Currencies

Trial of strength
Will todays currency interventions hurt or help the world economy? TWENTY-FIVE years ago this week, the finance ministers of America, Japan, Britain, France and West Germany met at a swanky New York hotel and agreed to push the dollar down. The Plaza Accord laid out a package of co-ordinated policies. The dollar duly fell, by more than 50% against the D-mark and yen by 1987. The deal is still seen as a high-water mark of international monetary co-operation. The appeal of intervention is now rising once again. But this time the trend is unilateral, unco-ordinated and in one direction. At its meeting on September 21st the Federal Reserve worried aloud about uncomfortably low inflation and made clear it was prepared to do more to help the flagging recovery. The prospect of even looser monetary policy pushed the dollar down sharply: it dipped to its lowest level since March on a tradeweighted basis. A weaker dollar means stronger currencies elsewherethe euro hit a five-month high against the dollar on September 22nd. A growing number of countries are determined to stop their currencies from rising. Japan sold about 2 trillion ($23.6 billion) on September 15th, its first foray into the currency markets in six years, to stem a surge in the yen that had pushed its nominal rate against the dollar to its highest since 1995. It is not the only rich country to target its exchange rate: in the 15 months to June, Switzerland quadrupled its foreign reserves, to $219 billion, in a bid to stop the franc from rising too fast. The most active interveners, however, are in the emerging world. China is the extreme case. It has built up $2.45 trillion of reserves thanks to its determination to keep the yuan stable against the dollar. Others have less rigid currencies but still intervene to stem what they regard as excessive upward pressure. Between September 13th and 16th Brazils central bank bought dollars at a rate of $1 billion a day. 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 todays 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 dont 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 goalto stop their domestic currency from risingtheir circumstances and motivations vary widely. Chinas ongoing determination to fix the yuan is the least defensible and most distortive. Unfortunately, it is also the worlds 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 Chinas, 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 Japans 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 (see chart). 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.

Those political risks are the best reason to resist going it alone. Not only is there the danger of a protectionist backlash. But unilateralism will also make it much harder to elicit further action from China, the country whose currency regime distorts the global economy most. The rich world needs reflating but the world economy also needs rebalancing. And that demands a weaker dollar. The finance ministers at the Plaza Accord recognised that reality. It is time their G20 successors did, too.

Brief This article says that 25 years ago the Plaza Accord (when the finance ministers of America, Japan, Britain, France and West Germany met at a swanky New York hotel and agreed to push the dollar down) took place. That was a great example of international monetary cooperation. Nowadays the situation is vice versa. Dollar dipped to its lowest level since March on a trade-weighted basis. A weaker dollar means stronger currencies elsewhere. A growing number of countries are determined to stop their currencies from rising.Japan and Switzerland are of this type. But some countries don`t even try to do so. China, for example, has built up $2.45 trillion of reserves thanks to its determination to keep the yuan stable against the dollar. Such situation worries thousands of people.However, some optimists believe this situation may still bring some benefits such as reflation for example. The rich world needs reflating but the world economy also needs rebalancing. And that demands a weaker dollar. The finance ministers at the Plaza Accord recognised that reality. It is time their G20 successors did, too.