Wednesday, 22 September 2010

Don't ask, don't tell

During the Great Depression, the world had a fixed exchange rate system, tied to the gold standard.  But then a number of smaller countries began to devalue their currencies. The purpose was obviously to obtain export advantages, since domestic demand was flatlined.
Given that domestic demand is still disappointing in many countries, we see that quite a number of (smaller) countries have provoked a depreciation of their currencies by flooding their markets with liquidity. Obviously, without a global fixed exchange rate system there is no longer talk about a round of competitive devaluations. It would be more correct to talk about competitive depreciations.

But whatever the label, the end result is that there are some countries that end up being the big losers in this game, since obviously we cannot all obtain an increase in export competitiveness at the same time.
While some smaller countries – Sweden is a good example – have had an enormous success with letting their currencies weaken dramatically in late 2008, it becomes more complicated when talk is about the major currencies, dollar, euro, and yen.

These economies are closed enough that management of the exchange rate is not a primary concern. Federal Reserve has often stated that they have no exchange rate policy for the dollar. ECB just wants a “strong and stable” EUR. USA and Europe have maintained a studied silence, even if the ECB (and the rest of the EU policy-making elite) feels that the EUR is way too strong against the USD.

Predictably, there were no objections from the ECB when the financial markets decided to sell EUR as a result of Greek trouble. With no inflationary pressures in the Euro-zone, a weaker EUR would exactly give the European economy a shot in the arm. And indeed, the Eurozone exporters have done very well as a consequence.

The story is slightly different when it comes to Japan. The country has been mired in a recession/deflation situation for nearly 2 decades. A direct consequence of a rapidly aging population and a stunning inability to make the right policy choices. JPY nevertheless started to strengthen in 2007, and has continued as everybody else introduced quantitative easing in order to revive economic growth. Since late 2007, JPY has gained some 40 per cent against a trade-weighted average of other currencies. Read that again, 40%! Not exactly doctor’s orders for an export driven country in order to pull out of a recession.

Recently, the Japanese government has begun to make all the right noises, rumours of a substantial (quantitative) easing of the monetary policy have been floating around and last week the BoJ finally decided to step in and intervene directly in the forex market.

Absurdly enough, this decision drew ire from many market participants. The Chairman of the Eurozone council sharply berated Japan for the unilateral intervention. Politicians of all colours were suitably “appalled”. Most of the FX market was in shock that Japan would do it alone. Personally, I have a hard time understanding the hoopla. Intervention to stop a currency from strengthening further after it has already gained significantly somehow appears to make good sense. Except of course if your competitors had more or less secretly hoped to profit from the rise of your currency.

And China drew its own conclusions. A spokesperson stated that China would never commit the same mistake as Japan, to let herself be pressured into an appreciation of the currency.

What can we learn from all this? That manoeuvering your currency in order to gain an export advantage is still very bad style. Unless you do it discretely. The Japanese did not. 

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