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Casualty rates

28 April 2015

Following recent influences from central banks and governments, it appears the lengthy truce in the global currency war is coming to an end.

Take full advantage of a record strong pound, advises an unsolicited email from a company marketing villa holidays in Europe. And, yes, it is cheaper for Britons to purchase European holidays since sterling has appreciated so strongly against the euro (though not to a ‘record’ as the exchange rate is still below pre-financial crisis levels). And yet, only a couple of years back, people went skiing in the Rockies rather than the Alps because the dollar was weak and the euro expensive.

Sharply oscillating exchange rates do affect people’s decisions – and not just over holiday destinations. They affect the cost of raw materials and the price at which companies can sell their goods or services abroad. If  exporters choose to hedge their currency risk, exchange rate volatility increases the cost of such insurance. And this year, foreign exchange markets have been particularly volatile, with many traders expecting the euro’s 20% slide against the dollar to continue until it reaches parity or even lower.

We have been here before. In the 1980s, sterling fluctuated between dollar parity and a two-for-one exchange rate. Were those currency wars? No, insofar as governments, in a world of floating exchange rates, cannot  suddenly declare a devaluation of their currency. But there are many means by which a central bank can either defend its currency’s value or encourage it to depreciate; in particular, the ‘unconventional measures’ – namely ultra-low interest rates and quantitative easing (QE) – adopted by some central banks since the financial crisis to combat weak growth and the threat of deflation, tend to weaken a currency, and thereby achieve deflation. As a result, accusations from other countries of exchange rate manipulation have multiplied in recent years.

The term ‘currency war’ was made famous by a Brazilian finance minister back in 2010 when money was pouring into Brazil because it offered better returns than anything available in the United States. These inflows caused the real to appreciate, making Brazilian exports more expensive – apart from commodities such as iron ore, which are priced in dollars.

But depreciation was not the main aim of the US Federal Reserve (or indeed of the Bank of England) in launching QE; it was to contain the financial crisis and rekindle growth. Similar domestic priorities, this time the threat of Europe going into a deflationary spiral, finally persuaded the European Central Bank to follow suit. Yet the most immediate result has been the euro’s fall by more than 20% against the dollar.1

‘Currency depreciation is one of the most important mechanisms to enable an increased rate of inflation,’ says Paul De Grauwe, professor of European Political Economy at the London School of Economics, adding that ‘the policies that cause a depreciation of the euro are necessary because there is no other way to prevent the eurozone drifting into deflation and negative growth’. He does admit, however, that this ‘shifts the problem to other countries’.

Countries with strong economies can cope with that pressure. ‘The US economy has recovered quite strongly and for the present it seems to be accepting the implied appreciation of the dollar,’ says former Bank of England rate-setter professor Charles Goodhart. But he sees ‘sterling’s usual position midway between the US dollar and the euro as not entirely comfortable, since most imported commodities are priced in dollars and most exports go to Europe’. That means the UK is at risk of losing competitiveness, squeezed between an appreciating dollar and a depreciating euro.

The problem is compounded for smaller countries trying to maintain a currency peg – where one country’s exchange rate with another is fixed – with larger trading partners. Switzerland has long been treated as a ‘safe haven’. Since its main trading partner is the eurozone, it decided to peg the Swiss franc to the euro. But the euro’s sharp depreciation in 2014 triggered massive inflows into Switzerland, putting upward pressure on its currency. When its central bank unexpectedly abandoned the peg, the Swiss franc’s value jumped by 20%, leaving the country’s exporters facing some hard choices. Since then the pressure has shifted to Denmark, whose currency is also pegged to the euro. ‘Denmark’s situation is very dangerous,’ says professor Philip Booth of City University’s Cass Business School.

‘It is similar to that of the UK when we were shadowing the Deutschmark in the early Nineties.’ Its central bank has moved to negative interest rates – effectively charging investors for the privilege of holding krone. But for speculators seeking large currency gains when the peg is abandoned, this looks like a one-way bet. ‘Small economies don’t have to peg,’ says De Grauwe, adding that countries ‘like Sweden and Norway, which have maintained flexible exchange rates, have been relatively successful’. But Sweden has had to reverse its policy of raising interest rates to head off a property bubble precisely because this had caused its currency to rise too far.

Booth believes that in the past ‘floating exchange rates have served very well in dealing with major financial shocks’. The greatest threat of currency wars may be in the Far East where Japan has embarked on the most extreme form of stimulus tried so far in order to jolt its economy out of two decades of stagnation. ‘The short-term effect has been to reduce the value of the yen, but there is as yet not much sign of it boosting economic growth,’ says Booth.

A weaker yen has made Japanese exports more competitive, but that is putting pressure on major trading partners. Should China take retaliatory action and further loosen its monetary policy, Booth believes this would most likely raise internal prices in Japan and offset any benefit of having a weaker currency. So the end result is that – except for gaining temporary competitive advantage – nobody really wins from currency wars. But currency wars mean interest rates will probably stay lower for longer, forcing investors further up the risk spectrum and fuelling asset prices. Herein lie the real dangers.

1 http://www.xe.com/currencycharts/?from=EUR&to=USD&view=10Y

2 http://www.tradingeconomics.com/switzerland/currency

Where the opinions of third parties are offered, these may not necessarily reflect those of St. James's Place.

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