Currency Wars
Jeffrey Frankel
Harpel Professor of Capital Formation & Growth,
Harvard University
MAS Sponsored Public Lecture, Singapore, 8 March, 2011
1

What are currency wars?
• Review of the last 6 months.
• Is the currency war metaphor appropriate?

Which emerging markets are intervening the most
to dampen the appreciation of their currencies?
• What is the right way to measure it?
• What should they be doing? Lessons from recent crises.
2
Currency Wars chronology
September 15, 2010
Japan buys $20 b for ¥,

• after 6-year absence from FX markets;
• thereby joining Switzerland, the other floater
to have appreciated in 2008-09 GFC and
to have fought it by FX intervention.
3
Currency Wars chronology, continued
September 27
warning from Brazil’s Finance
Minister Guido Mantega:
“We’re in the midst of
an international currency war,
a general weakening of currency.
This threatens us because it takes away our
competitiveness.”
 I.e., countries everywhere are trying
to push down the value of their currencies,
to gain exports and employment,

• a goal that is not globally consistent.
4
Currency Wars chronology,

Nov.2010
As European sovereign debt crisis resurfaces
in Ireland, euro hits low (1.3 $/€ ).
Nov.17

Chinese government,
responding to 4.4% inflation in October
• raises interest rate,
•
reserve requirements,
•
& price controls.

US core inflation falls to 0.6% for year,
• the lowest since 1957.
5
Currency Wars chronology, Nov.2010
G20 Summit in Korea
was the first chaired by a non-G8 country
6
Currency Wars chronology, Nov.2010

Nov. 12: G-20 Summit in Seoul
was judged a failure, at least for Obama:
• Rebuff of US proposal for cap on Current Account
surpluses at 4% of GDP.
• No pledge to refrain from “competitive undervaluation”
• A suggestion to countries with widely used currencies
like the $ to “be vigilant against excess volatility,”
a warning against loose monetary policy.
7
Currency Wars chronology, Nov. 2010

Nov.21: Fed announces QE2 decision -• Will purchase $600b in bonds.
• Short-term market reaction -- $ depreciates.
• Critiques -

Sarah Palin & John Taylor:
“US is debauching its currency.”
Germany, China & Brazil:
“$ depreciation = deliberate salvo in currency wars.”
8
Currency Wars chronology, Jan. 2011


Jan.14, 2011:
Secy.Geithner notes that -- including China’s higher
inflation -- RMB is appreciating in real terms.
That suggests (appropriately) lower USG priority
on the currency issue
• than on IPR, North Korea
& other issues

in Jan.19
Obama-Hu summit.
9
5% nominal appreciation per annum
+ 5% inflation differential
≈ 10% real appreciation per annum
over last half-year
10
Global Macro Monitor
Data sources: The Economist, BLS, CEIC, Thomson Reuters
Currency Wars chronology, 2011

Feb. 4, 2011
• In biannual report to Congress, U.S. Treasury
calls RMB "substantially undervalued."
• But it once again refrains from
naming China a currency manipulator,
• and points out real appreciation
is running at 10% per annum.
11
Currency Wars chronology
Feb. 15, 2011:
US Treasury Secretary
Geithner fails to
convince Brazil to
jointly pressure China.
Mantega responds:
“the $ is as much a
problem as the RMB.”
Financial Times Feb. 16, 2011
12
Feb. 18-19, 2011:



First meeting of G20 ministers
in France’s year as host.
Sarkozy no longer talking
of “a new Bretton Woods.”
But G20 goes ahead with
a system of indicators,
• including real exchange rates, current account
balances, budget deficits and sovereign debt levels.
13
Is the currency war metaphor applicable?

Fear of non-cooperative “competitive devaluation”
is an argument for fixed exchange rates
• rooted in the 1930s.
• It is why the architects of
the post-war monetary order
chose fixed exchange rates
at Bretton Woods, NH, in 1944.

But it is now used to argue that China
should move from fixing to floating.
• US Congressmen don’t
care about regimes;
• they just want a stronger RMB vs. $.
14
Is the currency war metaphor applicable?


Meanwhile, fear of “competitive devaluation”
is also used as an argument against
US monetary expansion.
But monetary expansion is not
a “beggar-thy-neighbor” policy:
• Although in theory it should depreciate $,
• at the same time it boosts US growth & so imports.
• The net of the two effects on trade balance
is ambiguous in theory and ≈ 0 in practice.
• Do other countries want a U.S. “double dip” ?
15
Is the currency war metaphor applicable?



continued
Economic historians have decided
competitive devaluation under 1930s
conditions was not a problem after all.
True, countries couldn’t all devalue
against each other,
But they could and did all devalue against gold
• which worked to ease global monetary policy,


just what was needed.
The same was needed in 2008-09

and Fed easing supplied it.
16
Is the currency war metaphor applicable?

continued
The currency war talk
-- especially the criticism of US monetary policy --
seems to forget the point of floating rates:
• Different countries will generally have
different needs at any point in time

e.g., high unemployment in US & European periphery,

while China & Brazil & India are overheating.
17
Inflation has recently crept up in many
of the major emerging markets
18
Goldman Sachs BRICs Monthly, Feb.18, 2011
In the advanced economies, by
contrast, inflation is still low
Goldman Sachs
19
BRICs Monthly,
Feb.18, 2011
Chinese inflation
reached 8% in 2008
and climbed back up
to 4.9% as of Feb.2011
Source: WSJ
20
Meanwhile, US core inflation is the lowest in 50 years
21
Jan 2011
Is the currency war metaphor applicable?
continued

The point of a floating rate system:
the US can choose its easy monetary policy
and Brazil its tight monetary system,

with appreciation of US $ vs. Braz. real
accommodating the divergence.

Multilateral cooperation is not necessary for this.
22
Is the currency war metaphor applicable? continued

But other kinds of international cooperation are needed;
• the “war” & 1930s metaphors are not totally misplaced:

Currency war could turn into trade war
• if Congress follows through on legislation to impose (WTO-illegal)
tariffs on China as punishment for non-appreciation.
• Protectionism is a beggar-thy-neighbor policy

unlike monetary expansion.
• Until now, the US & G20 have held the line on protectionism


compared to the milder recessions of 1991 & 2001,
let alone the Smoot Hawley tariff of 1930.
23
Ideally the US & China would reach agreement
on how to address current account imbalances:

China would take some responsibility
• to reallocate its economy away from
exclusive reliance on exports & manufacturing

toward domestic consumption & services,
• health, education, housing, environment, insurance & other services.
• How? By allowing the RMB to appreciate,
• but also by increasing domestic demand.

Meanwhile, the US would also take responsibility.
• The US should take steps today to lock
in a future return to fiscal responsibility,

e.g., by putting Social Security on a firm footing.
24
Bottom line on currency war metaphor

The metaphor is not fully appropriate.

Yes, China finds uncomfortable
the pressure of capital inflows,
• which is indeed increased by US monetary ease.

But this is a far more legitimate way
to let China feel the pressure to appreciate
than are US threats of WTO-illegal tariffs.
25
Intervention in emerging markets
to fight currency appreciation

Who is doing how much?
• It is not enough to look at increases in FX reserves.
• The question:
for a given increase in Exchange Market Pressure
(EMP), how much does the central bank absorb as an
rise in the value of currency (exchange rate) versus
how much as an increase in the quantity (reserves).

How much should it intervene, vs. appreciate?
• What can we learn from recent crises?
26
Capital flows to emerging markets, especially Asia,
recovered quickly from the 2009 recession.
These countries again show big balance of payments surpluses
Goldman Sachs
27
The 4th wave of inflows was reflected as an increase
in Exchange Market Pressure
on all Asian countries in 2010,
Singapore & Korea the most.
EMP is defined
as the sum
of currency
appreciation
plus
increase in
Reserves (Net
Foreign Assets)
as a fraction of
Monetary Base.
Goldman Sachs
28
Global Economics Weekly 11/07
Feb.16, 2011
Singapore has taken the inflows
heavily in the form of reserves,
while India & Malaysia in 2010 took the inflows
in the form of currency appreciation.
↑ moremanaged
floating
High EMP
less-managed floating
Low EMP
(“more appreciation-friendly”)
→
29
GS Global ECS Research
China gets the most attention,
partly because it is so large in trade and
partly because it absorbs most of its Exchange Market
Pressure as FX intervention, rather than appreciation
%
30
Korea (& Singapore & Taiwan PoC) are also
adding heavily to reserves.
GS Global ECS Research
31
In Asia since 2008, India, followed by Indonesia,
have had the greatest tendency to float, given EMP;
Hong Kong & Singapore the least, followed by Malaysia & China.
32
Goldman Sachs Global Economics Weekly 11/07
Feb. 16, 2011
India, Indonesia, & China
are in danger of overheating
=> Indonesia
& India have
done right
to allow
appreciation.
GS
Global Economics
Weekly No. 11/08,
Feb. 23, 2011
33
In Latin America, renewed inflows
are reflected mostly as reserve accumulation in Peru,
but as appreciation in Chile & Colombia.
more-managed floating
less-managed floating
(“more appreciation-friendly”)
34
GS Global ECS Research
If a country faces an increase in
exchange market pressure, should it
appreciate? Or intervene?

It is the old debate over floating
versus fixed exchange rate.

What can we learn about the answer
from recent crises?
35
Two lessons from the 1990s emerging
market currency crises

Advantages of floating:
• Speculators don’t have a target to shoot at;
• Accommodate shocks;
• Discourage unhedged $ liabilities.

Advantages of holding forex reserves
• Reduces danger of crisis.

How did these lessons fare in the 2008-10 crises?
36
The variables that show up as the strongest predictors of
country crises in 83 pre-2009 studies:
(i) low reserves and (ii) currency overvaluation
0%
10%
20%
30%
40%
50%
60%
70%
Reserves
Real Exchange Rate
GDP
Credit
Current Account
Money Supply
Budget Balance
Exports or Imports
Inflation
Early Warning Indicators
Equity Returns
Real Interest Rate
Debt Profile
Terms of Trade
Political/Legal
Contagion
Capital Account
External Debt
% of studies where leading indicator was found to be
statistically signficant
(total studies = 83, covering 1950s-2009)
37
Source: Frankel & Saravelos (2010)
Best and Worst Performing Countries -- F&S (2010), Appendix 4
GDP Change, Q2 2008 to Q2 2009
Lithuania
Latvia
Ukraine
Estonia
Macao, China
Russian Federation
Bottom 10
Georgia
Mexico
Finland
Turkey
Australia
Poland
Argentina
Sri Lanka
Jordan
Indonesia
To p 10
Egypt, Arab Rep.
Morocco
64 countries in sample
India
China
-25%
-20%
-15%
-10%
-5%
0%
5%
38
10%
Table Appendix 7
Coefficients of Regressions of Crisis Indicators on Each Independent Variable and GDP per Capita* (t-stat in parentheses)
bolded number indicates statistical signficance at 10% level or lower
F & Saravelos
(2010):
Multivariate
Exchange
Market
Pressure
Currency % Recourse to
Changes
IMF
(H208-H109
(SBA only)
Equity
%Chng
(Sep08Mar09)
Equity %
Chng
(H208H109)
S ignif ic a nt
a nd
C o ns is t e nt
S ign?^
Independent Variable
R
E
S
E
R
V
E
S
Reserves (% GDP)
0.164
(3.63)
0.087
(2.98)
-1.069
(-1.66)
0.011
(0.12)
0.010
(0.14)
Yes
Reserves (% external debt)
0.000
(1.06)
0.000
(1.1)
-0.006
(-2.29)
0.000
(1.81)
0.000
(2.65)
Yes
Reserves (in months of imports)
0.004
(2.25)
0.003
(1.95)
-0.119
(-3.01)
0.006
(1.32)
0.009
(2.32)
Yes
M2 to Reserves
0.000
(0.27)
0.000
(0.76)
-0.044
(-0.91)
0.000
(0.02)
-0.000
(-0.09)
-0.000
(-1.97)
-0.000
(-4.22)
0.000
(2.13)
-0.001
(-2.89)
-0.001
(-3.11)
Yes
-0.440
(-5.55)
-0.210
(-3.19)
1.728
(2.15)
-0.182
(-1.24)
-0.185
(-1.61)
Yes
-0.475
(-3.96)
-0.230
(-2.47)
2.654
(2.56)
-0.316
(-1.71)
-0.316
(-2.1)
Yes
GDP growth (2007, %)
-0.000
(-0.2)
0.001
(0.94)
0.070
(2.58)
-0.001
(-0.1)
-0.007
(-0.71)
GDP Growth (last 5 yrs)
-0.003
(-0.81)
0.000
(0.26)
0.084
(2.4)
-0.003
(-0.26)
-0.014
(-1.15)
GDP Growth (last 10 yrs)
0.000
(0.14)
0.001
(0.43)
0.064
(1.66)
-0.012
(-0.67)
-0.020
(-1.12)
Change in Credit (5-yr rise, % GDP)
-0.021
(-0.36)
-0.035
(-0.98)
0.552
(1.02)
-0.274
(-2.97)
-0.248
(-4.13)
Change in Credit (10-yr rise, % GDP)
-0.017
(-0.93)
-0.011
(-1.05)
0.210
(1.03)
-0.089
(-1.65)
-0.089
(-2.35)
Credit Depth of Information Index (higher=more)
-0.008
(-1.06)
0.000
(0.05)
0.224
(2.4)
-0.006
(-0.37)
-0.018
(-1.33)
Bank liquid reserves to bank assets ratio (%)
0.000
(3.84)
0.000
(0.5)
-0.000
(-11.44)
-0.002
(-0.54)
-0.002
(-0.79)
Yes
0.001
(1.48)
0.002
(2.7)
-0.023
(-2.09)
0.009
(3.84)
0.007
(3.95)
Yes
Current Account, 5-yr Average (% GDP)
0.000
(0.48)
0.001
(1.82)
-0.025
(-1.72)
0.007
(2.4)
0.006
(2.74)
Yes
Current Account, 10-yr Average (% GDP)
0.000
(0.14)
0.002
(1.39)
-0.035
(-2.11)
0.008
(2.21)
0.007
(2.44)
Yes
Net National Savings (% GNI)
0.002
(1.6)
0.001
(2.33)
-0.013
(-1.22)
0.006
(2.92)
0.004
(2.28)
0.003
(2.01)
0.001
(2.53)
-0.015
(-1.36)
0.008
(3.42)
0.006
(3.03)
Short-term Debt (% of reserves)
R
E
E
R
G
D
P
C
R
E
D
I
T
REER (5-yr % rise)
REER (Dev. from 10-yr av)
Current Account (% GDP)
C
U
R
R
E
N
T
A
C
C
O
U
N
T
ST Debt/Res
Gross National Savings (% GDP)
PPP
CA/GDP
NS/GDP
Yes
39 Yes
Yes
Reserves


Even though many developing & emerging market
countries described themselves as floating,
most took advantage of the boom of 2003-2008
to build up reserves to unheard of heights,
• in the aftermath of the crises of 1994-2001.

in contrast to past capital booms (1975-81, 1990-97).
40

When the 2008-09 global financial crisis hit,
• those countries that had taken advantage of
the 2003-08 boom to build up reserves did better.



E.g., Obstfeld, Shambaugh & Taylor (2009)
Frankel & Saravelos (2010),
This had also been the most common finding
in the many studies of Early Warning Indicators
in past emerging market crises.
41
Poland, the only continental EU member with a floating
exchange rate, was also the only one to escape
negative growth in the global recession of 2009
% change in GDP
Poland
Lithuania
Latvia
Estonia
Slovakia
Czech Republic
2006
2007
2008
2009
2010
6.2 6.8 5.1 1.7 3.5f 7.8 9.8 2.9 -14.7 -0.6f 12.2 10.0 -4.2 -18.0 -3.5f 10.6 6.9 -5.1 -13.9 0.9f 8.5 10.6 6.2 -4.7 2.7f 6.8 6.1 2.5 -4.1 1.6f Exchange Rate
Floating
Fixed
Fixed
Fixed
Euro
Flexible
Source: Cezary Wójcik, 2010
Hungary
3.6 0.8 0.8 -6.7 (de facto)
42
0.0f Flexible
The Polish exchange rate increased by 35%.
Depreciation boosted net exports; contribution to GDP growth > 100%
4,7
Source:
Cezary Wójcik
28,0
4,5
zlotys / $
23,0
4,2
Contribution of Net X to GDP:
4,0
2009: 2,5
3,4
3,2
GDP growth rate:
3,7
3,5
3,4
18,0
1,7
kroon / $
Estonia
13,0
lats / $
Latvia
3,2
8,0
I
III
V
VII
IX
XI
I
III
V
VII
IX
XI
I
III
V
VII
IX
43
2008
2009
2010
New lesson regarding exchange rate regimes

Old conventional wisdom: The choice was between
• fixing (changes in reserves; not in exchange rate) vs.
• floating (changes in exchange rate; no reserves).

Now it appears that:
• Intermediate regimes are indeed viable.
• Holding reserves
and floating are both useful.
44
45