With Abe picking his new dovish playmate, and Draghi doing his best to jawbone the EUR down without actually saying anything, it is becoming very clear that no matter what level of bullshit histrionics is used by the politicians and bankers in public, the currency wars have begun to gather pace. Japan’s more open aggressive policy intervention is the game-changer (and increasingly fascinating how they will talk around it at the upcoming G-20), as if a weaker JPY is an important pillar of the strategy to make this export-oriented economy more competitive again, it brings into the picture something that was missing from earlier interactions among central banks of the advanced economies – competitive depreciation. The last time the world saw a fully fledged currency war was in the early 1930s. Morgan Stanley’s Joachim Fels looks at what it was like and what lessons can be drawn for the sequence of events – there are definite winners and losers and a clear first-mover advantage.
Via Morgan Stanley, Back to the 1930s? What Would a Currency War Look Like?
What did the currency war of the 1930s look like?
The backdrop for the currency war of the 1930s was the Gold Standard and the Great Depression (many economists blame the former for the latter). By fixing the value of the currency to the price of gold, the Gold Standard prevented a country from printing too much money. If it did, people would simply exchange it for gold (or for other currencies pegged to gold). Yet, this rigid ‘rule’ also denied policy-makers any flexibility to deal with shocks to their economies. This was the reason why the UK abandoned this regime, setting off a volatile chain of events:
- On September 19, 1931, sterling was taken off the Gold Standard. It was devalued against gold and hence against the ‘gold bloc’ currencies (currencies that remained pegged to gold). The run-up to this event and its fallout was felt throughout the world.
- Prior to the devaluation, in June and July 1931, one prominent bank in both Austria and Germany failed, which led to capital controls being imposed in both places. Capital controls protected these economies in the near term, but exacerbated fears about the future of sterling and the Gold Standard itself.
- Following the devaluation of sterling, Norway and Sweden went off the Gold Standard on September 29. A day later, Denmark followed.
- The US economies, like other countries of the gold bloc, lost competitiveness and exports turned down. Eventually, in January 1934, the US Congress passed the ‘Gold Reserve Act’ to nationalize gold held by banks and monetized it by giving banks gold certificates that they could use as reserves at the Fed. More importantly, it also forced a devaluation of the US dollar against gold.
- Like the US economy, the remaining gold bloc countries (France, Germany and some smaller economies) also suffered a loss of competitiveness and poor export and industrial production growth. By 1936, they gave up and abandoned the Gold Standard as well.
What lessons can we draw from the events of the 1930s?
We draw three pertinent lessons from that episode:
Lesson 1: As in every crisis, events were and will always be highly non-linear, with domestic conditions the most likely cause: It was painfully high unemployment that was the main driver of the devaluation of sterling.2 Although unemployment had been painfully high for a while, it was only a few months prior to the devaluation that market fear really ratcheted up.
Lesson 2: Markets punish policy uncertainty: Needless to say, there were dramatic movements in the exchange rate of the countries that devalued. However, with the devaluation out of the way, market and economic pressure as well as policy uncertainty shifted to the ‘gold bloc’ economies. For investors, it became a matter of when, rather than whether, the gold bloc economies would be forced to respond.
Lesson 3: Early movers benefited at the expense of the gold bloc, a ‘beggar-thy-neighbor’ outcome: From an economic standpoint, the sharp improvement in competitiveness of the early movers stood them in good stead against the gold bloc economies who stuck to the regime. Exhibit 1 shows that the UK and the Scandinavian economies saw a significant improvement in industrial production by 1935, whereas the ‘gold bloc’ economies (France and Germany – even though the latter employed capital controls) suffered. By the time the gold bloc economies capitulated, they had lost significant ground on this front to the early movers.
Could it happen again? Like any historical precedent, there are differences and similarities that must be accounted for.
What’s different this time? Unlike the Gold Standard era, most major currencies are now part of a flexible exchange rate regime, which should make such large currency moves less likely. Further, extreme tail risks that might well have precipitated such dramatic policy responses only a few years ago have also receded.
What’s similar? Domestic origins and ‘beggar-thy-neighbor’ effects: Even though policy-makers battled using exchange rates, the events of the 1930s had their origins in domestic issues. As mentioned above, it was painfully high unemployment in England that led sterling off the Gold Standard. The competitive devaluations that followed were also reactions by policy-makers to protect their domestic economies.
Similarly, it is the domestic agenda that could drive competitive depreciation today. In this vein, the desire of Japan’s policy-makers to revive investment in their export-oriented economy likely means that the yen will likely play an important role. However, since global demand is likely to remain sluggish, a revival of Japan’s export sector on the back of yen weakness is likely to eat into the market share of other exporters – something that could well invite measures to curb significant weakening of the yen. These negative spillovers are identical in nature to the ‘beggar-thy-neighbour’ policies of the 1930s.
If it did happen, what could an improbable but not implausible sequence of events look like?
In what follows, we create a plausible sequence using events that have both a reasonable probability of occurring and are already on investors’ radar screens:
- The starting point: Japan’s policy-makers initially follow a concerted plan of reflating the Japanese economy, with a weak yen as an important pillar of strengthening the export sector.
- Further easing from the major central banks… The ECB and/or the Fed ease further due to a deterioration in financial conditions. In the case of the euro area, euro strength or an idiosyncratic increase in risks might be responsible for a tightening in financial conditions. In the US, the obvious candidate is the risk surrounding the fiscal cliff and the debt ceiling confronting the US Congress.
- …and/or capital controls from EM economies: Uncomfortable with the combination of further capital inflows and yen weakness, some AXJ and LatAm economies impose capital controls.
- Japanese policy-makers react to yen strength: In order to ensure export competitiveness, Japanese policy-makers take further measures to weaken the yen.
There isn’t much in the ‘timeline’ above that is news, yet the combination serves well to illustrate how a currency war could plausibly play out.
Where are we now?
The key variable in the sequence of events above is the reaction of Japan’s policy-makers. If a weaker yen is indeed an integral part of their plans and if they have a strong intent to make sure it remains so, the risk of a currency war is higher now than it has been in the past. Investors have moved beyond questioning whether EM economies will have a response and are now wondering at what point such a response is likely. At the same time, near-term risks in the US and euro area economies remain in play, as does the prospect of prolonged or even enhanced monetary stimulus.
In the EM world, Japan’s export competitors in AXJ could respond with some combination of verbal intervention, FX intervention, capital controls and, with a much lower likelihood, policy rate cuts. In the particularly interesting cases of Korea and Taiwan, our economist Sharon Lam believes that verbal intervention (already under way to some extent), intervention in the foreign exchange markets and capital controls represent the most likely policy reactions. Rate cuts at a time when both economies are already expanding may serve to accelerate domestic growth and perversely cause even more capital inflows and currency appreciation rather than depreciation. For moderate moves in the yen’s value, the effects on China are likely to be limited since it does not compete head-to-head with Japan’s high-end electronics and car exports. However, in a currency war situation, the slow-moving USDCNY exchange rate may make restoring competitiveness tricky.
However, even as we discuss AXJ, let us not forget that other parts of the EM world are also concerned about currency appreciation. For all the talk about potential policy action in AXJ, we have already seen some of it come out of Latin America. In contrast to AXJ, Latin America is slowing, which puts rate cuts firmly on the agenda. Indeed, Colombia’s recent rate cut was likely influenced by the peso’s strength. Luis Arcentales, our Mexico economist, believes that concerns about the currency war have also probably been an influencing factor in Banxico’s u-turn towards a dovish stance from a hawkish one just a few weeks ago. In an innovative twist to the usual FX intervention, Peru has announced that it will buy back its international bonds and issue ones denominated in its domestic currency instead. Even Chile, one of the most advanced and stable EM economies, is discussing structural reforms to address the strength of its currency.
In summary, while a currency war is not our base case, the new-found commitment of Japan’s policy-makers does raise the risk of retaliatory action to keep the yen weak, and brings us a step closer to a currency war. The experience of the 1930s suggests to us that such large currency crises are likely triggered by domestic issues, and that they do create distinct winners and losers. EM policy-makers are already gearing up to make sure they remain on the winning side, but the balance of power for now rests with Japan.