Currency wars and the exchange rate market
The world has seen many wars including a couple of world wars. Wars always have a reason and they are never beneficial. The world is now experiencing a new type of war in the economic world and it's called the currency war. Though the world has already seen the competitive devaluation in 1930's, the term currency war has been recently coined by the Brazilian finance minister Guido Mantega. Currency war is a series of devaluation of currencies by countries to make their products more competitive.
Just like the world war, the currency war also has leaders namely USA and China. China has always been condemned by the US for manipulating its exchange rate. Having experienced a recent financial crisis and a sluggish domestic demand most of the developed western nations are looking for exports and this has led to a greater focus on the devaluation of currencies. The USA wants the renminbi to rise as it is believed to be undervalued but China is determined not to let this happen. A weak currency provides an advantage to the exporters in the world market leading to growth in manufacturing sector and employment opportunities and this is what the countries want. 'Until recently the issues has been that Chinese intervention in the currency market has led to huge Chinese trade surplus and increasing US trade account deficit by selling renminbi and buying dollars'(Beattie, Cadman and Bernard, 2010). This intervention has led to the accumulation of $2.6 trillion by the Chinese. The following figure makes it clear-
Struggling with your essay?
Description: China-trade-chartsSOURCE: (Beattie, 2010) Financial Times
China is using the dollar flowing in from investors for high yield to purchase US securities and it is not letting the dollar to reach the market. It is argued that undervalued currencies are the global cause of macroeconomic imbalances. The US has done quantitative easing to help its economy grow. It has come up with Quantitative easing 2 which would pump another $600 billion in the market. This loose monetary policy along with ultra-low interest rate has been seen as the means to devalue dollar but US argues that it is to give a push to their sluggish economy growth. Caught amid are the other emerging nations which are facing two problems. A competition in the trade from China due to its exchange rate intervention and a huge capital inflow from the US due to its ultra-low interest rate leading to upward pressure on the currency. 'Uncomfortably strong currencies and overheating economies pose an excruciating dilemma for policymakers.Â If central bankers raise interest rates to curb inflation, they risk driving up the currency further.Â But if their interventions in the foreign-exchange market drive the currency down, that may boost inflation' (Economist, 2011). As a reaction these countries had to act to save their own interest. In the recent past many countries have followed many ways to safeguard themselves from currency war depending on their own situation. This can be grouped as-
Central bank announces curbs on short selling. Requires banks to meet reserve requirement on large bets against dollar. It doubled taxes on capital inflow
It spent around $26 billion to weaken yen. In last September Bank of Japan sold yen and bought an estimated $20 billion - its first intervention since 2004.
Quantitative easing has been used and it may continue.
Requires 30% of the capital brought in the country to be deposited in the central bank for a year and the capital has to stay in the country at least for a year.
Canada and Australia
Currency has appreciated but there has been no intervention.
Introduced in October a 15% withholding tax on capital gains and interest payment for government and state owned company bond and stopped exempting foreign investors from paying a tax on its bonds.
One month minimum holding period for central bank money market securities and the introduction of longer maturities, lower interest rate on fund deposited in central bank.
These issues has been summarised in the following figure-
SOURCE: (Reuters, 2010)
These actions by the countries shows the seriousness of the issue, so naming it as 'currency war' by the Brazilian finance minister is not wrong. Dominique Strauss-Kahn, managing director of the International Monetary Fund, voiced his concern. "There is clearly the idea beginning to circulate that currencies can be used as a policy weapon," he said. "Translated into action, such an idea would represent a very serious risk to the global recovery." 'What needs to happen is fairly clear. Global demand needs rebalancing, away from indebted rich economies and towards more spending in the emerging world. Structural reforms to boost spending in those surplus economies will help, but their real exchange rates also need to appreciate. And, yes, the Chinese yuan is too low. That is hurting not just the West but also other emerging countries (especially those with floating exchange rates) and indeed China itself, which needs to get more of its growth from domestic consumption' (Economist, 2010). But the concern of China about the appreciation of its currency leading to low growth and unemployment in its export houses is also genuine. The problem is that there is no neutral organisation to intervene and solve this serious issue. IMF has an article asking not to manipulate currencies for trade benefit but it is not enforceable. As this issue is no longer bilateral between US and China we need a multinational solution and all countries should work together or else there is a big threat of open trade war which would be destructive. IMF and G20 must come up with a solution and agree to stop currency war otherwise as is the nature of war, destruction is inevitable in the form of global economic shrinkage.
INTERVENTION OF CENTRAL BANK IN EXCHANGE RATE MARKET
This essay is an example of a student's work
As discussed earlier, the role of exchange rate is of utmost importance in the export of the economy which determines the current account balance and the growth of the economy and which is why we are experiencing currency war. The other reason for such an intervention is the intention of stabilizing the exchange rate as this attracts more foreign investors. Also the intervention is exercised when the exchange rate threatens domestic economic activity. This leaves us curious of the process of such an intervention. The central bank has two choices and its decision depends on many factors. The choices are-
Indirect Intervention - This type of intervention involves the central bank affecting its monetary policy by increasing or decreasing the money supply in the economy for which it has three tools. The tools are:
Open market operation: The money circulation is affected by buying or selling government securities. As in US when the government wants to increase the money supply it buys the government bills, notes or bonds and when it wants to reduce the money supply it sells them. This is the most widely used method.
Capital reserve requirement: By changing the amount of money as a percentage of deposits that the banks have to deposit to the central bank, the central bank can affect the money supply in the economy.
Discount rate: By affecting the rate at which banks lend each other or the central bank lends to banks for short period, it could affect money supply and interest rate.
The change in money supply changes the interest rate thereby affecting the exchange rate. Here two things happen - Increase in money supply by itself drives down the value of the currency as demand is constant. By this interest rate goes down which would see foreign investment flowing out thereby depreciating the currency and vice versa.
Direct Intervention- The central bank can directly intervene in the foreign exchange market by buying or selling a foreign currency against which it wants to affect its exchange rate. Simple law of demand and supply applies leading to change in exchange rate.
But the problem is that money supply, interest rate and inflation is linked. Say a central bank wants to slow down the economy by increasing interest rate thereby decreasing inflation, but at the same time it wants to depreciate its currency by buying forex. If it buys forex, money would enter the economy and interest rate goes down. This dilemma is generally faced by emerging countries. So maintaining all the objectives is a complicated job.
The economist came up with sterilized intervention where along with buying or selling forex to affect the exchange rate, central bank also buys or sells government bonds to control the money supply. The following figure makes the concept clear-
'Real world sterilizations have generally been ineffective in achieving any lasting effect upon a county's currency value. Sterilized FOREX intervention, not only will not affect GNP, but also will not affect the exchange rate. This suggests the impossibility of the FED's overall objective to lower the dollar value while maintaining interest rates' (Suranovic, 2005). Also, 'Central banks in developing countries, wanting to devalue the domestic currency, usually intervene in the foreign exchange market by buying up foreign currency using domestic money-often backing this up with sterilization to counter inflationary pressures. Such interventions are usually effective in devaluing the currency but lead to a build-up of foreign exchange reserves beyond what the central bank may need' (Basu,2009). China did this which has left it with a foreign reserve of $2.6 trillion.
The above discussion suggests that the central bank has many tools to intervene in the exchange rate market.
DEPRECIATION OF STERLING AND UK ECONOMY
As we have already established that currency value plays an important role in an economy's growth and that is why we are experiencing a 'Currency War'. Now we would critically evaluate the Bank of England's view on the effects of the depreciation of sterling on UK economy.
The sterling has depreciated a lot since the financial crisis in 2007. It was down by 30% though it has again regained 10% but it is still a lot low then what it was.
Cumulative change in selected sterling exchange rates since August 2007
Source: Interpreting recent movements in sterling
Freelance Essay Writing Vacancies
Looking to become a writer?
Due to high demand for our services we're always looking for new writers. If you're interested in becoming a freelance writer then why not read more about our freelance writer jobs.
Weak currency has some reactions in an economy. Two things immediately come in mind - inflation and export. Bank of England, the central bank of England, having a targeted inflation policy has monetary policy committee (MPC) to work on this. 'The impact on inflation of sterling's depreciation has been larger than the MPC had initially anticipated. In part, that may reflect the recognition by market participants and businesses that a substantial decline in the real value of sterling was necessary to re-balance the economy and the fall was consequently likely to be permanent' (Bean, 2011). The depreciation in sterling has contributed to increase in inflation which at the moment is 4% that is higher than the BOE's target of 2%. This depreciation has led to the increase in export which is represented by the good performance of the manufacturing sector. 'The manufacturing and construction sectors were estimated to have grown strongly during the second quarter and manufacturing year-on-year growth was now at its highest level for over fifteen years' (MPC,2010).
As we know that inflation and exchange rate is very closely related. Here comes an issue of the depreciation of sterling. On one hand it has contributed to the rise in inflation which is above the target rate and on the other it has led to an increase in export. The near term and long term inflation rate is uncertain. 'Near-term prospects for inflation remained unusually uncertain and sensitive to the impact of a number of factors whose impact were difficult to evaluate accurately' (MPC, 2010). Also the benefit of depreciation of sterling is not all that great. As has been seen the export has not increased to the extent it should have due to weak global demand. 'Overseas demand for some exported UK business and financial services might have softened, mitigating the benefit for those exporters from the past depreciation of sterling and recovery in the global economy' (MPC, 2010). The quantitative easing that has been brought forward would further affect interest rate, inflation and exchange rate. The Bank of England is caught in the dilemma of economic recovery by quantitative easing and low interest rate or inflation control by high interest rate. It has to access the developments more closely and controls the situation.
BALANCE OF PAYMENTS - CURRENT ACCOUNT SWINGS
To understand and study the fluctuations in the prices of the currency, every country maintains an itemised record of the factors causing the demand for or supply of their currency. This record is called the Balance of Payments account.
Although, the primary function of the BOP account is to determine the reasons for currency fluctuations, this is not its sole responsibility. A BOP account also acts as a signal to other countries portraying the account holder's position in the international trade market. It acts as a tool for measuring the country's performance in the international economic competition. A country's international transactions are grouped into three main accounts:
Current account - Records the exports and imports of goods and services.
Capital account - Records all transactions of assets such as real estate, bonds, stocks, businesses and bank accounts.
Official reserve account - Keeps track of the purchases and sales of the international reserve assets including gold, foreign exchanges, dollars etc.
For the purpose of this report, we will only provide insight into the current accounts of BOP. A current account can either have a deficit or a surplus balance. This is directly a result of the constituents of the account. If an economy heavily relies on its imports, it is said to have a deficit. Similarly, an economy inclined heavily towards exporting leads to a current account surplus.
The likes of Joseph W. Gruber & Steven B. Kamin (2007), Menzie D. Chinn & Jaewoo Lee (2009), and many others started their studies exploiting the established fact that US has huge deficits while East Asian countries like China, Hong Kong, Malaysia, Singapore etc. have trade surpluses. Various factors contribute to the fluctuations in the current account balances.
Import and export activities - The level of import and export activity of an economy, be it capital, labour, merchandise or services, affect the current account balances. Also known as the Elasticity approach, this model bases its findings on three main determinants - domestic activity, foreign activity, and the real exchange rate. For eg: Chinese Yuan is considered to be undervalued leading to a competitive position in the world export market which results in the current account surplus. On the other hand, relative to the Yuan the US Dollar is quite overvalued and thus this leads to cheaper import contributing to the current account deficit. Considering the fact that US is the single largest merchandise importer while, China is the single largest merchandise exporter, in the world (WTO, 2010), the large deficit in US current account balance & a large surplus in the Chinese accounts reflects this.
Investment and savings activity - The net difference between the savings and investments of an economy is also considered as the balance of the current account. Further implying this principle, it can be understood that the level of savings or investments of an economy directly affect the nature of the current account balance.
Borrowing and lending activity - Despite the fact that US has the largest economy in the world, US continues to borrow heavily on the international market when it has to technically be lending. This change in roles is because of the ever widening gap between the economy's exports and imports where the imports far outweigh the exports. As mentioned earlier, this trade imbalance reflects that the current payments by US residents which other than the payment for imports also includes the remittances, interest and dividend payments etc., greatly exceed the analogous payments the US residents receive from abroad. This difference between the payments made and those received is covered by borrowing from the international market, as the receipt on sales of its exports is insufficient to fill this gap (Bernanke, 2005).
BALANCE OF PAYMENT ANALYSIS - CASE OF THE UNITED KINGDOM
UK's balance of payment is a key economic statistical tool. It measures the economic transactions between UK residents and the rest of the world. It also provides net figures between the inward and outward transactions, a net flow of transactions between UK residents and the rest of the world and reports how that flow is funded. Simply put, it is a consolidated record of the UK economy as an accounting entity and the entries record the economic transactions between the residents of UK and those of the rest of the world (Pink book, 2009).
The UK's balance of payment has had a current account deficit since 1984 with the last surplus being recorded in 1983 (Pink book, 2010). However, records show that this deficit was measly and has been on the rise ever since. The deficit worsened in the late 80's and reached around a record low of $82 Billion in 2006 (IMF, 2010) which is the highest in cash terms. However, this figure only equated to -3.3 per cent of the GDP. Historically, the UK balance of payment has always been dependant on its most cyclical component - Trade in goods. Trade in goods deficit has been the root cause for the overall UK deficit. Income & current transfers - other components of the current account have been instrumental in 'cushioning' the deficit.
Current Account Summary
Both the trade in goods and current account deficits broadly fell and then subsequently rose.
While the goods deficit continued to grow, the current account deficit narrowed due to a widening income surplus.
The deficit on trade in goods increased steadily, matched by a rise in the current account deficit.
The increasing deficit on trade in goods was more than offset by increasing surpluses on both trade in services and income.
Reasons for Current account deficit
De-industrialisation - As mentioned earlier, trade in goods has always been UK's strength. However, with the onslaught of the deindustrialisation, industries started moving away from manufacturing towards services. Many economists do not regard this as a problem. Every developed country is doing the same now, outsourcing from developing countries to make manufactured goods at a lower cost whilst concentrating on high technology, high skilled industries. In terms of current account, the problem is that whilst most goods can be internationally traded, only 20% of services are considered as internationally tradable. By de-industrialising, UK is declining in a sector, which helps earn foreign currency to pay for imports and expanding in a sector that does not.
Tax receipts - The injection of tax receipts can cushion the deficit. It does so by filling in the gaps created by large deficits. However, it is understood that UK's budget was relatively in a poor shape in the last few years which has allowed for lesser tax receipts than expected by the treasury. A VAT holiday declared by the government further deteriorated matters. Designed to mitigate the effects of the recession, the VAT holiday cost around £25bn, or around 1.5% of GDP, much smaller in scale compared to the US. It did not fulfil its intended role, instead affected the tax reserves. This has also contributed the economy being the worst hit by the recession (Larry Elliott, 2010).
Recession - The depth and duration of the recent recession has added to the current account deficit in the last 3-4 years. Deficits tend to rise during downturns because tax receipts fall and spending on unemployment and other welfare payments rise. In Britain's case, the economy contracted by more than 6% over six successive quarters from early 2008 to late 2009. By the time growth resumed national output was 10% lower than it would have been had the economy continued to expand at its normal rate of around 2.5% a year. That punched a hole in the public finances (Larry Elliott, 2010).
Growth in consumer spending - Over the last few years, growth in consumer spending has also been increasing in the UK. A significant portion of this spending has been on imports (often luxury manufactured goods). As explained earlier, deindustrialisation coupled with increased imports widened the deficit gap.
Strong exchange rate - The gradual appreciation of the sterling over other currencies including the US Dollar makes exports less competitive and imports cheaper. This higher value of the exchange rates has induced reduction in the total value of exports.
Despite having huge amounts of current account deficits, UK has balanced its BOP by ensuring surpluses in the Capital/Financial account. The internationalisation of the financial markets, liberalisation of trade in financial instruments and globalisation, has made it easier to finance the current account deficit. Economists believe that there are no economic constraints if a country depends on its capital account surpluses as compared to its current account. The Capital account has recorded surpluses in the last 20 years (Pink book, 2010). One of the main reasons for this surplus has been UK's ability to attract cash flow into the country. Below is a summary that has contributed to these surpluses over the last few years:
Lower interest rates - The short term interest rates are quite higher in the UK compared to the countries in the euro zone and the US. This has attracted large amounts of inflows into the UK banking sector in return for a favourable interest rate.
Foreign direct investment - UK's economic structure and favourable standards regulating the financial markets have made UK a favourite FDI venue. Huge acquisitions such as the $16bn purchase of Abbey National by Santander Central Hispano, Spain's largest bank; the acquisition of UK-based Amersham by General Electric of the US for $9.6bn (Frances Williams, 2005) and the much talked about acquisition of Cadbury by US Kraft foods are some in a series of FDI that have contributed to UK's current position (Geoffrey Owen, 2010).
RELATION BETWEEN UK BALANCE OF PAYMENT AND ITS EXCHANGE RATE
As explained above the UK balance of payment for last 10 years has been in deficit and its exchange rate index has been fluctuating. By this statement we can conclude that there is not a simple relation between balance of payment and exchange rate. So we need to look at the theoretical explanation of this relation. The elasticity model of the balance of trade (Krueger, 1983) has shown the existence of a theoretical relationship between exchange rate and the trade balance. To begin with we know that a weak currency would improve the export and would reduce the import thereby reducing the deficit in the case of UK and vice versa. If we look from the balance of payment view, a deficit in UK would mean more supply of currency for the import and less demand of currency for the exports thereby depreciating the currency. But this doesn't always hold true. Also in the short term there are factors which don't let this simple relation hold. The factors that have been found in studies are:
Elasticity of Demand & Supply- According to Marshal Learner law depreciation in the exchange rate will only improve current account - if combined price elasticity of demand of export and Price elasticity of demand of import is greater than 1.
Profit margin- Often the companies don't change their product price in foreign currency but adjust the exchange rate fluctuation in their profit margin thereby not affecting the balance of payment.
Global Demand- The global demand determines the opportunities for export on depreciating the currency. The sluggish global demand has not contributed much in increasing exports on a fall in sterling.
Let us now explore what has been the relation of Balance of payment and exchange rate for the last 10 years for UK. To show this we can use a simple graph.
As the chart shows that the deficit has increased enormously in the last few years. From the beginning of this century the deficit has increased and a link could be established to the relative rise in sterling. By looking at the graph we can see that in 2003 the sterling depreciated which led to a decrease in deficit. Also from mid-2007 the sterling depreciated leading to a decrease in balance of payment deficit. But form the beginning of 2009 sterling again started to appreciate which led to a decrease in the deficit. So by looking at the graph we can easily conclude that there is a significant relationship between the exchange rate and balance of payment. However, ceterus peribus, these are not the only factors that affect each other. As Montiel (1999) states that factors such as productivity, government spending, changes in the international environment and changes in commercial policies are important determinants of the real exchange rate. On the other hand, Balance of payment is affected by a number of reasons including tax receipts, savings and investment level, nature of exports and imports, and the sovereign capacity of lending and borrowing.
If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please click on the link below to request removal: