Discuss Japan > Back Number > No.4 > THE LINGERING SPECTER OF A CURRENCY WAR
Economy, No.4  Dec. 6, 2010


Two years have passed since the bankruptcy of Lehman Brothers in September 2008 triggered the worst economic crisis in half a century. The aftereffects of the “Lehman shock” are now fading, but so, it seems, is the spirit of coordination among governments. The world appears to be entering a phase of currency confrontation, with countries competing to devalue their currencies and boost exports. The Group of 20 meeting of finance ministers and central bank governors in October 2010 produced a communiqué vowing to “refrain from competitive devaluation of currencies,” and the G20 summit the following month reiterated this sentiment. Yet fears of a “currency war” have not abated.

Finance Minister Guido Mantega of Brazil–a G20 member–publicly used the term currency war to describe the devaluation efforts of various countries in a speech he delivered in São Paulo on September 27: “We’re in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness.” Mantega added that Brazil’s dollar purchases have reached unprecedented levels and that its foreign reserves have grown to about $270 billion. He stressed that the government was taking measures to mop up excess dollars and that it was prepared to take additional steps. Among the measures the authorities might take to ease the upward pressure on the Brazilian real are a hike in the transaction tax for purchases of Brazilian bonds by foreign investors.

Polarization of the Global Economy

The strategies governments have adopted to prevent an escalation of currency values and to guide them lower include restrictions on inflows of capital and intervention in currency markets. South Korea has taken the latter approach, while Thailand and India have sought to curb the influx of foreign capital. Japan, too, fearing that a soaring yen would further batter an already slumping economy, intervened on September 15 to purchase dollars and sell yen for the first time in six years. The scale of the operation was ¥2 trillion, the highest single-day dollar purchase on record. While the yen edged down slightly as a result, the rate soon returned to its former levels.

There are three main factors behind the recent conflict over exchange rates. The first is a polarization of the global economy into two groups, the first comprising China, India, Brazil, Indonesia, and other emerging economies that recovered fairly quickly from the Lehman shock and the second consisting of developed economies that have managed to pull themselves out of a crisis situation but are still plagued by a slow recovery, partly due to balance sheet adjustments, and high unemployment. The second factor is a deterioration of many countries’ fiscal position after adopting large-scale stimulus packages; because they are unable to take further expansionary fiscal measures, these countries have been focusing on monetary relaxation to encourage economic growth. And the third factor is that many developed economies are now experiencing severe disinflation (Japan has been in a sustained state of deflation) and have lowered their discount rates close to 0%, providing unprecedentedly high liquidity to the market under a policy of quantitative easing.

It is in this context that a “currency war” has been escalating between the developed world and the emerging economies–most notably between the United States and China.

In their meeting in Gyeongju, South Korea, the G20 finance ministers and central bank governors managed to defuse growing tensions somewhat by issuing a joint statement to “refrain from competitive devaluation of currencies.” The communiqué reads: “The global economic recovery continues to advance, albeit in a fragile and uneven way. Growth has been strong in many emerging market economies, but the pace of activity remains modest in many advanced economies. . . . Specifically, we will . . . move towards more market determined exchange rate systems that reflect underlying economic fundamentals and refrain from competitive devaluation of currencies. Advanced economies, including those with reserve currencies, will be vigilant against excess volatility and disorderly movements in exchange rates. These actions will help mitigate the risk of excessive volatility in capital flows facing some emerging countries.”

Like most documents that emerge from international meetings, the communiqué is rather circumlocutory. In a nutshell, it expresses (1) the frustrations of the developed countries (notably the United States) that feel the emerging economies (notably China) are preventing the market from determining exchange rates by intervening in currency markets and restricting capital flows, and (2) the concern of the emerging economies that the developed countries are encouraging excessive capital outflows through monetary easing and ultralow interest rates, resulting in higher currency values and inflation for the emerging economies.

One key issue raised at Gyeongju was the setting of numerical targets to correct current account imbalances. This was a point advanced by the United States, which–with almost no prior consultation–proposed that imbalances be held to no more than 4% of gross domestic product by 2015 at a G7 meeting of finance ministers and central bank governors held just prior to the G20. In Gyeongju, the 4% target was jointly proposed by the United States and host South Korea.

Many countries came out against this idea. Following the G20 session, Chinese Finance Minister Xie Xuren urged major reserve currency nations to follow “responsible economic policies” and keep their foreign exchange rates relatively stable so as to ensure global financial stability. While Beijing has a medium-term target of reducing its current account surplus to 4% of GDP, the surplus currently exceeds that level, and the government has been unwilling to set deadlines. China also objects to the fact that US demands for reductions in the current account surplus are premised on a major revaluation of the yuan. For China, the exchange rate is a symbol of national sovereignty, and outside pressure to revalue is seen as unwarranted interference.

China and many other disgruntled emerging economies feel that the United States and the dollar are the real culprits behind the “competitive devaluation.” Their arguments are as follows: US President Barack Obama himself is seeking to revive the US economy through exports, as indicated by his announcement of an export-doubling initiative in January 2010. A weaker dollar is conducive to boosting exports and is indispensible to achieving an export-driven economy. The Federal Reserve has eased credit in an effort to overcome economic stagnation and avoid deflation, and this has resulted in a rapid decline in the dollar’s value. Washington is deliberately keeping the dollar weak, and the low interest rates and provision of liquidity by US monetary authorities have caused an influx of dollars into the emerging economies, further pushing up their already-high inflation rates and currency values. It is the United States that needs to make structural adjustments to correct its large current account imbalance (deficit), instead of making the emerging economies pay for its own economic management failures.

Zero Interest Pioneer

In announcing higher taxes for foreign purchasers of Brazilian bonds on October 4, Finance Minister Mantega pointed out that Brazil’s benchmark lending rate of 10.75% was luring speculative foreign capital. He named Japan as a country with extremely low rates, adding that investors were raising funds by borrowing yen and using the money to invest in Brazil and earn yields of 10.75%. Similar transactions, he said, were being conducted with US dollars and other foreign currencies.

The forerunner in introducing zero interest rates was Japan, which has been in chronic deflation since 1998. This is a policy under which the Bank of Japan conducts market operations to provide capital to the interbank market at little or no interest so as to guide the unsecured overnight call rate (corresponding to the US federal funds rate) close to 0%. The BOJ first adopted this policy from February 1999 to August 2000 and reintroduced it in March 2001, ending it in July 2006 in response to the recovery of the economy and a slight rise in prices over year-earlier levels. Even after the policy was discontinued, though, the discount rate remained near zero at around 0.5%.

At this point, Japan was the only country to have deflation and a zero interest rate policy. The benchmark rate in the United States was around 5% between 2006 and early 2008. It was at this time that speculators borrowed yen at almost no interest to invest in other foreign currencies, as Brazil’s Mantega noted. The selling of yen lowered its exchange rate to about ¥120 to the dollar. These transactions were called yen carry trades, and the unintended weakening of the yen led to an expansion of Japanese exports. Few countries complained at the time, since Japan was the only country with deflation and zero interest. In fact, most saw Japan as an example to be avoided. Deflation, the zero interest rate policy, and the yen carry trade were regarded as “someone else’s problem” and not taken very seriously.

The situation changed dramatically following the September 2008 collapse of Lehman Brothers. The United States and other developed economies all moved to ease credit, and interest rates plummeted. The Lehman shock paralyzed US financial markets, and the crisis soon spread to Europe, where–as in the United States–bubbles had formed in the real estate market. Many developed countries experienced a credit crunch, causing the crisis to spill over into the real economy and affecting the emerging economies as well.

Decoupling theorists had posited that emerging economies were no longer dependent on economic conditions in the developed markets to fuel high-paced growth. Such assertions subsided following the Lehman shock, but these economies then recovered much quicker than anticipated and managed to return to their previous growth levels. The developed countries, by contrast, were weighed down by heavy debts, and the need to adjust balance sheets resulted in high unemployment and performance far short of the potential growth rate. This lies behind the polarization of the global economy.

Is the Dollar to Blame?

Many developed countries have adopted expansionary fiscal policies, which have swelled their deficits but have done little to generate growth. Economists have begun to argue that public debts in excess of 90% of GDP are unsustainable, and the May 2010 fiscal crisis in Greece seemed to bear this out. The impact of this crisis was initially expected to be quite limited, since the country accounted for just 2% of the European Union’s GDP, but it quickly spread throughout the continent. Many developed countries were identified as being at risk of defaulting, raising concerns about sovereign risk.

The US fiscal deficit, meanwhile, has ballooned to 11% of GDP, the highest on record, excluding wartime. Britain–another epicenter of the Lehman-induced financial crisis–has also seen its deficit climb to 11% of GDP. The deficit is 8% in France, where the total public debt is now close to 90% of GDP. These figures far exceed the targets prescribed for euro zone member states, namely, deficits of not more than 3% and outstanding debts of less than 60% of GDP.

The straitened fiscal circumstances of these countries are preventing them from taking additional stimulus measures, even in the face of a sluggish recovery. The focus has inevitably shifted to monetary policy, and as a result Japan is no longer the only country with ultralow interest rates. The carry trade that had been conducted in yen is thus now carried out in dollars as well, resulting in a flood of capital flowing into emerging markets.

On November 3, the Federal Reserve announced a second round of quantitative easing (QE2), declaring it would maintain zero interest rates (guiding the federal funds rate to 0%-0.25%) and provide capital to the market by purchasing $600 billion in long-term US bonds through June 2011. This new policy applied upward pressure on currency values of not only the emerging economies but also the yen.

Governor of the People’s Bank of China Zhou Xiaochuan criticized QE2 during a November 5 speech in Beijing, saying that, from an international perspective, it was not the optimal choice for the global economy, since it has side effects for other countries. If monetary relaxation goes too far in the United States, which issues the international reserve currency, he said, this could push a wave of liquidity into global markets that could produce asset bubbles in the emerging economies. And on November 8, in advance of the G20 summit in Seoul, a senior Chinese Finance Ministry official noted that China would demand “responsible macroeconomic policies” from the United States as “a major currency issuing country.” The People’s Daily ran a critical editorial the same day claiming that US policy was tantamount to an indirect manipulation of the currency market.

Other developed countries, too, have expressed misgivings about QE2. German Finance Minister Wolfgang Schäuble doubted that these measures would help resolve America’s problems and worried that they may create unnecessary ones for the rest of the world. Christine Lagarde, the French minister of economic affairs, industry, and employment, observed that the US decision would have a negative impact on the euro.

Opinion is divided even within the United States. Not a few experts only passively endorse the measures or are dismissive altogether, arguing that quantitative easing has little effect and may eventually invite unwanted side effects like inflation. Others have called for measures on an even bigger scale, even if their effectiveness may be limited.

Federal Reserve Chairman Ben Bernanke responded to domestic and international criticism (notably from China) that QE2 causes higher currency values in and flows of capital into emerging economies. In a speech titled “Rebalancing the Global Recovery” given in Frankfurt at a central banking conference on November 19, he identified the “incomplete adjustment of exchange rates” as an “important driver of the rapid capital inflows to some emerging markets.” Bernanke declared, “The exchange rate adjustment is incomplete, in part, because the authorities in some emerging market economies have intervened in foreign exchange markets to prevent or slow the appreciation of their currencies.” Unless exchange rates are “allowed to fully reflect market fundamentals,” he said, capital inflows will continue, as investors “anticipate additional returns arising from expected exchange rate appreciation.”

In defense of QE2, Bernanke noted, “The best way to continue to deliver the strong economic fundamentals that underpin the value of the dollar, as well as to support the global recovery, is through policies that lead to a resumption of robust growth in a context of price stability in the United States. . . . Because a strong expansion in the emerging market economies will ultimately depend on a recovery in the more advanced economies,” there might be “slow growth for everyone if the recovery in the advanced economies falls short.” Both growth and trade are unbalanced, he said, as reflected in “the two-speed recovery” of the advanced and emerging market economies and in the “persistent current account surpluses” of countries like China and Japan and the deficits of the United States. “Neither situation,” he claimed, “is sustainable.” The G20 summit communiqué referred to these structural gaps as “uneven growth and widening imbalances.”

These gaps in the speed of growth and balance of payments may be part of a long-term, historical process by which power is shifting from the West to the East. This year’s G20 summit focused on exchange rate issues raised by these growing gaps. In 2011 and beyond, these meetings may also need to address ways to reform and restructure the International Monetary Fund and other key institutions in the global order in the light of such a power shift.

Among more immediate issues, the biggest is that involving China’s currency, the yuan (renminbi), which is already the main point of contention in external economic relations between the United States and China. Chinese authorities have conceded that reform of its currency system is an important policy issue, but Beijing’s basic stance is to not bow to foreign pressure and to achieve greater flexibility under the three principles of independent decision-making, controllability, and gradual progress. At the same time, China regards the Lehman shock as signaling the end of the era of US economic supremacy and the dollar’s role as the leading reserve currency and has begun exploring the role the yuan should play in a new economic and currency order.

Issues for Japan

One reason for Beijing’s cautious approach to currency reform is the lessons provided by Japan’s experience. The September 1985 Plaza accord on adjustment of currency values resulted in a steep appreciation of the yen and the loss of Japan’s industrial competitiveness. China regards this agreement as having been a US ploy to economically disarm Japan. Indeed, in the three years following the accord, the yen doubled in value from ¥240 to the dollar to just ¥120. A decade later, in 1995, it climbed at one point to ¥79.75–a threefold rise from 1985 levels.

Japan’s “mistake” was not just in yielding to external pressure but in overreacting to the appreciation with drastic fiscal and monetary policies. It failed to withdraw the expansionary measures even after the economy began showing signs of overheating, resulting in huge asset bubbles, and neglected to carry out structural reforms that should have been launched from the early 1980s, by which time Japan had essentially caught up with the leading industrial economies. The aim of such reforms should have been to establish a “post-catch-up” development model. The country was caught up in the bubble frenzy, though, and many were under the illusion that the old model was simply the world’s best. Following the collapse of the bubble economy, the nation entered a period of protracted stagnation that cast a mood of pessimism, thwarting initiatives to create a new model for growth–a situation that continues to this day.

China already holds $2.6 trillion in foreign reserves; this is more than any other country today and about 100 times the amount held by Japan at the time of the Plaza accord. China is clearly continuing to intervene heavily in foreign exchange markets and maintaining an unsustainable currency policy, and so its standoff with the United States will likely continue. If the US economy fails to pick up steam and unemployment remains high, Washington will stick to its expansionary monetary policy, even if it is unpopular with other governments, and this could mean a weak dollar for the foreseeable future.

Japan must thus brace itself for the likelihood that the yen will remain strong. Rather than attempting to drive the yen lower and becoming embroiled in a devaluation war, the country should consider how it can turn the strong yen to its advantage and establish a new growth model through institutional and structural reforms that have been put off for so long.

Translated from an original article in Japanese written for Japan Echo Web. [December 2010]