A cur­rency war seems to be in the mak­ing

The Pak Banker - - OPINION - Car­men Rein­hart

CUR­RENCY mar­ket volatil­ity has been around for decades, if not cen­turies. Wide gy­ra­tions in ex­change rates be­came a sta­ple of in­ter­na­tional fi­nan­cial mar­kets af­ter the Bret­ton Woods sys­tem broke down in the early 1970s, and mega-de­pre­ci­a­tions were com­mon­place later in the decade and through much of the 1980s, when in­fla­tion raged across much of the world. Even through much of the 1990s and early 2000s, 10-20 per cent of coun­tries world­wide ex­pe­ri­enced a large cur­rency de­pre­ci­a­tion or crash in any given year. And then, sud­denly, calm pre­vailed. Ex­clud­ing the may­hem as­so­ci­ated with the global fi­nan­cial cri­sis of late 2008 and early 2009, cur­rency crashes were few and far be­tween from 2004 to 2014. But re­cent de­vel­op­ments sug­gest that the dearth of cur­rency crashes dur­ing that decade may be re­mem­bered as the ex­cep­tion that proves the rule.

The near-dis­ap­pear­ance of cur­rency crashes in the 2004-14 pe­riod largely re­flect low and sta­ble in­ter­na­tional in­ter­est rates and large cap­i­tal flows to emerg­ing mar­kets, cou­pled with a com­mod­ity price boom and (mostly) healthy growth rates in coun­tries that es­caped the global fi­nan­cial cri­sis. In ef­fect, many coun­tries' main con­cern dur­ing those years was avoid­ing sus­tained cur­rency ap­pre­ci­a­tion against the dol­lar and the cur­ren­cies of other trade part­ners. That changed in 2014, when de­te­ri­o­rat­ing global con­di­tions re­vived the cur­rency crash en masse. Since then, nearly half of the sam­ple of 179 coun­tries have ex­pe­ri­enced an­nual de­pre­ci­a­tions in ex­cess of 15 per cent. True, more flex­i­ble ex­change-rate ar­range­ments have mostly elim­i­nated the drama of aban­don­ing pre-an­nounced pegged or semi-pegged ex­change rates. But, thus far, there is lit­tle to sug­gest that the de­pre­ci­a­tions have had much of a salu­tary ef­fect on eco­nomic growth, which for the most part has re­mained slug­gish.

The av­er­age cu­mu­la­tive de­pre­ci­a­tion ver­sus the dol­lar has been al­most 35 per cent from Jan­uary 2014 to Jan­uary 2016. For many emerg­ing mar­kets, where de­pre­ci­a­tions have been con­sid­er­ably greater, weak­en­ing ex­change rates have ag­gra­vated cur­rent prob­lems as­so­ci­ated with ris­ing for­eign-cur­rency debts. More­over, in an in­ter­con­nected world, the ef­fects of cur­rency crashes do not end in the coun­try where they orig­i­nate. Back in 1994, China re­formed its for­eign-ex­change frame­work, uni­fied its sys­tem of mul­ti­ple ex­change rates, and, in the process, de­val­ued the ren­minbi by 50 per cent.It has been per­sua­sively ar­gued that the Chi­nese de­val­u­a­tion re­sulted in a loss of com­pet­i­tive­ness for Thai­land, Korea, In­done­sia, Malaysia, and the Philip­pines, which had pegged (or semi-pegged) their cur­ren­cies to the dol­lar. Their cu­mu­la­tive over­val­u­a­tion, in turn, helped set the stage for the Asian cri­sis that erupted in mid1997. Over­val­ued ex­change rates have been among the best lead­ing in­di­ca­tors of fi­nan­cial crises. So one can­not help but won­der if we are fac­ing a re­peat of what hap­pened from 1994 to 1997 - only this time with the roles re­versed. Since early 2014, the ren­minbi has de­pre­ci­ated by a mere 7.5 per cent against the dol­lar, com­pared to the euro's roughly 25 per cent de­pre­ci­a­tion in this pe­riod, not to men­tion even faster cur­rency weak­en­ing in many emerg­ing mar­kets. For a man­u­fac­tur­ing-based econ­omy such as China's, the over­val­u­a­tion-growth con­nec­tion should not be un­der­es­ti­mated.

China's an­nounce­ment last Au­gust of its in­tent to al­low mod­est de­pre­ci­a­tion and even­tu­ally move the ren­minbi to­ward greater ex­change-rate flex­i­bil­ity trig­gered a roller-coaster ride in fi­nan­cial mar­kets. To pro­vide re­as­sur­ance, pol­i­cy­mak­ers is­sued state­ments to the ef­fect that China would move only grad­u­ally in that di­rec­tion. But per­haps the cau­tion­ary tale from the Asian crises is that grad­u­al­ism on this front car­ries its own risks. Of course, the po­ten­tial beg­gar-thy-neigh­bour ef­fects of the spike in cur­rency crashes in the past two years are not unique to China. They may also ap­ply to any coun­try that has main­tained a com­par­a­tively fixed ex­change rate (a cat­e­gory that in­cludes ma­jor oil pro­duc­ers). What dis­tin­guishes the Chi­nese case from oth­ers is the sheer size of its econ­omy rel­a­tive to world GDP, as well as its ef­fects on nu­mer­ous coun­tries across re­gions, from sup­pli­ers of pri­mary com­modi­ties to coun­tries that de­pend on Chi­nese fund­ing or di­rect in­vest­ment. The broader point is a sim­ple one: Emerg­ing mar­kets now ac­count for around 60 per cent of world GDP, up from about 35 per cent in the early 1980s. Restor­ing global pros­per­ity re­quires a much broader ge­o­graph­i­cal base than it did back then. The re­turn of the cur­rency crash may make achiev­ing it all the more dif­fi­cult.

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