Explained: Currency wars

November 15, 2010 By Peter Dizikes, MIT News

This month’s G-20 meeting of industrialized countries was rife with talk of potential "currency wars," in which states try to devalue their currencies to help their economies. While a central tension is the United States’ unhappiness with China’s undervalued yuan, the issue is really hydra-headed: One country’s actions can create many reactions globally.

Currency policies are a particularly hot topic because the United States can no longer try two traditional remedies for a sluggish economy: government spending, because the political tide has turned against it; and lower short-term interest rates, because they’re already effectively at zero.

As a result, this month the Federal Reserve announced a new round of quantitative easing, in which the government puts cash into circulation by buying back its own bonds. Intended to encourage business activity, the move could also drive down the dollar. But that should actually boost the U.S. economy: a weaker dollar would make U.S. products more affordable globally, increasing U.S. exports, income and employment.

Because the Chinese yuan is undervalued, as a July report by the International Monetary Fund concluded, it allows China to be a net exporter of goods. Experts believe that China’s government engineers this by using yuan to buy foreign currencies; this puts more yuan in circulation and keeps down its value. In June, China announced it was resuming a "flexible" policy, letting the yuan float on world markets, as the dollar does; but the yuan has barely risen since then. Meanwhile, a potentially weaker dollar affects the United States’ interactions with many other countries.

After all, a lower dollar hurts exports from Europe, too. “If the euro starts to appreciate relative to the dollar, it is more difficult for Germany and the other Euro-Zone countries to compete in world markets,” says David Singer, an associate professor of political science at MIT, who has written about the political dimension of exchange rates. German officials have already lambasted the new round of U.S. quantitative easing. “It’s inconsistent for the Americans to accuse the Chinese of manipulating exchange rates and then to artificially depress the dollar exchange rate by printing money,” said German finance minister Wolfgang Schauble.

American policies also affect developing countries, especially in South America and Asia. The low interest rates in the U.S., and low returns on U.S. bonds mean that investors looking for better opportunities have been pouring money into emerging markets, which are generally growing faster than advanced economies. But investors must make purchases — whether for stocks, bonds or real estate — in local currencies. That increases demand for those currencies, raising their values and making it harder for the issuing countries to export goods, slowing their growth.

Officials in developing countries dislike a declining dollar; it was Brazil’s finance minister, Guido Mantega, who declared in September that an “international currency war” was breaking out. “These countries with emerging markets are also trying to adjust to the global economic contraction,” notes Singer. "They want competitive exports, and they’re seeing the value of their currencies appreciating with all this capital flowing in.”

Some developing countries combat demand for their currencies by imposing capital controls, such as taxes on bonds, on foreign investment. But why don’t all emerging-market countries intervene directly in currency markets, like China? A few countries do, actually. But printing more currency to sell on exchange markets has a potential downside: inflation.

“Inflation is the tradeoff that the Chinese face in keeping their currency artificially depreciated,” says Singer. However, the Chinese government has more political insulation from the consequences of inflation than their counterparts in democratic countries, he adds. “Most of the Latin American countries have histories of bad bouts with inflation. They know it can bring down a government and wipe out middle-class savings.” Those countries, as well as the U.S., Germany and some other European states, are “more wary of inflation than are some of the Asian countries.” So they tend not to print money to lower their currency values.

How the currency disputes will unfold is hard to forecast. But they do make clear how international tensions can arise when states seek to protect their own interests in a deeply globalized economy.

This story is republished courtesy of MIT News (web.mit.edu/newsoffice/), a popular site that covers news about MIT research, innovation and teaching.

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