetary policy easing back in June, when Governor Draghi and
his men decided to cut several interest rates and announce new targeted LTRO. They followed this up with
another round of rate cuts in September and dropped hints on purchases of asset-backed securities, which many
speculated would be the start of more quantitative easing. The RBNZ also made an effort to weaken the Kiwi,
as it staged a secret currency intervention back in August.
Switzerland is also plagued with deflationary concerns, but the SNB has stopped short of actual intervention
and has been sticking to jawboning for now. The RBA also seems to be taking the same approach, as Governor

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Stevens has repeatedly emphasized that the Australian dollar remains high by historical standards. Meanwhile,
the BOJ is starting to join this jawboning bandwagon, as Governor Kuroda mentioned that theyd welcome a
lower exchange rate to help Japan reach its inflation target.
Market analysts say that deflation is both a catalyst and by-product of weak economic performance. Downbeat
growth prospects weigh on price levels, which then result to a slowdown in consumption and production,
eventually dragging growth much lower. Once a country enters this cycle, it would make sense to try to exit
before things get much worse, sometimes even at the expense of other economies.
The problem with dumping deflationary issues from one economy to another is that it winds up hurting global
economic growth. Do you think the G20 should step in again before its too late?

What QE means for the world

Positive-sum currency wars
Feb 14th 2013, 23:24 BY G.I. | WASHINGTON, D.C.
Brazils finance minister coined the term currency wars in 2010 to describe how the Federal
Reserves quantitative easing was pushing up other countries currencies. Headline writers and
policy makers have resurrected the phrase to describe the Japanese government and central banks
pursuit of a much more aggressive monetary policy, motivated in part by the strength of the yen.
The clear implication of the term war is that these policies are zero-sum games: America and
Japan are trying to push down their currencies to boost exports and limit imports, and thereby divert
demand from their trading partners to themselves. Currency warriors regularly invoke the 1930s as a
cautionary tale. In their retelling, countries that abandoned the gold standard enjoyed a de facto
devaluation, luring others into beggar-thy-neighbor devaluations that sucked the world into vortex of
protectionism and economic self-destruction.
But as our leader this week argues, this story fundamentally misrepresents what is going on now,
and as I will argue below, what went on in the 1930s. To understand why, consider how monetary
policy influences the trade balance and the exchange rate.
Typically, a central bank eases by lowering the short-term interest rate. When that rate is stuck at
zero, it can buy bonds, i.e. conduct quantitative easing (QE), or verbally commit to keep the short
rate low for longer, or it can raise expected inflation. All these conventional and unconventional
actions work the same way: by lowering the real (inflation-adjusted) interest rate, they stimulate
domestic demand and consumption. America, Britain and Japan are all doing this, although only
Japan has explicitly sought to raise expected inflation; America and Britain have done so implicitly.
This pushes the exchange rate down in two ways. First, a lower interest rate reduces a currencys
relative expected return, so it has to cheapen until expected future appreciation overcomes the
unfavorable interest rate differential. This boosts exports and depresses imports, raising the trade

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balance. Second, higher inflation reduces a currencys real value and thus ought to lead to
depreciation. But higher inflation also erodes the competitive benefit of the lower exchange rate,
offsetting any positive impact on trade.
If this were the end of the story, the currency warriors would have a point. But it isnt. The whole
point of lowering real interest rates is to stimulate consumption and investment which ordinarily leads
to higher, not lower, imports. If this is done in conjunction with looser fiscal policy (as is now the case
in Japan), the boost to imports is even stronger. Thus, QEs impact on its trading partners may be
positive or negative; it depends on a countrys trade intensity, the substitutability between its and its
competitors products, and how sensitive domestic demand is to lower rates. The point is that this is
not a zero sum game; QE raises a countrys GDP by more than any improvement in the trade
balance.
There are other spillovers. Lower interest rates in one country will generally tend to send investors
searching for better returns in another, lowering that country's interest rates and raising its asset
prices. By loosening foreign monetary conditions, that boosts growth, though this may not be
welcome if those countries are already battling excess demand and inflation.
Determining whether QE is good or bad for a country's trading partners requires working through all
these different channels. In 2011, the International Monetary Fund concluded the spillover of the
Feds first

round of QE onto its trading partners was significantly positive, raising their output by as much as a
third of a percentage point, while the spillover of the second round was slightly positive. As the
nearby charts show, the IMF concludes the weaker dollar was indeed slightly negative for the rest of
the world, but this was more than offset by the positive impact of lower interest rates and higher
equity prices.
The 1930s are often cited as a lesson in the evils of competitive devaluation, but they actually show
something quite different.

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In the 1980s, Barry Eichengreen at the University of California, Berkeley and his co-authors
demonstrated that the first countries to abandon the gold standard recovered much more quickly
from the Depression than those that stayed on gold longer. Mr Eichengreen has just written a new

paper, to be published soon in the Journal of Policy Modeling, elaborating on the international
spillovers as countries quit gold, and their implications for today. I strongly recommend it. In it, Mr
Eichengreen describes three channels by which leaving the gold standard boosted a country's
output:
First, central banks engaged in what we would now call forward guidance. They committed to
keeping interest rates low, expanding supplies of money and credit, and raising the domestic
currency price of gold for as long as it took for conditions to normalize Second, the change in
monetary policy had a positive impact on asset prices and therefore on investment. Third
[c]ountries abandoning the gold standard and taking steps to depreciate their currencies were
able to expand their exports relative to countries remaining on gold. This channel is controversial
because the expansion of exports took place at the expense of other countries, worsening the
latters economic difficulties
As Mr Eichengreen notes, determining the net effect of these spillovers on other countries is
muddied by these offsetting effects. The direct spillover of depreciation was negative, while the
spillover of increased money and credit was positive, as capital outflows "helped to relax conditions
in money and credit markets and moderate expected deflation in other countries." Nonetheless, he
concludes that from both calibration exercises and historical literature, the spillover effect was net
negative. This might have been averted if everyone adopted the same monetary policy, i.e. quit gold
at the same time:
In circumstances where different countries had all experienced the same deflationary shock, the
appropriate foreign response was to meet monetary expansion with monetary expansion and
currency depreciation with currency depreciation. Two dozen countries, primarily trade and financial
partners of the United Kingdom, responded by depreciating their currencies along with sterling. In
other countries, considerations of history, politics and ideology delayed or even precluded recourse
to this first-best response. Some countries in this position responded with capital controls and trade
restrictions designed to switch demand toward local producers. This was less efficient than the
first-best response both for them and for their foreign partners.
An international coordinated response, it was argued then and has been argued since, would have
been better. But the sum of the first-best unilateral responses was also the global optimum.
Explicit coordination was not needed to achieve it. With few exceptions, countries had arrived at this
set of policies (the depreciation of currencies against gold was all but universal) by the end of 1936.
The irony is that to the extent devaluation led to protectionism and falling trade volume, it was more
due to countries that did not devalue. In an earlier paper, Mr Eichengreen and Doug Irwin of
Dartmouth College note that countries that remained on gold were more likely to erect protectionist

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measures against imports than countries those that quit. So while imports did collapse, they fell far
less for countries that abandoned gold (like Britain, whose imports rose slightly between 1928 and
1935) than for those that stayed with it, like France, whose imports fell 15% (see nearby chart).

What are the lessons for today?

The key insight of Mr Eichengreens work was that the more countries abandoned gold, the more
positive become the spillover effects: "what are now referred to as currency wars were part of the
solution, not part of the problem." The analogy for today is that countries whose currencies are rising
because of easier foreign monetary policy should ease monetary policy as well, assuming they, too,
suffer from weak demand and low inflation. In fact, Americas QE and the resulting upward pressure
on the yen was one of the key reasons Shinzo Abe, Japans prime minister, demanded the Bank of
Japan take a more determined assault against deflation. The fact that global stock markets have
been chasing the Nikkei higher as Mr Abe's programme is put in place suggests investors believe
this is virtuous, not vicious, cycle. This also implies that the euro zone ought to respond with easier
monetary policy which would both neutralize upward pressure on the euro and combat recession in
the euro zone.
But Mr Eichengreen notes that unlike in the 1930s, today there is a large group of emerging
economies who did not suffer a deflationary shock and thus would not benefit from easier monetary
policy. Their optimal response, he says, would be to tighten fiscal policy, which would cool demand,
putting downward pressure on interest rates and their currencies. But, as in the 1930s, he notes that
there are political and institutional barriers to doing so, and instead they are opting for second-best
policies such as capital controls, currency intervention, and in some cases, import restrictions.
Those actions have yet to trigger a significant backlash because they are, for the most part, simply
trying to slow rising currencies. The countries that have embarked on QE have so far largely steered
clear of those measures, with one exception, Switzerland (which I discuss below.) Indeed, Mr Abes
rhetorical assault on the yen constitutes currency war only insofar as traders think it will be followed

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by intervention. If Japan stays out of the markets, as the G7s recent statement suggests, there is no
reason to attribute the yen's decline to anything other than the Bank of Japans monetary policy.
Theres an interesting debate over whether even intervention constitutes currency war. Economists
traditionally thought such intervention had limited effect. If the central bank intervenes but does not
change expectations about interest rates, investors will simply buy up all the currency that the
central bank sells until expected returns were once again equal across all markets.
But Joseph Gagnon of the Peterson Institute for International Economics challenges this
conventional wisdom. Studies that found intervention does not work were done in the 1980s and
1990s when the sums were far smaller, he says. Central bank intervention is now hundreds of times
larger. He explains in an interview:
Japan did $177 billion of intervention in 2011. When countries intervene on that magnitude, I dont
think all the hedge funds and investment banks in the world are enough to neutralize that effect.
Theyre not willing to gamble more than a few tens of billions. Hedge funds need differential rates of
return to induce them to take opposing positions. And the riskier it is, the more they have exposed,
and the higher return they need. They expect to make money because government is distorting
markets in a way they think is not sustainable, but governments can distort markets longer than you
can stay solvent.
This has parallels to the debate over QE. Skeptics like Michael Woodford believe that if the central
bank does not change the publics expectations of interest rates or inflation, no amount of bond
buying will alter asset values or stimulate growth. But advocates like Mr Gagnon believe investors
have a preferred habitat; they hold certain types of bonds or assets because of legal or institutional
constraints, even if their returns seem too low relative to their own expectations of interest rates.
Most intervention is sterilized: the central bank is selling currency previously held by the public, so
the money supply does not change. Unsterilized intervention, in which the central bank prints the
currency it sells, as the Swiss National Bank has done, has different implications. It is, in practice,
QE plus sterilized intervention. Imagine an investor sells euros to the SNB and gets newly printed
Swiss francs. He invests them in Swiss government bonds, buoying their prices. The result is exactly
the same as if the SNB had bought Swiss government bonds with newly printed money, then sold
those bonds in order to buy foreign exchange. Based on our analysis here, it is getting one thing
right (the QE) and one wrong (the intervention). The SNB justified its action based on the fact that its
domestic bond market was too small to acommodate QE in sufficient size. Its trading partners must
have agreed, because they didn't kick up much fuss. Or perhaps Switzerland is too small to matter.
Japan should not assume it would get the same, hands-off treatment.

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