Currency competition: who will be winner?

By Gu Bon-sung

When the subprime crisis broke out, the global foreign exchange market felt the importance of a particular hard currency, the US dollar. It was the period when demand for dollars lopsidedly outstripped supply in the foreign exchange market on a global basis. It was mainly caused by the massive deleveraging of both US financial institutions and households.

Thereafter, the global market turned into the second stage of sharp recovery initiated by the concerted efforts of central banks to revive the global economy. It was the period of strong commodity currencies from countries such as Australia, Brazil and Russia. In the meantime, the global demand for the dollar quickly stabilized as the monetary expansion by central banks from advanced countries to emerging countries continued with various unprecedented non-standard monetary operations.

In 2010 with the outbreak of the Eurozone crisis, the global financial market experienced another round of currency realignment when the so-called safe currencies such as the Swiss franc, Japanese yen, as well as the Chinese yuan showed relative appreciation against the dollar. This new wave of appreciation caused counteractions through other targeted operations by central banks of the affected countries such as a pegging policy (Switzerland) or direct intervention to foreign exchange markets (Japan) or allowing wider bands (China) to alleviate the appreciation movement.

Such currency realignment seems to turn into a new round of currency competition. Commodity currencies such as the Brazilian real turned weaker as the expectations on the global economic recovery became moot or disappointing. On the other hand, currencies of the export-driven economies, especially in Asia such as Singapore, Taiwan, and Korea started to appreciate. This round of currency revaluation of export-driven economies appears to be rather unexpected, given the sluggish world economic growth. What lies behind the scenes or what kind of corrections follow need to be vigilantly guarded against.

First, the new appreciation of Asian currencies may not be wholly related to the global issues that happened in 2008. In the positive sense, the Asian economies have been well integrated as a result of the sustained growth of the Chinese economy, especially the growth of exports to advanced countries and that of imports from adjacent economies such as Japan or Korea. This means it may be just the regional realignment of adjacent currencies.

Second, the new currency movement may wholly be driven by the dedicated weak-yen-policy. That is to say, the yen-dollar exchange rate may be the major target because the local currency market for the yen is not fully developed. As the Japanese government started to use the monetary expansion and made direct market intervention to weaken the yen against the dollar, it could spread out expectations on the future depreciation of the yen against the dollar, which may cause another rise of carry trades or capital outflows from Japan. The carry trader will increase the overall dollar liquidity and will lead to further appreciation of Asian currencies. Or it could be just a case of “beggar-thy-neighbor” policies.

Third, the lower pressure on commodity prices may lead to lower inflation partly driven by the fragility of global consumption. The lower inflation may reduce the risk of raising interest rates in the future or in the very short term. The interest rate spread between advanced countries and emerging countries may persist for longer-than-expected periods. So the capital inflows from advanced countries to emerging countries, in particular, in the government bond market may persist for the time being. Especially, considering that the Eurozone crisis and the fiscal cliff issues may hover in the global financial market the demand for government bonds of emerging countries may remain strong. Even if the currency movement of the high-interest countries and the high-export countries diverge, such a motive may not disappear anytime soon.

In a nutshell, the currency competition focal to Asian markets may be regarded as a regional issue, and may be driven by the weaker yen or sluggish Japanese growth ignited by the monetary intervention by the central bank. Then, what are the implications on the neighborhood countries such as China and Korea?

Without doubt the growing capital movement within the region could be reversed when the global economy may be struck with shock. The deepening Eurozone crisis may be one of such risks. Especially, those countries with shallow FX markets may repeatedly experience the high volatility driven by the capital flight to quality during the global turmoil. Also if the export growth may fall with sluggish growth of the global economy, the relative strength of Asian currencies may not be sustained. Such global real shocks may deepen the volatility of Asian currencies. In this regard, the small open economies need to improve their external resiliencies through quick reforms in the capital mobility and promoting overseas investments in response to the case when the current situation may persist.

There is also a possibility that the long-term sustainability of the Japanese economy may be challenged. The weak-yen-policy may be partly beneficial to boost the export of Japanese firms. However, the massive intervention into the foreign exchange market may challenge the fiscal stability even if the overall ownership of Japanese government bonds may be domiciled differently from those of European countries and, furthermore, the immense foreign exchange reserves and the foreign assets may avoid the consolidation issues of fiscal sustainability. However, what would happen in the fiscal sustainability of Japan will be one of key issues in the foreign exchange market in the long term. Then the current active intervention may be limited or short-lived.

In particular the recent currency movement may be the convergence of the yen and the dollar, being depreciated against Asian currencies. On the other hand, the other currencies including the Euro and commodity currencies are mostly depreciated against dollar. It is quite uncertain how the current situation may evolve or be reversed. Could the world monetary system be transformed into the situation of the strong dollar in last 1980s? Or could the dollar-based hard currency system weaken and turn into more diversified global monetary system where the Chinese yuan or the Euro compete? For the time being it seems unlikely that the current dollar-based system will be structurally transformed to a multiple hard-currency system.

Yet, the relatively dominant aspect of the current currency competition is that it is clearly caused by the policy responses in order to improve the structural competitiveness of the individual economy. The benefit and cost of such policy interventions may not be foreseen fairly or quickly. However, the foreign exchange mobility and volatility will surely affect the flow of private sectors driven by risk appetites and future expectations on the global monetary system. The new pattern of global investment may re-emerge from emerging markets to advanced markets but with less magnitude. The benefit and cost of the current currency competition will be determined by the degree and speed of private capital outflows in the end. Who could be the first mover?