The current theme in the foreign exchange (FX) markets has concerned the dramatic decline of the U.S. dollar (USD) following the Federal Reserve's last official statement alluding to another round of quantitative easing (QE) deemed necessary to support the sagging U.S. economy. While the value of the USD has dropped more than 6 percent on a trade-weighted basis since September, many see this move as artificially inflating the value of the G-7 currencies, and putting a severe strain on the export-driven economies of the global emerging markets in Latin America, Eastern Europe, and Asia. Ever since Brazil's finance minister, Guido Mantego, declared on September 27 that an "international currency war" had broken out, various financial officials have openly debated the subject. Their tone grows more combative as they blame each other for distorting global demand with monetary "weapons" that range from QE (printing money to buy government bonds) to actual currency intervention coupled with associated capital inflow controls.
Behind all of the smoke and rhetoric, there appears to be several battlesraging at the same time, the biggest one being the issue surrounding China's unwillingness to allow its currency, the yuan, to rise at a more rapid pace. American and Western European officials have long sounded their concern on this subject, but have recently pointed to the damaging effects of China's undervalued currency, and the negative effect it's having on the global recovery. An example of this was seen last month, as the U.S. House of Representatives passed a law via a huge bipartisan majority, allowing firms to seek tariff protection against counties with undervalued currencies. China's "unfair" trade practices have become one of the focal topics in the upcoming mid-term elections next month.
The second "currency battle" has been directed squarely at the Fed, as itprepares to embark on QE2 to liquefy the U.S. financial system — in effect driving long-term borrowing rates to ever-changing all-time lows. The result of this policy move hopefully will encourage investment flows into other asset classes and eventually stimulate the economy. As previously mentioned, the prospect of this massive stimulus has been the primary force behind the severe drop in the USD, as the financial markets have priced in the expectation of the Fed acting swiftly and boldly once the program is approved, possibly at their next meeting in November. The EUR has directly benefited as the European Central Bank (ECB) has shown the least amount of enthusiasm for such an action. In the U.K., the Bank of England is also preparing for its own QE2 program as its economy tries to digest a massive government austerity budget against a backdrop of an anemic economy. In Asia, specifically from China's perspective, the prospect of additional U.S. QE could create further distortions in the world economies as global investors continue to pour massive investment capital flows into China and other emerging market economies, distorting their currencies and adding to the growing inflation problem.
The third major area of contention stems from how the developing counties faced with this environment have responded specifically to those increased capital inflows. Rather than letting the value of their currency rates to soar, many governments have intervened both the traditional route (buying foreign currency against their own in the open market), or have imposed various taxes/levies on the foreign capital inflows. Brazil, as an example, has recently doubled a tax on foreign purchases of its domestic debt, while Thailand just announced a new 15 percent withholding tax imposed on foreign investors purchasing government bonds. Between September 27 and October 11, Asian central banks in South Korea, Malaysia, Indonesia, Thailand and Taiwan have collectively purchased $28.74 billion in foreign exchange reserves, two to six times their normal levels, but with little success. The South Korean won has actually climbed 5.7 percent versus the USD, Malaysia nearly 1.3 percent, Thailand about 4.3 percent, and China has also allowed the yuan to appreciate by over 2 percent since the beginning of this month. The weakening USD has also prompted the Bank of Japan to actively intervene in the open market for the first time since 2004, but despite an initial fall of the yen in mid-September, its currency has continued to rise versus the USD, in fact posted a 15-year high of 80.92 on October 20.
Despite all the media hype relating to the currency war subject, much of the gloom appears to be overdone. The real story centers around the structural rebalancing currently taking place and the role exchange rates are having on that process. As global policymakers continue to contend that their currencies are under attack via unwanted appreciation, the reality is that the USD is actually under huge depreciating pressures ahead of the Fed's next monetary policy move (QE2). Going forward, global demand will need to shift away from the major industrial economies and toward increased spending in the emerging world, as the conditions driving the divergence of these economic policies (particularly sluggish growth in the wealthier parts of the world,) will likely last for many years while fiscal austerity measures take hold.
A currency war, consisting of highly volatile FX markets, fueled with tit-for-tat protectionism as countries try to boost their exports at the expense of others, could endanger world trade and further alarm already anxious businesses and investors. The good news coming out of this for the U.S. is that the approaching monetary tidal wave nearly should ensure that the prospect of another global double-dip recession is remote at best. The bad news for global emerging markets is that the next major threat to their economies could originate in their own backyards.
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