- Less accommodative monetary policy or fiscal austerity by
- Raising interest rate
- For example, Fed Chief Paul Volcker hiked interest rates to fight off inflation during the 1970s and early 1980s and subsequently the dollar surged 78% from June 1980 to December 1984.
- Under the best practices, governments are encouraged to use interest rate tools rather than manipulate the exchange rate.
- Slashing budget
- Stronger economy
- Recently, the dollar surged to its highest level in nearly six years—weak economic data from around the world was mainly responsible for the dollar's gains.
- Supply and demand (see next section)
- Capital flows
- In a deflationary scenario, funds will fly to safe havens and flee from the currencies of emerging markets.
- Capital inflows will tend to increase the value of the nation's currency
- The Chinese yuan has been steadily losing value as capital outflows create a negative feedback loop of selling and depreciation.
Exchange Rate on Trade and GDP
Using the dollar-peso exchange rate as an example, the price of the peso in dollars is determined by U.S. demand for Mexican goods and Mexican demand for U.S. goods. Here is the sequence of events could happen based on the supply-and-demand dynamics:
- U.S. demand for Mexican imports increased.
- This increased U.S. demand for pesos.
- The increased U.S. demand for pesos raised the price of the peso in dollars.
- When Americans purchase more imports from Mexico—holding all else equal—U.S. net exports (and GDP and employment) will decrease.
- However, the change in the exchange rate will automatically correct this situation, because
- As the price, in dollars, of Mexican imports rises, U.S. demand for Mexican imports will fall
- As the price, in pesos, of U.S. exports to Mexico falls, Mexican demand for U.S. products will rise
- When U.S. exports to Mexico rise (because they are cheaper), it will reverse the trend that began when U.S. demand for Mexican products increased. It will also reverse the effect on U.S. net exports, which will increase when exports to Mexico increase, which in turn will impact on trade and GDP.
In summary, when the exchange rate changes, that affects the price of each country's goods; that price change affects each country's demand for the other's goods in ways that tend to reverse the initial trend. This mechanism depends on floating exchange rates. If exchange rates are not permitted to respond to the forces of supply and demand, these automatic adjustments cannot occur. When central banks around the world try to intervene in the currency market—the largest market in the world, a currency war will ensue.
Published in Project Syndicate on 12/01/2014, Nouriel Roubini announced that:
The recent decision by the Bank of Japan to increase the scope of its quantitative easing is a signal that another round of currency wars may be under way.
Central banks in China, South Korea, Taiwan, Singapore, and Thailand, fearful of losing competitiveness relative to Japan, are easing their own monetary policies – or will soon ease more. The European Central Bank and the central banks of Switzerland, Sweden, Norway, and a few Central European countries are likely to embrace quantitative easing or use other unconventional policies to prevent their currencies from appreciating.
All of this will lead to a strengthening of the US dollar...
Similarly, John Mauldin echoed the same opinion on his Thoughts from the Frontline:
A global currency war (kicked off by Japan last year and just now heating up) and a rising bull market in the US dollar are the big macroeconomic drivers not just for 2015 but for the next four to five years.For different reasons, we begin to see central banks from the world pledged to defend their own currencies:
- Mexico declared that it is ready to intervene in currency markets to fight the peso's fall against the dollar amid concerns over dropping oil prices and a possible increase in U.S. interest rates.
- Denmark resorted to negative rates for the first time in July 2012 to fight back a capital influx into its AAA-rated markets.
- The energy-rich former Soviet republic of Turkmenistan Thursday devalued its currency against the US dollar by 18% in the latest sign of contagion among Russia's neighbors from the plunging ruble (following Krgyzstan's 17% plunge in 2014 and Kazakhstan's 14% tumble).
- Vietnam devalues dong to boost growth.
- Swiss central bank has ditched its exchange rate peg to euro on Thursday. At one stage, the euro had plunged a stunning 30 percent against the franc before recovering somewhat to trade 13 percent lower at 1.04 francs.
- Canada just joined the easing party — and now the Canadian dollar is going crazy.
- Singapore unexpectedly eased monetary policy, sending the currency to the weakest since 2010 against the U.S. dollar as the country joined global central banks in shoring up growth amid dwindling inflation.
- Australia is another country which cut interest rates. It has followed the Eurozone, China, Canada, Denmark, India, Korea, Singapore and which have all cut interest rates in recent months.
The acts of intervention, self-defense, or fighting off speculators in currency markets will probably grow and flare up a full-blown currency war. If this happens, some country's currency may fall victim to the sudden movements of capitol flows.
How to Spot a Currency Is in Trouble?
Due to easy money policies, global money has chased high yields into emerging markets in the last five years. Roughly two-thirds of the emerging-market debt now is denominated in dollars. Most of these debts must be liquidated or rolled over sooner or later and be paid back in dollars, not other currencies. These risks unleashed by central bank funding of massive carry trades, policy-driven devaluations and currency crises have yet to manifest.
Ideally currencies make moves measured in single digits over multiple years, which support stable trade and world GDP growth. However, the violent moves like recent Russia ruble’s or Japan yen's signal that something is seriously wrong.
For example, some $11 trillion is estimated in carry trades which the central banks have funded. Massive carry trades like these are being deleveraged in a rapidly destabilizing environment of Japan devaluing its currency, the yen, by 40% since late 2012, and the withdrawal of the Fed's $1 trillion-a-year QE programs.
To spot if a currency is in trouble, Mike "Mish" Shedlock has listed six ways that a country tends to behave:
- Crackdown on "currency speculators"
- Accusations of foreign interference
- Measures to stop capital flight
- Repatriation amnesty in hopes money will return home
- Currency action itself
- Currency controls
Strong US Dollar and Its Implications
As fiscal austerity and asymmetric adjustment have taken their toll on economic performance, monetary policy has borne the burden of supporting faltering growth via weaker currencies and higher net exports. But the resulting currency wars are partly a zero-sum game: If one currency is weaker, another currency must be stronger; and if one country’s trade balance improves, another’s must worsen.
For the US, the combination of a stronger economy and less accommodative monetary policy will put additional upward pressure on the dollar’s exchange rate against both the euro and the yen. With few other countries willing to allow their currencies to strengthen, the dollar’s tendency toward appreciation will remain strong and broad-based. Moreover, as it becomes increasingly difficult for currency markets to perform the role of orderly reconcilers, friction may arise among countries. This could disturb the unusual calm that lately has been comforting equity markets.
- If a country's currency is determined by the strength of its economy, why isn't the U.S. dollar worth more than the British pound?
- International Finance: Effect on Imports, Exports, and GDP
- Where Will Risk Erupt This Time?
- Roubini: Another Round of Currency Wars Might Be Underway
- 6 ways to spot a currency is in trouble
- A year of divergence
- The return of currency war
- ECB’s Arsenal Draws Danish Pledge on Limitless Currency Defenses
- Mexico vows to sell dollars to halt peso's slide
- Global Renminbi Payments Are Growing Steadily as China Mulls Unrestrained Currency Liberalization
- The US Dollar and the Cone of Uncertainty
- The Strong Dollar: A Too-Rapid Rise Could Harm the Economy
- What Lies Behind The Plunge Of The Ruble?
- BIS Quarterly Report Shows China's Swap Lines Misunderstood
- The Bank for International Settlements recently warned of currency and funding mismatches, especially for companies from emerging market countries that are particularly exposed by an appreciating U.S. dollar.
- What the various crises over the past 40 years or so have in common is a currency or maturity mismatch that was accelerated just prior to the onset of the crisis.
- When China's leader Xi blinks, a tool of choice may be to drive down the yuan to fight Japan’s devaluation, and to counter beggar-thy-neighbour dynamics across East Asia.
- FX Wars: Its catalysts include a U.S. dollar surge that negatively affects U.S. earnings, a Euro crash stemming from a failure to avoid deflation and excessive yen depreciation driven by the Bank of Japan that deepens an FX war with China.
- "A nation's exchange rate is the single most important price in its economy." said Paul Volcker, former Fed Chief
- Such an interest rate race is not nearly as troublesome as a true currency war of beggar-thy-neighbor competitive depreciations. Currency wars are zero-sum undertakings. It allows one country to take aggregate demand from another country via exports. Lower interest rates can help foster new demand. It is not zero-sum.
- As global financial markets have opened up over the past 60 years, capital flows throughout the world have not only become enormous, but they have grown beyond the capabilities of central banks to offset them and protect local currencies and economies.
- Bubbles rise and fall as the inflows and outflows of capital proceed at the will of sophisticated investors.
- No longer can we expect devaluation to be a panacea
- The more a country is integrated within the worldwide supply chain, the less it can expect a currency depreciation to drive export growth--- the high cost of imports mitigates much of the advantages of a lower currency.
- Central Banks try to stem their currency devaluations by buying their domestic currencies (selling dollars and U.S. treasuries).
- How is manipulating interest rates different than manipulating currencies?
- Manipulating currencies is a zero sum exercise.
- Manipulating interest rates needs not be zero-sum. It can help spur demand. It trading partners could also respond by easing monetary policy; thus boosting demand further.
- Budget deficits and trade deficits tend to be linked
- An increase in the U.S. government budget deficit will cause an increase in the real interest rate, which causes additional foreign capital to flow into the country.
- The increase in the budget deficit leads to an increase in the trade deficit.