Saturday, November 14, 2015

Currency wars turning into policing by central banks?

There has been a hope for a return to fundamentals in the foreign exchange markets with a decline in foreign currency reserve buying. In the last 12 years the foreign currency reserves held by central banks has increased by a factor of 6x from $2 trillion to $12 trillion as measured by the IMF's COFER data, but that flow has been changing with declines in reserves as central banks have sold reserves to arrest currency declines.

The return to fundamentals has come back with a vengeance for many countries. Falling commodity prices, capital outflows, declining economic growth have all led to declining currencies not as a means of enhancing exports but as a reflection of poor economics. The result may be a change in the terms of trade and exports but not because of anything central banks have done.

The currency war of the last decade of using foreign reserves to stop appreciation is now being reversed to a war of controlled declines. Foreign reserves are being used as a buffer stock to control short and medium term fluctuations in currencies. Arguably this can be considered good policy for small economies that are appreciably affected by trade. The investment impact of capital flows can be dampened and the currency impact on both exports and importers can be reduced. 

The marginal use of foreign reserves to dampen extreme fluctuations can be viewed as police actions between countries as opposed to currency wars. By policing extreme behavior, central banks hope to avert more dramatic actions. The traditional liberal view may not have room for currency policing but with market extremes it may offer some economic stability. However, make no mistake, the slowing of growth around the world can easily turn policing of extremes into another round of currency war to boost anemic economies.

No comments: