Opinion: Get ready for the ‘reverse currency wars’

Jeffrey Frankel is professor of capital formation and growth at Harvard University.

The U.S. dollar is up 12 per cent against the euro over the past year and, at €0.93, is approaching parity. If prices of oil and other commodities now seem high in dollar terms, they look even higher in euros. With the greenback surging, and inflation in many countries currently at multidecade highs, we may be entering so-called “reverse currency wars” – in which countries compete to strengthen their currencies’ foreign-exchange values.

The term “currency wars” was originally a colourful description of what international economists had long called “competitive devaluations” or, after exchange rates began to float in the early 1970s, “competitive depreciations.” In these situations, countries feel aggrieved that their trading partners are deliberately pursuing policies to weaken their own currencies in order to gain an unfair advantage in international trade. Competitive depreciation can arise when all countries’ main macroeconomic goals, in addition to maximizing GDP growth and employment, include improving their trade balances. This generally describes the past few decades in the world economy.

A reverse currency war, on the other hand, involves competitive appreciation. Here, countries think their trading partners are deliberately trying to strengthen their currencies in order to rein in inflation. This could describe the period that began in 2021, when inflation returned as a serious problem in most countries.

In both cases, it is impossible for all countries to pursue such strategies, because they cannot all move their exchange rates in the same direction at the same time. Both competitive depreciation and competitive appreciation are often perceived as evidence of a lack of international co-operation to achieve exchange-rate stability, and sometimes lead to calls for a new Bretton Woods-type arrangement to promote greater policy coordination.

The United States has often been quick to allege that other countries’ currencies are unfairly undervalued. Since 1988, Congress has required the Department of the Treasury to submit semi-annual reports on whether the United States’s major trading partners are manipulating their currencies. China and other Asian countries are the most frequent targets.

In February, 2013, the U.S. Treasury spearheaded a sort of micro-Bretton Woods agreement whereby Group of Seven countries would refrain from taking steps to depreciate their currencies. The 2013 pact is little known, but it has worked. Over the past decade, Group of Seven members have not intervened to sell their own currencies on the foreign-exchange market.

China, which is not a Group of Seven member, does intervene in the currency market. Since 2014, however, it has done so to slow the renminbi’s depreciation, not to encourage it.

There is ample historical precedent for fears of competitive devaluation, most notably the 1930s, when major powers devalued their currencies against gold and thereby against each other. Is there also a precedent for competitive appreciation?

Some have argued that the early 1980s provided such an example. When the Paul Volcker-led Fed raised interest rates sharply to fight inflation, it knew that it would be aided in that task by the dollar’s appreciation. But the corresponding depreciation of U.S. trading partners’ currencies worsened their inflation rates and forced them to raise interest rates as well.

Today, the most likely victims of a strengthening U.S. dollar are not other major rich countries, but rather emerging and developing economies. Many of them have substantial dollar-denominated debts, exacerbated by the fiscal spending required to fight the COVID-19 pandemic. When the dollar appreciates, their debt-servicing costs increase in local-currency terms. The combination of rising global interest rates and a stronger dollar can trigger debt crises, as it did in Mexico in 1982 and 1994.

But not all fears of competitive appreciation are justified or merit a reform of the international currency system. Unlike most central banks, the Bank of Japan kept its monetary policy very loose over the past year, in a continuation of its long campaign to raise growth and inflation. So, while the Fed is raising interest rates in an effort to slow U.S. price rises, Japanese rates are still at or below zero. As one would predict, the widening interest-rate differential has caused the yen to depreciate by about 15 per cent against the dollar over the past year.

Over all, this big change in the dollar-yen exchange rate is not really a problem. It has pushed up Japanese prices while exerting downward pressure on U.S. inflation. That is what both countries wanted. Floating currencies allow each country to pursue the monetary policy that suits its own circumstances.

But with high global inflation likely to persist for some time, the prospect of reverse currency wars is looming larger. Instead of a race to the bottom in the foreign-exchange market, we may see a scramble to the top – and poorer countries are likely to suffer the most.

Copyright: Project Syndicate, 2022.

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