Note: In one of our class on NISM currency derivatives a NISM exam aspirant inquired about the Bank of Japan’s announcement of doubling money supply and its after-effects. This leads to some good discussion and we thought to share our points of view in a refined way to help other students and professionals. So, test the impact of the cold war weaponry…..

Currency War: Devaluation of Currencies

A currency war sounds weirdly abstract, like a game played by rival politicians – but it can have devastating effects in the real world. It is a condition in international affairs where countries compete against each other to achieve a relatively low exchange rate for their own currency. This policy is also referred to as “Beggar Thy Neighbour”.

However, the emergence of currency wars came from different sets of policies. The huge stimulus from developed economies’ central banks flooded the markets with their currencies leading to lower value of their currencies. This concern especially picked up in Sep-2010 when it became apparent that Fed would initiate another round of quantitative easing (or QE2). Brazilian Finance Minister Guido Mantega termed the practice of trying to keep currencies undervalued as ‘Currency War’ and this sentiment picked up after his comments.

It can be defined as competitive devaluation of a country’s own currency so that exports become more competitive and imports become costly. As a result imports are expected to reduce and exports are expected to go up. As a further result, employment within the country goes up and employment in the competing country may go down. The country which devalues its currency may get net trade surplus (exports more than imports) and its foreign exchange reserves go up.

Mechanism of Currency Devaluation: How it works?

In order to understand the mechanism and outcome of the currency devaluation game – let’s imagine a pair of brothers together owns a honey-making business in Lahore, (undivided) India. After the partition, one brother decided to move to India, just a few miles away to Amritsar, while the other one decided to stay back – so they divide the company in two.

Now, assume that both businesses make the same honey, sold in a 1 Kg. jar; priced the same, Rs. 1 per jar. When the partition happened and the brothers moved apart, the Indian and Pakistani Rupees were at parity, so a jar of honey – regardless of where it was made – was worth both 1 INR and 1 PKR.

All goes well, until….CURRENCY DEVALUATION! The brothers wake up, and find that 1 PKR is now worth just 0.50 INR! Or, to put it another way, 1 INR is worth 2 PKR. And now an Indian consumer can buy two jars of Pakistani honey as his 1 INR will now buy him 2 PKR.

The currency devaluation allows him to get two jars of honey for the price of one. It is great news for Indians, as it is a good deal; and it is great news for the Pakistani honey company, also, since the cheap Pakistani currency has allowed it to boost its share of the market.

But this is really bad news for the elder brother and his Indian honey company as he can’t afford to compete in given situations. Unless the government does something to weaken the INR, he’s going to go out of business, which means he’ll have to lay off honey workers and sell off those bees. And this will be happening all over the country, eroding India’s manufacturing base and accelerating unemployment.

History of Currency Devaluation
An important episode of currency war occurred in the 1930s. As countries abandoned the Gold Standard during the Great Depression, they used currency devaluations to stimulate their economies. Since this effectively pushes unemployment overseas, trading partners quickly retaliated with their own devaluations. The period is considered to have been an adverse situation for all concerned as unpredictable changes in exchange rates reduced overall international trade.

Following the turmoil of 2007-08 crisis, states engaging in competitive devaluation have used a mix of policy tools, including direct government intervention, the imposition of capital controls, and, indirectly, quantitative easing. As the price to buy a particular currency falls so too does the real price of exports from the country. Imports become more expensive. So domestic industry, and thus employment, receives a boost in demand from both domestic and foreign markets. However, the price increase for imports can harm citizens’ purchasing power.

This policy can trigger retaliatory action by other countries which in turn can lead to a general decline in international trade, harming all countries. While many countries experienced undesirable upward pressure on their exchange rates and took part in the on-going arguments, the most notable dimension of the 2010-11 conflict was the rhetorical conflict between the United States and China over the valuation of the Yuan.

Recent Woes
Japan has also joined the money printing spree like its peers from the developed world. The Bank of Japan (BoJ), in a statement released on April 4, 2013, said, “The Bank will achieve the price stability target of 2% in terms of the year-on-year rate of change in the consumer price index (CPI) at the earliest possible time, with a time horizon of about two years. It will double the monetary base.”

In plain language what the statement means is that the BoJ will try and create an inflation of 2% in the earliest possible time with an overall limit of two years.

Japan’s decision of doubling its money supply to $2.71 trillion in order to propel its economy out of two decades of stagnation eventually devaluing her currency, sparked concern of a possible second 21st century currency war breaking out, this time with the principal source of tension being not China versus the US, but Japan versus the Eurozone and other Asian nations.

Rationale behind this megalomania
For the period of three months ending December 2012, the Japanese economy grew by a minuscule 0.5%. In three out of the four years for the period between 2008 and 2011, the Japanese economy has contracted. To get over this, Japanese politicians have wanted to create some inflation so that people will start spending again.

The question is how will this inflation be created?
The BoJ plans to print Yen and double the money supply in the country. This money will be pumped into the financial system by the BoJ buying various kinds of bonds, including government bonds and exchange-traded funds from Japanese banks and other financial institutions. Banks can then go ahead and lend this money. As an increased amount of money chases the same amount of goods and services, the hope is that prices will rise and some inflation will be created. And this will put an end to the deflationary scenario that has prevailed over the last few years.

So by trying to create some inflationary expectations in Japan the idea is to get consumption going again and help the country come out of a more than two-decade-old recession. With prices of things going up people are more likely to buy now than later and thus economic growth can be revived.

There is another angle to this entire idea of doubling money supply, and that is to cheapen the Yen against the Dollar. As the BoJ starts printing the Yen to create inflation, there will be more Yen in the market than before. And this will lead to a fall in the value of the Yen against other currencies. A greater price competitiveness will ensure that exports pick up and that in turn will help revive economic growth. At least that’s how things are supposed to work in theory.
Neighbours, those are wary of becoming beggar…

The Japanese currency, the Yen, has dropped by 25% in value since the last government was voted in power in November 2012 as they pledged to kick start the economy by creating demand devaluing their currency. This has already given a major boost to Japanese goods and services. There is little confidence that the Yen will stop here as the government pursues an inflation rate of about 2% a year in order to end deflation and stimulate consumer spending.

With the price of Japanese exports becoming daily more attractive, neighbouring countries are weighing their options, and devaluing their own currencies is at the top of many lists. There is a good deal of outrage and anger among Japan’s neighbours. Not only neighbouring nations but even billionaire investor George Soros also criticize the Abe government and said, “If the Yen starts to fall, which it has done, and people in Japan realize that it is liable to continue, and want to put their money abroad, then the fall may become and avalanche.”

Although some of the strongest criticism of the Japanese program has come from China, the impact is unlikely to be felt as strongly there as in other parts of Asia. Most Chinese exports do not compete directly with Japanese products. Indeed, some Chinese companies may benefit from importing cheaper Japanese components.

The prospects for South Korea, whose manufactured goods from cars to washing machines do compete directly with Japanese brands, are much more troubling. About 60% of South Korea’s GDP comes from exports and the Seoul government has said it is very worried by the probable fallout from the Japanese stimulation program.

The barometer of currency values is also being watched carefully among the exporting countries of Southeast Asia.

Where it could go wrong?
In fact, by wanting to double money supply by printing the Yen, the BoJ is only doing what various other central banks around the world have already been up to. The Federal Reserve of United States has expanded its balance sheet by 220% since early 2008. The Bank of England has done even better at 350%. The European Central Bank came to the party a little late and has expanded its balance sheet by around 98%. The BoJ has been rather subdued in its money printing efforts and has expanded its balance sheet only by 30% over the last four years.

What is apparent that central banks can print all the money they want, they can’t dictate where it goes? Central banks which have tried this path have managed to create very little inflation and economic growth. The money that they have been printing is being borrowed by large institutional investors at close to 0% interest rates and being invested in all kinds of assets all over the world into speculative oil futures, luxury real estate in major financial capitals, and other non productive investments.

So the question is what stops all the money that will be printed in Japan from meeting the same fate, as the money that was printed by other central banks? And the answer is, Nothing.

With the BoJ expected to buy all kinds of bonds from banks and other financial institutions, it means that the financial system will be flush with money. This along with a depreciating Yen is expected to unleash a massive Yen carry trade.

Investors will borrow in the Yen at very low interest rates and invest it in various kinds of financial assets all over the world. This is called carry trade because investors make the carry – i.e. the difference between the returns they make on their investment (in bonds or even in stocks for that matter) and the interest they pay on their borrowings in the Yen. This money will be invested in all kinds of financial assets around the world.

What is the fate of such printing mania?
This stance of easy monetary policies has already been greatly criticized. Huge monetary accommodation by developed economies is being blamed for sharp surge in commodity prices elevating inflation levels globally. This has been sharply criticized by developing economies who have recovered smartly from the crisis but growth prospects are being hurt by inflation. Hence, any more monetary accommodation via the currency route is not going to be appreciated.

The BOJ says it just wants to get inflation to 2%. It says it will buy assets with money that didn’t exist previously…and keep buying…until inflation reaches 2%.

Then what? Well, we guess it will stop. And then what? Will the economy collapse when the money-printing stops? Or will the economy pick up…and the banks begin to lend…and the people go on a spending binge? Or will investors all over the world dump their Yen back onto the home islands…eager to get out of the Japanese paper money before inflation levels get out of control?

We don’t know. But neither do the Japanese nor for that matter other central bankers. As Reuters describes it is a ‘radical gamble’ and for a central bank to make a ‘radical gamble’ bespeaks desperation and lunacy.