The Economist pubished a piece on the positive and negative effects of currency intervention (“Trial of strength. Will today’s currency interventions hurt or help the world economy?”). The article highlights the problems with unilateral and unco-ordinated intervention, where all countries effectively seek to lower the value of their own currency:
As the recovery slows, a growing number of people worry about a descent into competitive depreciation, as countries try to grab a bigger share of global demand at others’ expense, a trend that could fuel protectionism. Optimists, however, argue there may be benefits from today’s fad for currency fiddling. One argument is that intervention may be a backdoor route to reflation. If central banks all print money to prevent their currencies appreciating and don’t mop up or “sterilise” that liquidity by issuing bonds, then their exchange rates might end up the same but the world will have had a monetary boost in the interim.
The truth lies in between. Although most of the intervening governments have the same goal—to stop their domestic currency from rising—their circumstances and motivations vary widely. China’s ongoing determination to fix the yuan is the least defensible and most distortive. Unfortunately, it is also the world’s most effective intervener. Thanks to a closed capital account (even if cracks are appearing) and government control over domestic banks, China has been able to buy vast quantities of dollars without fuelling inflation. The central bank issues bills to mop up the liquidity created from buying reserves, which obliging banks hold at low rates.
For most emerging economies, however, intervention is more about coping with volatile capital flows. Thanks in part to rock-bottom interest rates in the rich world, foreign capital is flooding back into emerging economies. By intervening, emerging-market central banks restrain the pace at which their currencies appreciate. But they do so at a price. In countries with freer banking systems than China’s, sterilisation becomes increasingly costly the more reserves are bought. But if the intervention is not sterilised, the added liquidity fuels inflation.
In the rich world, where demand is weak and deflation a risk, the calculus is different. Unsterilised intervention is seen as a route both to counter excessive currency strength and to combat deflation (the prime motive for Swiss intervention). In Japan’s case the first argument does not cut much ice. Thanks to Japanese deflation the yen, in real effective terms, is below its average value since 1990 […]. The second rationale has some merit provided the Bank of Japan really does resist the urge to mop up any liquidity. But it could achieve the same reflation, without the political risks of unilateral intervention, in other ways.
There certainly is a need for discussing these interventions within the G-20. However, since most of the intervening economies — including China and Korea, and since recently also Japan — are in East Asia, it would be more effective to try to forge consensus on this issue among the East Asian countries. China’s exchange rate policy has an enormous effect on the exchange rate policy of the other East Asian countries, and unless China appreciates, the others will feel compelled to continue intervention to maintain relative comeptitiveness vis-à-vis China and each other. And although China has a genuine interest in reducing dependency on the dollar, it fears that an appreciation would badly reduce its exports and hurt domesitic growth and employment. Game theorists would call this situation a Nash equilibrium. A coordinated appreciation among East Asian economies would take away pressure from China, since its most important export competitors would also appreciate and hence relative competitiveness among them would be maintained. Before the G-20 summi in Seoul, China should invite its East Asian peers to Beijing and discuss such a joint appreciation. 25 years after the Plaza Accord, the time is ripe for a Beijing Accord.
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