Politicians invariably misunderstand foreign exchange rates, often ascribing a degree of national pride to the level of their currency. Normally, having a strong currency is taken as a suggestion that all is well, even if it has a negative impact on a country’s economy. For instance, the ejection of sterling in September 1992 from the European Exchange Rate Mechanism was swiftly labelled as Black Wednesday. At the time, current UK prime minister Gordon Brown was in opposition; he made a remark that has subsequently come back to haunt him, proclaiming: “A weak currency is the sign of a weak economy, which is the sign of a weak government.”
Subsequently, though, sterling’s devaluation was seen to have proved a benefit for the UK because it helped to increase the country’s competitiveness. A familiar lesson was learnt after the Asian crisis of the 1990s. Now, with the world in an era of relative devalue trading, for every currency seemingly some politicians have realized that it might not necessarily be bad to have a weak currency. The unfortunate result, though, is that they are now playing a game where they blame their countries’ economic woes on an “unfair” exchange rate.
Irish accusations
Recently, Ireland’s finance minister, Brian Lenihan, accused the UK of actively devaluing sterling which, he said, was exacerbating Ireland’s economic woes. “It is a question for all of us in the EU as to the extent to which a competitive devaluation can be used as any kind of weapon,” he was quoted as saying by the Financial Times.
According to Standard Chartered, the issue has become so emotive that it was believed to have been high on the agenda at the G7 meeting in mid-February held in Rome. “Heading into the G7 meetings, markets expected the eurozone to press the UK on the issue of the British pound’s collapse. This was partly fuelled by comments from eurozone officials – notably France’s finance minister,” the bank writes.
Regained control urged
However, the expectations were “cruelly dashed. Indeed, UK chancellor Alistair Darling stressed that the pound was not even discussed at the meetings. Given the extent of eurozone unhappiness, we are likely to hear more on this issue. Nevertheless, eurozone calls for the UK to ‘regain control of its currency’ raise an important point. Should a country prop up its currency at a time of economic recession? Our answer is a resolute ‘Non!’”
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“Most central banks are turning a blind eye to currency depreciation because the exchange rate provides extra stimulus. Are they deliberately targeting exchange rates? No. But by refraining from intervention, they indirectly signal that they are comfortable with currency moves” John Normand, JPMorgan |
But John Normand, head of global FX strategy at JPMorgan, believes that the politicians are wrong to talk about such currency manipulation. “Competitive devaluation is a term that had more meaning in the 1990s when many G10 and emerging markets pegged their exchange rates. The central bank could then make a deliberate decision to abandon the peg in order to establish or regain competitiveness versus a major trading partner. That devaluation is an active decision,” he says. This is not what is going on now. “Today almost every major and emerging market currency is floating. The exception is the Chinese renminbi, which is only allowed to fluctuate plus or minus 0.5% a day. Central banks are targeting interest rates instead.
“They want to get rates as low as possible to stimulate growth, and a consequence of that easing is currency depreciation in countries with low interest rates and high current account deficits,” Normand says.
Blind eye
He adds: “Most central banks are turning a blind eye to currency depreciation because the exchange rate provides extra stimulus. Are they deliberately targeting exchange rates? No. But by refraining from intervention, they indirectly signal that they are comfortable with currency moves. I wouldn’t call this tactic active, competitive devaluation as we witnessed during the Asian crisis of the late 1990s. Instead it is tacit acceptance of weaker currencies with the goal of obtaining some competitive edge when the global economy recovers. Central banks have plausible deniability – if they are accused of competitive devaluation, they can easily say: ‘We’re not targeting the currency. We are targeting rates, and the currency is simply responding indirectly as many asset prices do.’”
But in a world of floating exchange rates, China stands out. “It [competitive devaluation] is not really an issue, unless it can be substantiated that a country is manipulating its currency,” says Derek Halpenny, European head of global currency research at Bank of Tokyo-Mitsubishi UFJ.
“The country that really implies is China; but what was interesting is how quickly the Obama administration backtracked from an initial assertion that it was a manipulator. If anything, China has done the US a huge favour by maintaining its peg. The flows suggest it has suffered a hot-money unwind and that would have driven the dollar/renminbi rate sharply higher if it had been floating,” he argues.
Managed renminbi
Normand agrees that China is sensitive about the level of the renminbi. “China is a country which can pursue a competitive devaluation to catch up with the rest of Asia but it won’t. The move would be destabilizing in Asia and would not gain market share. The Chinese authorities will continue to manage the renminbi within a tight range and stimulate the economy through fiscal means instead. You can imagine the eruption in Washington if China devalued versus the dollar during a US recession.”
Ultimately though, while currency devaluation is a politically sensitive issue, does it have the level of impact that is often implied? “There are several factors to consider,” says Normand. “One is the price of goods being exported, which is determined by the exchange rate. Another is the ability of trade partners to import given their income levels. The third is the quality and uniqueness of exports irrespective of price.
“The big issue for UK exporters currently is that the rest of the world is in recession. Price doesn’t matter when falling incomes are the dominant driver. In six months’ time price will matter, assuming the global economy is expanding again. Sterling looks like it will remain relatively cheap for the near term.”
Dangerous misunderstandings
The worry, though, is that politicians will continue to misinterpret what is actually occurring. “There is a clear danger if politicians make decisions based on a misunderstanding about what has driven currency moves,” says Normand. “For example, if US policymakers see foreign currency weakness as a deliberate attempt to erode US competitiveness, they may think the tactic is best combated through protectionism, like inserting Buy America provisions into the fiscal stimulus package. The US response can then prompt third-round retaliations by countries which didn’t actively challenge the US in the first place. Countries only allowed their currency to respond to a widespread process of capital repatriation into dollars.”
