There will be wars and rumours of wars

THE Brazilian finance minister’s talk of “currency wars” last week seems to have set the agenda. Dominique Strauss Kahn, the head of the IMF, told the FT that talk of currencies being used as a policy weapon “would represent a very serious risk to the global recovery.”

In the same issue of the FT, Martin Wolf, who has been taking an aggressive line on a number of subjects, cheers on the idea of a currency war with China while John Plender worries about the effect of currency policy on international co-ordination.

It seems not that long ago that the G20 countries were in general agreement on the need for fiscal stimulus. With an IMF meeting at the weekend, one might hope for a similar agreement, like the Plaza or Louvre accords of the 1980s. But as David Bloom, the currency strategist at HSBC, remarks:

The US and Europe seem to think global imbalances are all down to China’s refusal to allow its currency to go higher. China does not seem to agree and, at best, might accept an increase in the very modest rate of strengthening, a move that is unlikely to appease its critics.

Could all this turn into something more serious? A China trade bill (the Currency Reform for Fair Trade Act) did pass the House but not the Senate and everything is now on hold for the mid-term elections. Protectionism has been more a Democrat than a Republican issue but the bill could be adopted again next year. China itself has imposed a tariff on American chickens, a move that will hardly calm the situation.

Martin Wolf’s column prefers an approach based on the capital account, particularly a plan whereby surplus countries wouild be prevented from purchasing financial instruments in deficit countries, unless the surplus countries offered unfettered access to their own capital markets (China imposes strict capital controls). This idea comes from Daniel Gros at the Centre for European Policy Studies.

The plan set me back a bit; it reminded me of my sister’s letter to her bank manager threatening “to take her overdraft elsewhere”. I am not clear that it would work in practice. China accumulates dollars as a result of its trade surplus so it would have to do something with them. It could hold the money in US banks, but such banks might then be vulnerable to an outflow of hot money. Or it could accumulate private sector assets, except that the US hasn’t been keen on that option in the past either (blocking the Conoco deal, for example).

The Chinese could sell the dollars but given the size of their positions, they would probably have only two options; buying the euro or the yen. Neither the Japanese nor the Europeans would be very keen on this, since it would drive their currencies higher. They might feel this was as much of a war on them as on China.

And while the US might welcome a weaker dollar if this was the result, what about the effect on bond yields? Mr Gros writes that “this is a large and liquid market, meaning that other buyers would come forward and the interest rate paid on the US debt might not increase by much”.

This seems a rather blithe assumption. Higher bond yields would make the deficit much worse and would increase the cost of capital for US industry and homeowners.

Still, it is interesting to see the debate heading in this direction. Economists have long talked of the trilemma; one can have a fixed exchange rate, free-flowing capital and an independent monetary policy, but not all three. Post-1971, much of the developed world abandoned fixed exchange rates in order to have the other two. But the Bretton Woods system worked quite well for a while with fixed exchange rates and capital controls.

Perhaps, given the financial crisis and China’s role as dominant global creditor, a world where capital movements are restricted might be the way we are heading. Brazil made a very modest attempt in this direction this week with an increase in the levy on fixed interest inflows. Brazil is discovering that one of the penalties of economic success is an overshooting exchange rate.