Global policymakers are digging themselves into a very deep hole with few viable exit plans. Growing turmoil on financial markets and deepening world economic gloom is leading policymakers to turn to
desperate measures to beat the downturn.
Pumping the global economy with huge infusions of quantitative easing money and driving interest rates into negative territory are proving less effective in stopping the rot. The worry is the world’s central banks and governments are being tempted into competitive currency devaluation as a last resort to reboot faster growth.
It is a mistake as currency devaluation in the long run is a zero sum game. There may be some short term benefits, but, as everyone joins in, it ends up a no-win situation. It raises the spectre of a dangerous currency war breaking out, increases trade tensions and exposes global investors to more risk in the process.
Currency devaluation is like pyramid selling. It may work temporarily for countries which are the first in to use it, but other countries adopting the strategy at a later stage will see any potential benefits cancelled out as other nations join in the devaluation merry-go-round.
For currency devaluation to work effectively, it must be backed up by other complementary measures. Monetary, fiscal and currency policies all need to be pulling in the same direction to ensure the resulting stimulus is channelled to maximum effect.
The experience of the US and British economies in the wake of the 2008 global financial crisis are good examples of how currency depreciation works when properly handled. By slashing interest rates and unleashing significant QE programmes, the US Federal Reserve and the Bank of England both ended up weakening their currencies. It was anathema to investors, who fled the US dollar and British pound in droves.
They might have seemed random acts at the time, but they were co-ordinated ploys to boost export-led recovery with currency devaluation, while simultaneous monetary and fiscal easing reflated domestic demand at the same time. The strategy paid off as the US and UK economies reaped much faster recoveries than their major industrial peers over the last six years.
Countries trying to achieve the same results today have missed the boat. Calculated plans to boost growth with currency devaluation are simply stoking up global tensions and market volatility to negative effect.
Since China’s 3 per cent devaluation in August last year, the yuan’s continuing slide has undermined economic stability in Asia. With growth in China’s mainland economy slowing to its lowest rate in 25 years, there are understandable fears of more in the pipeline if Beijing believes more yuan weakness will help to bolster faster export-led growth ahead.
It raises the odds of copy-cat currency devaluations elsewhere in the region. With global uncertainties and volatility already running high, the ramifications of China’s forex strategy are having major consequences further afield.
The flipside of devaluation is other currencies get stronger, not good news while global growth is slowing down. Having enjoyed the fruits of dollar weakness in recent years, US officials are concerned over the dollar’s resurgence. In the last year alone, the dollar’s currency index has jumped 20 per cent, the monetary equivalent of a 5 per cent rise in short term interest rates. Trade tensions with China are bound to resurface at some stage.
Japan is also wary about the stronger yen, driven up by the weaker yuan and safe haven capital flows flooding back home. Japan’s reflation plans are dependent on a weaker yen to boost export-led recovery, so the authorities must push interest rates even deeper into negative territory to protect the yen’s export competitiveness.
Forex developments are also forcing the European Central Bank into another round of monetary easing soon. With negative ‘risk-off’ sentiment building in the financial markets, the euro has strengthened on the back of unwinding carry-trades and market short covering. The ECB needs a weaker euro to revive inflation and boost recovery, so the odds of another rate cut and more QE in March are high.
The global economy is in disarray right now and the last thing it needs is a currency war, increasing trade tensions and heightened market uncertainty. It is time for global policymakers to work together and settle differences.
The Group of 20 economic powers meeting in Shanghai on February 26-27 provides a valuable opportunity for closer co-ordination to help forestall a new global crisis. Currency perils could be the final straw.
David Brown is chief executive of New View Economics