Analysis: The Real Currency War

The United States believes the Chinese government keeps its currency artificially weak. China shows little interest in listening to criticism and will probably only allow a small appreciation of its currency through the next year. It had probably been best to have a common global solution to the currency issue, but this seems now unlikely, currency expert Camilla Viland at DnB NOR Markets writes in her latest analysis.

“The criticism of quantitative easing bottoms probably largely in fear of a weaker dollar.”

Camilla Viland


“The most likely outcome in our eyes is that you can not find a common solution. China is likely to let its currency appreciate, but at their own pace, a pace they are comfortable with – and that is slow. This means that the adjustments of global imbalances will be a long and heavy process,” Camilla Viland at DnB NOR Markets writes.

Interventions in the foreign exchange market of Japan and emerging economies such as Asia has contributed to a debate about whether we are facing an international currency war.

The debate has again raised the tug of war between China and the United States and focus on global imbalances.

Japanese yen has been one of the “winners” in the foreign exchange market in the last three years.

An important reason for the trend is currency’s status as a safe haven in the currency market.

However, in mid-September the Japanese central bank intervened in the forex market for the first time in six years to prevent the further strengthening of the Japanese currency.

Also other currencies of emerging economies (including in Asia) has strengthened.

“The reason for this is that low-interest rates in western countries have investors to place their money in other countries where the returns are better,” Ms. Viland points out.

Adding: “This has resulted in a sharp increase in capital inflow to emerging economies.”

Now, several of these countries have followed Japan’s example and intervened in the currency market to weaken their own currencies.

This was the reason why Brazil’s finance minister, Guido Mantega, the end of September, warned that an international currency, war has broken out, which has received considerable attention in the markets.

“However, we believe that the fear of an international currency war, in which countries use all means to weaken its own currency, is excessive. G7 countries have repeatedly stated their belief that exchange rates should reflect fundamental economic conditions and in this lies a strong commitment to not intervene actively in the foreign exchange market to affect their own exchange rate,” the DnB NOR analyst says.

The ongoing debate about the currency of war has again raised the tug of war between the US and China and focus on global imbalances.

Several years of high consumption, low savings rates and expansionary fiscal policy has contributed to large government deficits in the US.

In the same period, China has grown rapidly and had large current account surpluses.

The Chinese surpluses have largely been invested in US assets, including government securities.

“But how long can the US be dependent on other countries’ savings? And how long will countries like China, find it appropriate to set their savings funds available to the US? The situation is probably not sustainable in the long-term and the large imbalances between countries should be adjusted,” Camilla Viland notes.

China operates a fixed exchange rate, measured against a basket of currencies, determined by China’s foreign trade.

“This is certainly the official policy, but if it is actually practiced is more uncertain,” Ms. Viland says, and explains:

* “Many believe that regardless of China through its fixed exchange rate regime keeps its currency, the yuan artificially weak. A weak currency is good for the Chinese economy as it improves the country’s competitiveness relative to other countries.”

* “The Chinese foreign policy has been criticized by the international community, especially the United States. Americans want a stronger yuan to improve its competitiveness, which can reduce the large U.S. trade deficit and ease the country’s large debt burden. On the other hand, the U.S. depends on China are still willing to finance the country’s large public deficit.”

* “China defends himself with a quick appreciation of the currency could lead to export-oriented businesses must close down, which could lead to increased unemployment and social unrest. China also claims that the US is not much better even when they perceive the quantitative easing as a form of currency intervention.”

* “The criticism of quantitative easing bottoms probably largely in fear of a weaker dollar as this will have major negative consequences for China’s financial assets in dollars.”

China also showed great opposition when the United States introduced the extraordinary monetary policy measures in 2009, standing in front of the debate on an alternative international reserve currency.

Although there is wide interest differentials between countries, it is also a strong dependence, which contributes to the constant friction.

But the situation is not completely locked, according to the Norwegian analyst.

“China probably sees some advantages to a stronger currency, and can probably accept such a development if it does not get too large a negative impact on Chinese economy and the trend towards better living standards for Chinese persists. But it is very important to the Chinese that they can choose how much and how fast the currency will appreciate,” she emphasises.

In June China went out and said that their fixed exchange rate system should be made more flexible. Many hoped this meant a steady and gradual strengthening of the yuan.

Since then, the currency appreciated by about 2 percent against the dollar. This has not been enough to calm the critics.

A Common Solution?

It generally seems as if both parties focus primarily on their own interests in this conflict, DnB NOR Markets rightfully points out.

The DnB NOR analyst believes it would be much better if the involved managed to reach an agreement to a common solution.

The turmoil in the foreign exchange market was discussed at last weekend’s meeting,  organized by the IMF and World Bank, but without concrete results.

In November, the leaders of the G20 countries meet, and the currency issue will be on the agenda again.

“However, we are skeptical whether it will get something out of this. Some believe the G20 is too big and that maybe it is more likely to reach an agreement within the G7 China. But the G7 is becoming a less important forums and we do not think this is a likely outcome. An alternative may be to give the IMF a larger and more formal role,” Ms. Viland writes.

After last weekend’s IMF/World Bank meeting, it was announced that the IMF will publish reports that emphasize the relationships between economies.

“The IMF should also expand efforts investigations capital flows, changes in exchange rates and the structure of foreign exchange reserves in the world,” Viland comments, and says “this is positive, but the IMF generally struggling to get countries to follow their recommendations and to achieve this, the IMF should have more formal influence.”

China is an important player in this game, as they generally have stood in the way of reforms in its currency system.

It’s probably unlikely they will change stance on this now, DnB NOR assumes.

“The most likely outcome in our eyes is that you can not find a common solution. China is likely to let its currency appreciate, but at a pace they determine and are comfortable with-that is slow. This means that the adjustments of global imbalances will be a long and heavy process.”

From Currency War To Trade War?

The big fear is that the ongoing conflicts in the currency market developes into a trade war in which countries apply protectionist measures to support their own economy.

There have been some signs that we have moved in that direction, DnB NOR Markets confirms.

In relation to the financial crisis, the US government (among others) have provided selective support to US companies, and called for purchase of US goods.

And for a few weeks ago, the House of Representatives proposed a penalty tariffs on Chinese goods. The decision will be made in the Senate, in November.

“Nevertheless, it seems as if Americans want to stay within the WTO framework. Past experience suggests that protectionism may reinforce an economic crisis, and there are indications that the world economy will try to avoid the outbreak of a global trade war. We therefore believe this is not a likely outcome.” Camilla Viland writes.

An important step to resolve the ongoing conflicts in the foreign exchange market is the Chinese currency, according to DnB NOR Markets.

“However, we expect no major changes in the Chinese currency policy in the future. The exchange rate will still be used as a political tool, and with signs of slower growth in China, the government will hardly accept a faster appreciation of the currency going forward. War of words between the U.S. and China will likely to continue, but that’s all. We consider the likelihood that it will develop into a comprehensive trade war as small,” Camilla Viland at  DnB NOR Markets, concludes.

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