By now, we’re all too familiar with both the so-called currency wars and its underlying cause – the inexorable appreciation of emerging market currencies. As more and more Central Banks enter the war in the form of forex intervention and capital controls, however, they are inadvertently stoking the fires of price inflation. They will all soon face a serious choice: either raise interest rates and cease trying to weaken their currencies or risk hyperinflation and concomitant economic instability.
This dilemma is fairly basic: a Central Bank cannot simultaneously control its currency and conduct an independent monetary policy. For example, if it seeks to adjust interest rates to serve domestic economic goals, it must understand that this will have unavoidable implications for demand for its currency, and vice versa. These days, that dilemma is becoming increasingly sharp. Inflation in many emerging markets is rising to dangerous levels, real interest rates or negative, and all the while, latent pressure continues to bubble under their currencies.
The problem is that investors have become so desperate for yield that they are willing to tolerate negative real interest rates in the short-term if they believe that interest rates and/or currencies will inevitably rise over the long-term. While capital controls have forced a modest decline in the carry trade, the expectation is that an inevitable tightening of monetary policy will soon make it viable once again.
Due to the ongoing (perception of) currency wars, emerging market Central Banks are trying to hold out for as long as possible, lest they make themselves into sudden targets for carry traders and currency speculators. Some have already bitten the bullet. Brazil, for example, raised its benchmark Selic rate to 11.25% recently and indicated additional rate hikes will follow. China has embarked on a similar path, but from a lower base. The majority of countries remain in firm denial, however. Last week, Turkey took the unbelievable step of lowering interest rates in a vain attempt to decrease pressure on the Lira.
Most Central Banks believe that they can enjoy the best of both worlds by cutting access to credit and raising banks’ reserve requirements (in order to combat inflation) and maintaining strict capital controls (in order to limit inflation). While they should be patted on the back for creativity, such Central Banks must understand that their efforts are probably doomed to fail over the long-term. That’s because currency investors understand that only a masochistic, short-sighted Central Bank would pursue a weak currency policy in spite of rising inflation for a sustained period of time. Unless economic growth slows (which is unlikely without certain policy measures) and/or inflation magically abates (due to steadying food/commodity prices, etc.), they will eventually have no choice to concede defeat. “Central banks view the level of exchange rates as the priority rather than using them to help slow inflation. Once you start targeting multiple objectives, the odds for policy mistakes increase,” summarized one strategist.
The only win/win solution involves a simultaneous appreciation of all emerging market currencies. This would alleviate some inflationary pressures without altering the competitive dynamics of national export sectors and negatively impacting economic growth. According to the Financial Times, “There could be a surprise agreement to rebalance currencies at the Group of 20 this spring, although the failure of its November summit does not augur well.” Besides, any agreement would probably be in the form of a reiteration of the status quo, in which emerging markets independently (rather than in concert) pursue similar economic policy objectives.
For better or worse, emerging market governments have started to refocus the blame for the currency wars away from the US and towards China. Regardless of whether the US is at fault for its quantitative easing program, emerging markets compete with China – and its allegedly undervalued currency – in matters of trade. Pressuring China to allow the Yuan to appreciate, then, would ultimately go a lot further in ending the currency war and eliminating their predicament than screaming at the Fed for flooding the world with Dollars. Due to a new President and shifting politics, Brazil is angling to force the issue. Given that China is currently in the same boat (rising inflation with low interest rates), this might be the straw that breaks the camel’s back. “China may be more sensitive to what the other major emerging market countries think about its currency. It undermines their moral high ground when it’s Brazil criticizing them instead of the U.S,” observed one analyst.
In any event, barring some unforeseen crisis and a flare-up in risk aversion, emerging markets are expected to continue attracting outside capital (more than $1 Trillion in 2011 alone), and their currencies are expected to continue their steady, upward march.
This dilemma is fairly basic: a Central Bank cannot simultaneously control its currency and conduct an independent monetary policy. For example, if it seeks to adjust interest rates to serve domestic economic goals, it must understand that this will have unavoidable implications for demand for its currency, and vice versa. These days, that dilemma is becoming increasingly sharp. Inflation in many emerging markets is rising to dangerous levels, real interest rates or negative, and all the while, latent pressure continues to bubble under their currencies.
The problem is that investors have become so desperate for yield that they are willing to tolerate negative real interest rates in the short-term if they believe that interest rates and/or currencies will inevitably rise over the long-term. While capital controls have forced a modest decline in the carry trade, the expectation is that an inevitable tightening of monetary policy will soon make it viable once again.
Most Central Banks believe that they can enjoy the best of both worlds by cutting access to credit and raising banks’ reserve requirements (in order to combat inflation) and maintaining strict capital controls (in order to limit inflation). While they should be patted on the back for creativity, such Central Banks must understand that their efforts are probably doomed to fail over the long-term. That’s because currency investors understand that only a masochistic, short-sighted Central Bank would pursue a weak currency policy in spite of rising inflation for a sustained period of time. Unless economic growth slows (which is unlikely without certain policy measures) and/or inflation magically abates (due to steadying food/commodity prices, etc.), they will eventually have no choice to concede defeat. “Central banks view the level of exchange rates as the priority rather than using them to help slow inflation. Once you start targeting multiple objectives, the odds for policy mistakes increase,” summarized one strategist.
The only win/win solution involves a simultaneous appreciation of all emerging market currencies. This would alleviate some inflationary pressures without altering the competitive dynamics of national export sectors and negatively impacting economic growth. According to the Financial Times, “There could be a surprise agreement to rebalance currencies at the Group of 20 this spring, although the failure of its November summit does not augur well.” Besides, any agreement would probably be in the form of a reiteration of the status quo, in which emerging markets independently (rather than in concert) pursue similar economic policy objectives.
For better or worse, emerging market governments have started to refocus the blame for the currency wars away from the US and towards China. Regardless of whether the US is at fault for its quantitative easing program, emerging markets compete with China – and its allegedly undervalued currency – in matters of trade. Pressuring China to allow the Yuan to appreciate, then, would ultimately go a lot further in ending the currency war and eliminating their predicament than screaming at the Fed for flooding the world with Dollars. Due to a new President and shifting politics, Brazil is angling to force the issue. Given that China is currently in the same boat (rising inflation with low interest rates), this might be the straw that breaks the camel’s back. “China may be more sensitive to what the other major emerging market countries think about its currency. It undermines their moral high ground when it’s Brazil criticizing them instead of the U.S,” observed one analyst.
In any event, barring some unforeseen crisis and a flare-up in risk aversion, emerging markets are expected to continue attracting outside capital (more than $1 Trillion in 2011 alone), and their currencies are expected to continue their steady, upward march.
