Economic Commentary: Skirmishes In A Currency War?

The latest round of media speculation about a new currency war started when incoming Japanese Prime Minister Shinzo Abe vowed to end Japan’s deflation and liquidity trap by immediately devaluing the yen and raising interest rates.[xvii] Since the election in late 2012 the yen has fallen from 80 to 95 per dollar (about 19%), but has recently gained back about 3%.  This fall in the yen sounds like a lot, but in fairness we should consider the fact that the yen rose from about 150 per dollar in 1999 to about 76 per dollar a year ago, for a total increase in value of about 49%.[xviii]  In fact, the yen has risen about 70% over the last three decades.  Against that gain a fall of 16% is hardly excessive.  The idea behind the falling yen is to end the steep decline in Japan’s export market share they’ve experienced over the last 20 years as the yen rose, and reinvigorate Japanese competitiveness versus other Asian countries.  At the same time the new, perpetual round of QE undertaken by the Federal Reserve recently could exert some downward pressure on the dollar over time, assuming (per discussion above) that inflation rises a bit.  This declining dollar trend, if it happens, might help the competitiveness of the US manufacturing and export sectors, but it could also potentially cause troubles for some other countries. 

Niels Jensen[xix] has pointed out that there are really two mechanisms for adjustment when central banks print huge volumes of money.  Foreign investors who demand compensation for super low bond yields and/or lagging equities can be appeased by either an increase in sovereign bond yields, or by a devaluation of the currency.  Increased bond yields have indeed been a major adjustment mechanism in Europe, which in turn has greatly increased the risk of a banking collapse.  This was especially true when Spanish, Portuguese, Italian and Greek yields soared in 2011, for example.  Alternatively, the mechanism of a falling currency should make local stock markets soar and thus adequately compensate foreign investors who move their assets from bonds to stocks to get away from QE-induced low yields.  Jensen suggests that the preferred adjustment mechanism is going to be currencies rather than bonds in many countries, since many over-indebted nations have major portions of their sovereign debt parked in their banking systems, and they simply cannot risk another financial crisis.  So we should expect most advanced economy sovereign bond yields to stay low much longer than the consensus expects, and their currencies to gradually devalue as the adjustment mechanism for foreign investors. 

The main currencies rising against the US dollar (USD) and the other major currencies should be those in developing Asia.  The world’s primary reserve currency (USD) itself may eventually rise a bit, since it serves as a safe haven and will be in demand as the global debt crisis reaches its endgame.  Indeed, any sustained drop in the USD would be a disaster for many other countries, since it would cost them some export volume at a time when they need more trade to survive.  The US economy has done well with a strong dollar in the past, so there shouldn’t be much impact on US manufacturers, especially given their new cost advantages derived from abundant, cheap natural gas.  But if the US currency doesn’t adjust for foreign investors seeking compensation for low bond yields, it may be that US bond yields will have to rise instead.  That would make the US the one major exception to the idea of currency adjustments.  However, to the extent that European bond yields continue to rise whenever an adjustment is needed, perhaps the euro (EUR) will not be used as an adjustment mechanism and will fall again.  It appears now that the yen (JPY) will continue to fall as well, both because of the new monetary policy stance, and because of the huge holdings of government debt parked on the balance sheets of Japanese banks.  The British pound (GBP) is more of a problem, and it could go either way, although right now the direction is down.  It is expected that the Chinese yuan (CNY) will continue to rise as it has for many years now, since it is still considered undervalued; bonds would not be used as an adjustment mechanism in a centrally planned economy anyway.  Thus, it would appear that since several of the major currencies will rise, and others will fall in the next two years, an outright global currency war is not yet occurring.  However, the need for export-driven economies to grow their international trade volumes in order to keep GDP growing and unemployment under control, at least in the near term, poses a serious risk going forward.       

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