By Elizaveta Belugina, leading analyst at FBS Markets Inc., FXBAZOOKA.com
The Chronicles of Currency Wars. Part 1: Inception
Currency wars have truly become a phenomenon of the 21st century. Financial globalization has made individual countries more entangled with each other via trade and capital flows. Hence, the problems in one region get quickly transferred elsewhere.
In order to keep their economies ticking, some nations unleash the fastest and the easiest weapon – currency depreciation. Others then start shortly feeling the ill effects of such policy and respond with devaluation of their own currencies.
When it comes to the national currency, everyone wants to stay competitive. This desire has provoked a wave of monetary easing. The intensity of the easing is different from year to year, but the accommodative monetary policy is clearly prevailing over the restrictive one. Now currency wars are the new reality of global finance and risk becoming an ever-present element of the world’s financial environment.
The mechanics of QE: how it should work in theory
One of the main weapons of the contemporary currency was is the so-called ‘quantitative easing’ or QE. According to the definition, QE is a an unconventional monetary policy in which a central bank purchases government or other securities from the market in order to lower interest rates and increase the money supply. In more simple words, the purpose of QE is to revive economic growth. Note the word ‘unconventional’: the central bank uses QE when it needs to act, but has run out of standard measures. In particular, it means that the benchmark credit rate is already at its lowest.
The idea of QE is to provide commercial banks with liquidity so that they could increase lending to the real economy providing a vital stimulus for GDP growth. To do that the central bank purchases government and corporate debt from commercial banks. To pay the institutions for these securities it creates new electronic money. As a result, the central bank’s balance sheet increases by the quantity of assets it has purchased. This is why the easing is called ‘quantitative’.
Another reason why the commercial banks become eager to lend is that when the central bank buys government bonds or other assets, their supply goes down. This makes the price of the securities rise, and yields fall. As a result, the banking sector can earn more by lending money to business and consumers than by keeping securities which are bringing low interest.
The prospects of cheaper money is usually enough to lift the market’s confidence, so the announcement of QE is usually followed by the rally in stocks. Other effects of the increased money supply include higher inflation and devaluation of the national currency. While the first QEs were more about lifting economic growth, now the central banks of advanced economies ease to achieve higher price growth. Examples include the Bank of Japan and the European Central Bank. Whatever the purpose, QE tends to debase the national currency. On the one hand, lower currency is beneficial for the nation’s exports. On the other hand, massive devaluation of a certain nation’s currency is certainly not welcome by its trade partners. If the currency is important enough, it sets the currency wars in action. The US dollar is important enough.
America stroke the first blow
To be fair, Japan was the first country to resort to quantitative easing in the early 2000s. However, QE on the big scale originated in the United States as an aftermath of the global financial crisis.
US dollar is the most traded currency in the world. That’s why when America has launched itself into QE, it had a worldwide impact. By the end of 2008 the Federal Reserve cut its benchmark rate to near zero and then conducted 3 rounds of quantitative easing from that year and till 2014. The policy was designed and inspired by the Fed’s chief Ben Bernanke, the devoted advocate of monetary stimulus. Bernanke, also known by the nickname of “Helicopter Ben” for his remark about using a helicopter to drop off money to fight deflation, actually criticized Japan for its slow response to the economic crisis. So, when Bernanke was appointed the head of American central bank, he made sure he lost no time to fight the crisis at hand with as much monetary ammo as possible.
The scale of American easing is impressive. The Fed’s balance sheet has surged from around $700 billion at the beginning of the financial crisis to more than $4 trillion. All 3 rounds of the US QE were not the same. The very first one was aimed to cure the US from the credit crunch. It was considered necessary by the majority of economists and policymakers. QE2 and QE3 got more criticism. Although US economy did improve during these periods (especially during QE3), one of the main arguments against this type of easing is that financial markets turn into liquidity junkies and become too dependent on cheap money.
The Federal Reserve is often accused of thinking about the well-being of the stock market more than about the health of the real economy. Many experts worry that QE has created a bubble in the US stock market and that its eventual burst will be extremely painful for everybody. Even as the Fed has finished QE and is planning to start raising interest rates, there is no certainty that the US economic growth will be sustainable enough and that the nation’s stocks will keep performing well without the support of QE. Consequently, one can’t rule out the possibility of further easing in the foreseeable future.
Although the Fed denies that it is practicing competitive currency devaluation, quantitative easing programs exerted downward pressure on the dollar. Theoretically QE should have boosted lending to the US companies and households. In practice many banks invested outside of the US where the yields tended to be higher. To do that, they sold the dollar and bought foreign currencies. This made foreign currencies appreciate against the greenback. At the same time, the US actually exported its inflation elsewhere. As a result, many emerging nations had to raise interest rates. This made monetary inflows to them even higher pushing their currencies further up and hurting their economies. Since 2009 many states had to take measures to either devalue or at least check the appreciation of their national currencies. In 2010 Brazil’s finance minister Guido Mantega was the first one to spot an “international currency war”. You will find out about how this war developed in our next article.