A primer on currency wars and foreign exchange manipulation

Among the numerous ways governments can try to influence the value of their exchange rate, four stand out:

• Jawboning – Many governments do this routinely, if they feel that the value of their currency is too high or too low. Jawboning is only effective if markets believe that the governments in question have both the willingness and the resources to back their words with action.
• Direct Intervention – Governments can buy or sell their own currency or others to influence their exchange rates. This is most effective in extreme situations and when done in coordination with other governments. It is also limited by a country’s foreign exchange reserves, especially when trying to prevent a currency selloff.
• Capital controls – These are mostly used by emerging markets whose financial sectors are fragile and who have experienced large swings in their exchange rates. In recent years, developed economies have rarely put limits on the inflows and outflows of capital.
• Monetary policy – This is one of the most effective ways that exchange rates can be influenced. Often it is used defensively, when central banks in emerging markets are forced to raise interest rates to protect their currencies.

Some emerging markets have used all these techniques to manage their currencies. China is a case in point, where the government until recently tried to keep its currency stable and prevent it from falling too much. In this sense, it was not engaged in a currency war or competitive devaluation.

In contrast, most developed economies have mostly flexible exchange rates, which are largely determined by economic fundamentals and market forces. While recent expectations of easing by the ECB could weaken the euro (much will depend on other factors, including what the Federal Reserve does next), the primary motivation for the ECB (and the Fed) easing is to boost the domestic economy and not to weaken the currency per se; the Fed’s mandate only covers growth and inflation, and not the value of the dollar. The recent round of easing is likely more a case of a “competitive stimulus” than a currency war.

In today’s multi-trillion-dollar forex markets, economic fundamentals carry more weight than government actions, especially in the medium- to long-term.

In the medium- to long-term, economic fundamentals, including interest rate and growth rate differentials and current account balances, are far more influential than government intervention. This means that the current strength of the dollar, which has risen around 25%, on a trade-weighted basis in the past five years, is mostly a function of US growth being faster than most developed economies thanks to ongoing fiscal stimulus, and US interest rates being higher than most.

Intervening in forex markets to go against these fundamentals is likely to be ineffective; it could, nevertheless, add to financial volatility. This is especially true if the United States intervenes alone, which seems likely. At a time of weak growth, other central banks are not interested in tightening policy; and quite contrary, almost all are set to ease more. Stronger growth elsewhere is probably the most effective way for the dollar to weaken.