Currency chaos will hit global recovery

The past few weeks have seen the emergence of global currency chaos, which is a new threat to prospects for economic recovery. The situation is being depicted by the media and even by some political leaders as a ‘currency war’ between countries.

Some major countries are taking measures to lower the value of their currency in order to gain a trade advantage. If the value of a country’s currency is lower, then the prices of its exports are cheaper when purchased by other countries, and the demand for the exports therefore goes up. On the other hand, the prices of imports will become higher in the country, boosting local production and improving the balance of trade.

The problem is that other countries which suffer from this action may ‘retaliate’ by also lowering the value of their currencies, or by blocking the cheaper imports through higher tariffs or outright bans. Thus, a situation of ‘competitive devaluation’ may arise, which can contribute to a contraction of world trade and a recession.

The present situation is quite complex and involves at least three inter-related issues.

Double edged sword

First, the US is accusing China of keeping the yuan at an artificially low level, which it claims is causing its huge trade deficit with China. A US Congress bill is asking for extra tariffs to be placed on Chinese products. China claims such a measure would be against the World Trade Organisation rules, and that a sudden sharp appreciation of the yuan would be disastrous for its export industries, nor would it solve the problem of the US deficit.

Japan, whose yen has appreciated sharply against the dollar, intervened on the currency market on Sept 15 by selling 2 trillion yen in order to drive its value down. Japan has criticised South Korea for taking the same intervention measure to curb the appreciation of the won.

Second, the US is trying to lower the value of its dollar, through a new round of ‘quantitative easing,’ in which the Federal Reserve will spend $600 billion to buy up government bonds and other debts.

This will increase liquidity in the market, which would reduce long-term interest rates and thus, it is hoped, contribute to a recovery. But it would weaken the US dollar further.
And the new liquidity would also add to a surge in capital flowing out from the US to developing countries. In fact critics of the Fed’s initiative predict that a large part of the $600 billion would not remain in the US but would leak abroad.

In the past, such surges of ‘hot money’ would have been welcomed by the recipient countries. But many developing countries have now learnt,  the hard way, that sudden and large capital inflows can lead to serious problems, such as:

*The capital inflow leads to excess money in the country receiving it, thus increasing pressure on consumer prices, while fuelling ‘asset bubbles’ or sharp rises in prices of houses, other property and the stock market. These bubbles will soon burst, causing a lot of damage.

*The large inflow of foreign funds will build up pressures for the recipient country’s currency to rise significantly. Either the financial authorities would have to intervene in the market by buying up the excess foreign funds (known as ‘sterilisation’) and thus build up foreign reserves, or allow the currency to appreciate and this would have an adverse effect on the country’s exports.

*The sudden capital inflows can also turn into equally sudden capital outflows when global conditions change, as the Asian crisis in the late 1990s showed. This can cause economic disorder, including sharp currency depreciation, loan servicing problems, balance of payments difficulties and economic recession.

Some developing countries have introduced capital controls to slow down the huge inflows of foreign capital. The Institute of International Finance estimates that a massive $825 billion will flow to developing countries this year, an increase of 42 per cent over last year.

Brazil has tripled the tax on foreigners buying local bonds, while Thailand recently imposed a 15 per cent withholding tax on interest and capital gains earned by foreign investors on Thai bonds and South Korea has warned of new limits on forwards, while banks are asked not to lend in foreign currency.

Finally, there are fears that if the currency chaos or currency war is not solved soon, the world faces a threat of trade protectionism, whether it takes the old form of an extra tariff, or a new form of competitive currency depreciation.

Moreover the US quantitative easing may exacerbate the speculative flows of funds in search of profits, and this can be destabilising to the recipient countries and the global economy overall.

IPS

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