THE THREAT OF 'CURRENCY WARS': A EUROPEAN...

ISSUE 2010/12 DECEMBER 2010 THE THREAT OF

'CURRENCY WARS': AEUROPEAN PERSPECTIVE

ZSOLT DARVAS AND JEAN PISANI-FERRY

Highlights

• The so-called ‘currency war’ is manifested in three ways: 1) the inflexiblepegs of undervalued currencies; 2) attempts by floating exchange-ratecountries to resist currency appreciation; 3) quantitative easing.

• Europe should primarily be concerned about the first issue, which relates tothe renewed debate about the international monetary system.

• The attempts of floating exchange-rate countries to resist currency apprecia-tion are generally justified while China retains a peg.

• Quantitative easing cannot be deemed a ‘beggar-thy-neighbour’ policy aslong as the Fed’s policy is geared towards price stability. Current US inflatio-nary expectations are at historically low levels.

• Central banks should come to an agreement about the definition of price sta-bility at a time of deflationary pressures.

• The euro’s exchange rate has not been greatly impacted by the recent cur-rency war; the euro continues to be overvalued, but less than before.

This Policy Contribution was prepared as a briefing paper for the European Par-liament Economic and Monetary Affairs Committee’s Monetary Dialogue, entit-led ‘The threat of ‘currency wars’: global imbalances and their effect oncurrencies,’ held on 30 November 2010. Christophe Gouardo and Lucia Granelliprovided excellent research assistance. Bruegel gratefully acknowledges thesupport of the German Marshall Fund of the United States to researchunderpinning this publication.

Telephone+32 2 227 4210 [email protected]

www.bruegel.org

BRU EGE LPOLICYCONTRIBUTION

THE THREAT OF 'CURRENCY WARS':A EUROPEAN PERSPECTIVEZSOLT DARVAS AND JEAN PISANI-FERRY, DECEMBER 2010

itself from gold, in effect trying to export its unem-ployment. But it became evident that not every-body can have a weak currency at the same time.A major lesson from the 1930s is that one of theroles of the multilateral system is to prevent futilebeggar-thy-neighbour depreciation.

Two years have passed since the high point of thefinancial crisis in September 2008. It would seemthe same chain of events is being set in motion,with the same time lag. This reading is however toosimplistic. As Avent (2010) has observed, the cur-rent situation is not one of ‘war’ between coun-tries. Rather, countries face different challengesand policies carried out to achieve domestic eco-nomic goals differ. This in turn directly or indirectlyimpacts other countries through exchange ratedevelopments. But exchange rate movements canbe, and in some important respects are, part of anappropriate response to the asymmetric charac-ter of the current challenges.

Indeed, whereas the Great Recession of 2008-09was mostly a common shock affecting all majorcountries simultaneously, its aftermath has beenhighly asymmetric. Major asymmetries are seenbetween advanced and emerging/developingeconomies. Advanced countries are still strug-gling with the fallout from the financial crisis, butemerging and developing economies are againthriving. However, neither the advanced nor theemerging country groups are homogenous. Forexample, in the US damage to the supply-sideseems to be limited, but private demand contin-ues to be dented by the extent of household lever-age. In Europe pessimism about the supply-sideprevails, while private demand has on averagebeen hit to a lesser degree than in the US.

The existence of asymmetries does not rule outthe possibility of beggar-thy-neighbour

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BR U EGE LPOLICYCONTRIBUTION THE THREAT OF 'CURRENCY WARS': A EUROPEAN PERSPECTIVE Darvas and Pisani-Ferry

WHILE EMERGING COUNTRIES recover reasonablyquickly from the crisis, the recovery in advancedcountries has been unspectacular, and unem-ployment has risen significantly, especially in theUnited States and the crisis-affected Europeancountries. The US, the country with largest current-account deficit, continues to stimulate its econ-omy using monetary tools, weakening the USdollar and all currencies that are tied to the USdollar. As a by-product of US monetary policy, cap-ital flows to emerging countries with open capitalaccounts have accelerated, pushing up theircurrencies. This is thought to threaten economicrecovery in emerging economies and has resultedin various actions to limit appreciation. Japan andSwitzerland have also intervened in the foreign-exchange market, while the UK’s quantitativeeasing has a downward pressure on sterling. Butnot all currencies can be weak at the same time.

In this context, this Policy Contribution aims to:

• Clarify the currency war(s) debate and toassess its significance;

• Discuss the motives behind national policyresponses;

• Assess the implications for the euro area.

1 CURRENCY WARS: HOW SIGNIFICANT?

1.1 The issue

In October 2010, Brazil's finance minister GuidoMantega captured the spirit of the time when hespoke of currency war. The expression is reminis-cent of the 1930s, when the major currenciesrelinquished the Gold Standard in an uncoordi-nated way. Then, it took two years after the crash,from October 1929 to September 1931, for Britainto sever sterling’s link to gold and set in motion acurrency war. One country after another detached

competitive depreciations in the context of weakglobal demand. But it does imply that divergencesin policy approaches and the correspondingexchange-rate movements cannot by themselvesbe taken as signs of non-cooperative behaviour.We will continue to speak of ‘currency war’,because this is the commonly used expression inthis debate, but we want to point out from theoutset that the expression can be misleading.

1.2 Policy measures impacting currencymovements

When discussing the 'currency war', it is importantto distinguish three main issues:

• The decade-long dispute over the managementof currencies pegged to the US dollar, first andforemost the Chinese renminbi, but also thecurrencies of other exporters of manufacturedgoods and oil producers;

• Recent attempts by a number of floatingexchange-rate countries to depreciate theircurrencies or at least to resist appreciation;

• Unconventional monetary policy measures,such as the announcement by the US FederalReserve of a new programme of asset pur-chases (known as QE2 – quantitative easing2) which may impact on the exchange rate ofthe US dollar vis-à-vis all floating currencies,including the euro and other Europeancurrencies.

The first of these issues, the US-China exchangerate debate, dates back at least to the middle ofthe last decade. The issue is if China’s exchange-rate policy amounts to a subsidy for its exportsector. China has maintained a peg to the US dollar,except for a period from 2005 to 2008 when Chinaallowed its currency to rise 17 percent against thedollar, but this nominal appreciation seems verylimited against the background of rapid economiccatching-up. China has accumulated and contin-ues to accumulate huge foreign-exchangereserves. These developments suggest that theChinese real exchange rate is indeed undervalued.We will not expand on the issue here because ithas been extensively studied elsewhere, but it

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BR U EGE LPOLICYCONTRIBUTIONDarvas and Pisani-Ferry THE THREAT OF 'CURRENCY WARS': A EUROPEAN PERSPECTIVE

should be noted that China’s exchange-rate policyis relevant for the broader currency war debate inthree important respects. First, China is a signifi-cant player in the world economy and its policystrongly affects the pace and magnitude of therequired global rebalancing that the IMF (2010b)has called for. Second, China’s exchange-ratepolicy has major implications for the policies ofother emerging and developing countries; as longas the renminbi does not appreciate, other coun-tries do not want their currencies to appreciateeither. Third, the bilateral China-US relationship isparticularly sensitive and there is a risk that thetense discussion over exchange rates at somepoint spills over into the trade field.

The second issue – measures to counter appreci-ation – concerns a large number of countries.Table 1 lists various kind of recent (mostlybetween August and October 2010) attempts toslow down currency appreciation, including actualinterventions, suspected interventions and oralinterventions. The fact that 20 countries areincluded in the table indicates that recentattempts to depreciate home currencies havebeen widespread.

Table 1: Recently adopted policy measures toresist currency appreciation or favour deprecia-tion in countries with a flexible exchange-rateregime

Type of intervention Country

Intervention

Argentina, Colombia, Egypt,Indonesia, Israel, Japan,Peru, Poland, Romania,Russia, South Korea, Switzer-land, Ukraine

Intervention fears Brazil, Chile, Thailand

Intervention talk India

Suspected intervention Philippines, Taiwan

Adjustment in reserverequirements

Turkey

Source: Adapted from Kaminska (2010).Note: Australia was included in Kaminska (2010) as a countrythat has intervened in the foreign-exchange market, but theintervention by the Reserve Bank of Australia in May 2010aimed at strengthening the currency and we have thereforeexcluded this case. Most measures were introduced betweenAugust and October 2010. Countries with pegged currencies,such as China, are not included.

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Intervention is only one way for countries to limitthe impact of capital inflows. Increasingly, gov-ernments also rely on an array of capital-controlmeasures (Table 2).

The third issue – unconventional monetary policymeasures – came to the fore after the announce-ment in November 2010 by the Federal OpenMarket Committee of a $600bn asset-purchaseprogramme (QE2). This was widely seen in Europeand in the emerging world as an attempt to depre-ciate the US dollar. It prompted a series of nega-

tive reactions from senior policymakers in Europe,China and several emerging countries. AlthoughBernanke (2010) emphasises that “the best wayto continue to deliver the strong economic funda-mentals that underpin the value of the dollar, aswell as to support the global recovery, is throughpolicies that lead to a resumption of robustgrowth”, the Fed’s policy continues to be disputed.This raises the question of how to determine whena monetary policy conducted in a floatingexchange-rate regime context can be considered‘beggar-thy-neighbour’. While the current empha-sis is on the Federal Reserve, the Bank of Englandand the Bank of Japan have also adopted similarmeasures in the past year (Table 3). The EuropeanCentral Bank’s purchase of periphery euro-areasovereign bonds is primarily aimed at improvingthe liquidity of these particular government bondmarkets and is deliberately sterilised, so it cannotbe regarded as a way to stimulate the economy.

1.3 Exchange rate developments

With this background in mind, we now turn toassessment. How significant are recent exchangerate movements? To shed light on this, we scruti-nise exchange rate developments from a medium-term (1995-2010) perspective. The mostreasonable benchmark for assessing the value ofa currency is a comparison to its equilibriumvalue. Unfortunately, methods for calculating equi-librium exchange rates all suffer from weaknessesand lead to largely diverse results: for example,

Table 2: Examples of capital controls andrelated measures

Country Measures taken or considered

Brazil

Two increases in October of the financialoperations tax (IOF) applicable toincoming foreign investment in fixed-income instruments and funds.

Increased tax on margin deposits forderivative contracts of non-residents,aimed at reducing the profitability andvolumes of foreign-exchange contracts.

IndonesiaAnnouncements by the government of aminimum holding period for centralbank bills.

South Africa

Reserve accumulation, loosening ofexchange controls for capital outflowsof residents and raising of the maxi-mum investment authorised overseas.

South Korea

Bill submitted by South Korean lawmak-ers in November to impose a 14 percentwithholding tax on interest income onbonds bought by foreign investors aswell as a 20 percent capital-gains tax.Auditing of banks handling foreignderivative contacts.

Specific measures announced in July tomitigate the volatility of capital flows:ceilings on FX derivative positions ofbanks, regulations on the use of foreigncurrency loans, tightening of regulationon foreign currency liquidity of banks.

Thailand

Introduction of a 15percent withholdingtax in October, applicable to interestincome and capital gains on Thai debtfor foreign investors. Officials haveannounced that they are studying theuse of levies to control capital inflows,but not for short-term use.

Source: IIF, Financial Times, Reuters.

Table 3: Unconventional measures by majorcentral banks

No expansionof base

money (quali-tative easing)

Expansion ofbase money

(quantitativeeasing)

Purchase of privateassets (crediteasing)

ECBBoE, BoJ, Fed,

SNB

Purchase ofgovernment bonds

ECB BoE, BoJ, Fed

Purchase of foreign-currency assets

BoJ, SNB

Source: Adapted and updated from Meier (2009).

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estimates presented in Evenett (2010) suggestthat the Chinese renminbi’s undervaluationranges between zero percent and 50 percent. Therecent estimates by IMF (2010b) for major G20regions are shown in Table 4.

Table 4 indicates asymmetries. Advanced coun-tries are estimated to be somewhat overvalued,while other emerging countries (Russia, SouthAfrica and Turkey) are substantially overvalued,Asia is substantially undervalued, and the resultsfor Latin America vary between models.

There are also likely asymmetries within eachregion. Country-specific data is unfortunately notavailable, but, for example, it is likely that the eurois much more overvalued than the British pound,or that the Brazilian real is more overvalued thanthe Argentine peso.

Lacking proper and up-to-date country-specificmisalignment estimates, we use in the followingsections the index of the real effective exchangerate, which measures the change in the inflation-adjusted exchange rate vis-à-vis the weightedaverage of trading partners compared to a baseperiod.

1.3.1 Medium-term movements

Figure 1 on the next page shows the change in thereal effective exchange rate since January 1995for the 23 countries listed in Tables 1, 2 and 3, plusGermany, Australia and New Zealand (three coun-tries in which there was no intervention aimed atweakening the currency) and China (which pegsits currency to the US dollar). The general impres-sion is that apart from a few exceptions, move-ments over the past few months have not beenout of the ordinary relative to the trends of thepast 15 years. It is more likely that fears over eco-nomic growth and unemployment in a lessdynamic global environment make the currencyissue more acute.

Only some countries can justify complaints aboutsharp appreciations. For example, India experi-enced a steady real appreciation (likely reflectingits economic catching-up) until the collapse ofLehman Brothers in September 2008, when thepace of appreciation speeded up. Another exam-ple is Brazil, which had a rather strong exchangerate before Lehman’s collapse, and faced a sharp,but only temporary depreciation after the Lehmanshock and its current real exchange rate is veryhigh by historical standards.

‘With a few exceptions, exchange-rate movements over the past few months have not been out

of the ordinary. It is more likely that fears over economic growth and unemployment in a less

dynamic global environment make the currency issue more acute.’

Table 4: G20: Assessment of real effective exchange rate (percent deviation frommedium-term equilibrium valuation)

Macroeconomic balanceapproach

Equilibrium realexchange-rate approach

External sustainabilityapproach

Advanced 5.6 2.8 5.1

Asia -14.8 -6.6 -12.6

Latin America 8.9 -1.3 4.5

Other 5.8 12.1 15.0

Source: Table 1 from IMF (2010b).Note: IMF (2010b) indicates that results reported are still a work in progress. Advanced: US, EU, Japan, UK, Canada and Australia);Asia: China, Korea, Indonesia and India; Latin America: Brazil, Mexico, Argentina; Other: Russia, Turkey and South Africa. Theestimates of ‘under’ or ‘over’ valuation of the REER are based on three approaches used by staff to assess misalignments:macroeconomic balance, equilibrium real exchange rate and external sustainability. IMF staff does not assess REER for oilexporters. Unfortunately information is not available about the period to which the misalignment calculations refer to.

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Figure 1: Real effective exchange rates based on consumer prices (July 2007=100), January 1995- November 2010

Source: authors' calculations using data from the IMF International Financial Statistics (USD exchange rates and consumer prices),Datastream (USD exchange rates for periods that are missing from the IMF database), National Statistics of the Taiwan Provinceof China (USD exchange rate and consumer price index for Taiwan).Note: increases in the index indicate real appreciation. The real effective exchange rate is calculated against 143 trading partners,covering, on average, 98.8 percent of foreign trade. Weights are derived on the basis of Bayoumi, Lee and Jaewoo (2006). Thevertical dashed line indicates September 2008. Consumer prices are available till July 2010 in most cases: we have projected theconsumer prices index till November 2010 by assuming that 12-month inflation rate does not change between the latest availableobservation and November 2010. Monthly average exchange rates are used up to October 2010, while the 29 November 2010 ratesare used for November 2010.

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But there are also countries for which the extent ofcurrency appreciation does not seem to be wor-rying when looking at this longer time horizon. Forexample, South Korea’s current real exchange ratelevel is still well below what it was around 2005,which leads some observers, especially in Japan,to claim that Korea’s policy is one of deliberatedepreciation. But Japan’s real exchange rate levelis also not exceptional: even though the Japaneseyen experienced a huge jump from a historicallylow level at the time of the Lehman shock, the cur-rent rate is similar to the average value of aboutan eight-year period between 1996 and 2004.Egypt’s real exchange rate is about 40 percentabove its July 2007 value, but Figure 1 shows thatit also had a historically low value in 2007. Israel’sreal rate is close to its average over the past 15years. Taiwan and especially Argentina long fol-lowed a policy of keeping their currencies downand the crisis has not changed this policy1.

It is also interesting to observe that the Australiandollar’s current real rate is well above the valuesobserved in the past 16 years, but despite thisdevelopment Australia has not been regarded asa participant in the recent ‘currency war’.

All in all, our assessment shows that the recentchanges in real effective exchange rates are notsignificant enough by themselves to justify speak-ing about a serious currency war. But they aresubstantial enough to bring to the fore the morefundamental issue of Chinese exchange rate fixityand capital controls, and those of a few otheremerging countries in the current feeble globaleconomy, since resumed capital flows to emerg-ing countries now disproportionately impact someof those countries that have no or minor restric-tions on capital inflows.

1.3.2 Advanced versus emerging countries

So far we have computed trade-weighted realeffective exchange rates for individual countriesin relation to 143 other countries of the world. It isalso possible to construct an effective exchangerate index between two groups of countries.Gouardo and Pisani-Ferry (2010) construct the

index between two blocs of countries, ‘advanced’and ‘emerging’. The sample is not comprehensivebut it contains all major countries: it is comprisedof the top 20 countries in terms of total trade(excluding euro-area countries), plus the euroarea. In order to ensure a minimal degree of homo-geneity with respect to the shock of the financialcrisis, the group of advanced countries includesonly western countries plus Japan (countriessuch as Singapore, or South Korea thus fall into theother group)2.

This simple, summary indicator helps to monitorthe evolution of exchange rates betweenadvanced and emerging economies. The ‘effectiveexchange rate of emerging countries againstadvanced countries’ is not simply the inverse ofthe ‘effective rate of advanced countries vis-à-visemerging countries’, due to different weights(Figure 2), though the two series largely mirroreach other.

Figure 2 shows long real exchange rate swingsbetween the two major regions. Emerging coun-tries appreciated until about mid-1997, when aseries of contagious crises (in Asia, Brazil, Russia)pushed their currencies sharply down. Then theyappreciated again until about 2001, when a newwave of emerging market crises (originating inArgentina, Brazil and Turkey) and the depreciation 1. It is also important to

highlight that real exchangerate appreciation is anequilibrium phenomenon incountries that are on acatching-up economicgrowth path. Since mostemerging countries shownare on such a growth path,one should have expected atrend real appreciation, butthis was not the case formany of these countries.

2. Advanced countries(Australia, Canada, EuroArea, Japan, Switzerland,Sweden, United States,United Kingdom) andemerging countries(Brazil, China, Hong Kong,India, Korea, Malaysia,Mexico, Poland, Russia,Saudi Arabia, Thailand,United Arab Emirates).

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Figure 2: Real effective exchange rates betweenemerging countries and advanced countries(based on consumer prices, July 2007=100),January 1995 - November 2010

Source: updated and corrected from Gouardo and Pisani-Ferry(2010). Note: the increase in the index indicates realappreciation. The vertical dashed line shows September 2008.

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of the US dollar pushed them down again. The nextrebound lasted until the summer of 2008, whenemerging countries were close to their previousrecord high levels; this time the sudden stoppingof capital inflows that followed the collapse ofLehman Brothers led again to a fall in theircurrencies. But the rebound was quite quick, mostlikely because previous emerging market criseshad their origins in the unsustainable positions ofcertain emerging countries, while the currentcrisis has originated in the advanced world. Bysummer 2010 the real effective exchange rateindex of the emerging countries was close to thepre-Lehman level. It has depreciated somewhatsince because of a dollar effect: those emergingcountries that tightly peg their currencies to thedollar (China, Hong Kong, Malaysia, United ArabEmirates) have all depreciated vis-à-vis theadvanced countries’ group, while the currenciesof India, Korea, Mexico, Poland and Thailand haveappreciated. While volatility was high duringrecent periods, taking again a historical view,Figure 2 does not suggest that the recent periodwas extraordinary. On the contrary, what isextraordinary is the fact that despite an asym-metric shock of exceptional magnitude, emergingcountries as a group have not appreciatedmarkedly in real terms since summer 2007.

This observation does not exclude that from thepoint of view of individual countries, pressures toappreciate are seen as a threat to competitive-ness and export-led growth. But this signals a col-lective-action problem within the emerging grouprather than excessive appreciation of the group.

1.3.3 A closer look at the euro

So far we have looked at the real effectiveexchange rate of Germany, the largest euro-areacountry. The real effective exchange rate of Ger-many also takes into account intra euro-area tradeand therefore the euro/dollar rate or the effectiveexternal exchange rate of the euro has lesserimpact. But it also makes sense to look at the euroarea as a whole and to analyse the euro’s externalnominal and real exchange rate3.

Let us start with the nominal exchange rate of theeuro against the dollar, which is presented inFigure 3 along with its purchasing power parityvalue4. It is important to notice that the euro-dollarexchange rate continues to stay well above itsequilibrium value as defined by purchasing powerparity since mid-2003. While the euro area's prob-lems undoubtedly triggered the depreciation ear-lier this year, they were in fact just a correctiontoward equilibrium. As a consequence, the euroseems to have been overvalued against the dollarsince about mid-2003.

In tables 1, 2 and 3 we listed 23 countries that canbe considered as having directly or indirectlyparticipated in the currency war: four advancedeconomies (US, Japan, UK and Switzerland) and19 emerging countries. The left hand panel ofFigure 4 shows long term (1970-2010) bilateralreal exchange rate of the euro area against thesefour advanced economies. The right hand panel

3. The importance of anymeasure of the real

exchange rate can beassessed on the basis of

trade/GDP ratios: eg theimportance of the real

effective exchange rate ofGermany against all

countries can be assessedon the basis of total German

exports and imports, whilethe importance of the

external real rate of the eurocan be assessed on thebasis of extra-euro-area

exports and imports ofGermany and other euro-

area countries.

4. Purchasing power parityis a contentious equilibriumconcept, but still can serve

as a rough benchmark.

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Figure 3: Exchange rate of the euro against theUS dollar and the purchasing power parity (PPP)conversion rate, 4 Jan 1999 - 29 Nov 2010

Source: daily market rate: ECB; implied PPP conversion rate:authors’ calculations using data from the IMF World EconomicOutlook October 2010. The PPP conversion rate is available foreach euro-area member state and we have calculated a time-varying weighted average (considering only those countriesthat were member of the euro area in the given year; using givenyear shares in aggregate euro-area GDP).Note: an increase in the index indicates appreciation of the euro.A fixed-weight average of the PPP conversion rates of the first12 countries that adopted the euro remains within plus/minus0.6 percent range around the shown time-varying weightedaverage during 2001-10.

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shows the external real effective exchange rateagainst 143 countries (all countries for whichexchange rate and consumer price index data areavailable at least for the 1995-2010 period) andagainst the 19 floating emerging countries thatparticipated in the currency war.

The long-term trends and recent levels of bilateralreal exchange rates against the four advancedcountries do not suggest any extraordinary move-ment that Europe should be concerned about.Against the US dollar, for example, the euro is atabout the average level of 1990-96 and well belowits summer 2008 peak level. Since July 2007, theeuro has appreciated against the British pound,but its current level is quite similar to the averageof the past four decades, and the euro has depre-ciated against both the Japanese yen and theSwiss franc.

In real effective terms (right hand panel of Figure4), the euro is well below its average 2002-08value. Consider only the 19 floating currency waremerging countries, the euro’s real value is closeto historical lows.

Consequently, since July 2007 the euro hasgained competitiveness against almost all coun-tries regarded as having participated in the cur-rency war (only the British pound has depreciatedagainst the euro, while the US dollar is practicallyat the same level as July 2007). Therefore, thecomplaint of euro-area policymakers about thepartial reversal of the euro’s fall since July 2007 isnot well founded.

2 MOTIVES FOR POLICY MEASURES IMPACTINGCURRENCY MOVEMENTS

2.1 The output shock

There is a fundamental asymmetry betweenadvanced and emerging countries concerning theimpact of the shock on the real economy duringthe crisis, and also considering longer term growthdevelopments. In advanced countries, privatedeleveraging remains incomplete while publicdeleveraging has barely started, and demand isset to remain subdued for years to come. But thedeveloping and emerging countries remain on agrowth track. Figure 5 on the next page presentsthe diverging developments by showing GDP,

‘Since July 2007 the euro has gained competitiveness against almost all countries regarded as

having participated in the currency war. Therefore, the complaint of euro-area policymakers

about the partial reversal of the euro’s fall since July 2007 is not well founded.’

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143 countries19 currency-war emerging countries

Bilateral real exchange rates,January 1970 – November 2010

Real effective exchange rates,December 1992 – November 2010

Figure 4: External real exchange rate of the euro (July 2007=100)

Source: see Figure 1. Note: see Figure 1. An increase in the index indicates real appreciation of the euro against the countriesindicated in the legend. The vertical dashed line indicates September 2008.

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normalised as 2007=100, as seen in October2007 and in October 2010 in the two main coun-try groups5 and a few selected countries.

Emerging countries were barely hit with the excep-tion of eastern European emerging countries, suchas Russia. But Brazil, India and China have notbeen hit at all.

By contrast, advanced countries have been hit hardon average and positive examples are rare. Australiais one positive example, having not suffered toomuch from the crisis and having one of the bestgrowth prospects among advanced economies. Thislikely explains its absence from the currency wardispute despite having a strong currency: instead,Glenn Stevens, governor of the Reserve Bank of Aus-tralia, has welcomed a stronger exchange rate (seeGoodman and Zachariahs, 2010).

But most other advanced countries suffered in thecrisis, even though there are quite significant dif-ferences between the euro area, Japan, the UKand the US (Figure 6 on the next page). These dif-ferences warrant different policy responses

(Pisani-Ferry and Posen, 2010):

• First, US GDP declined less and recovered fasterthan in the euro area, Japan or the UK – thoughit remains early days for a recovery, whichseems to weakening in the US, and perhapsstrengthening in northern continental Europe;

• Second, US employment declined much morethan European, Japansese and UK employmentand did not start exhibiting feeble signs ofrecovery until early 2010. Consequently, the2008-09 employment decline was exception-ally deep and prolonged in the US whereas inEurope (including the UK) and Japan it was notexceptional;

• Third, as a result, productivity developmentshave been strikingly divergent. Nine quartersafter the start of the recession, GDP peremployee had increased by about 4 percent(the more appropriate measure of productivity,GDP per hour, had increased by about 7 per-cent) in the US whereas it was still below theinitial pre-crisis level in the euro area, Japanand the UK;

• Fourth, Japan’s investment was the hardest

5. The compositions of theadvanced and emerging

country groups are identicalto the groups shown in

Figure 3; see footnote 2.

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Figure 5: GDP forecasts to 2012: October 2007 versus October 2010 (2007=100)

Source: authors’ calculations using data from the October 2007 and October 2010 IMF World Economic Outlooks.Note: due to revisions of historical data, the pre-2007 data are not identical in the two vintages.

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hit: it fell by 35 percent with major conse-quences for potential output developments.There are less pronounced differences in theUS, the UK and the euro area, despite the dif-ferences in growth rates and financial systems.

It is not entirely clear why there was a big diver-gence in employment and therefore productivitybetween the US and Europe (where the evolutionsin the euro area and the UK are remarkably simi-lar). Part of the explanation is that US companies,which are less constrained by firing restrictions,traditionally adjust their payrolls faster thanEuropean counterparts. But if this was the onlyreason, the evolution in the UK, which also haswhat is considered to be a flexible labour market,should mimic that of the US6. Part has to do withspecific shocks affecting the real estate andfinance sectors, which had grown very large in theUS compared, on average, to Europe. And partresults from the fact that in response to the crisis,

several European governments introduced orstrengthened schemes aimed at encouraging jobpreservation, such as the German Kurtzarbeit(IMF, 2010a); those policies, however, did notinclude all countries with limited unemploymentrises, such as the UK. The strength of the post-recession US productivity boom and the subduedproductivity response in most of continentalEurope remain puzzling (Wilson, 2010).

2.2 Private deleveraging

The strength of domestic demand in the short tomedium run largely depends on the extent towhich private agents will engage in deleveraging.To assess the comparative situation in the US, theeuro area and the UK, Table 5 on the next pageshows changes in levels of indebtedness from1999 to 2007, and from 2007 to 2009. The num-bers seem to tell a clear story.

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GDP Employment

GDP per employee Non-residential investment

Euro area Japan United Kingdom United States

Figure 6: Impact of the crisis on GDP, employment, hourly output and non-residential investment inthe euro area, Japan, the UK and the US (% movement per quarter from pre-recession output peak)

Source: updated and extended from Pisani-Ferry and Posen (2010) using data from OECD and Datastream. Note: pre-recessionoutput peak is 2008Q1 for euro area, Japan and UK, 2008Q2 for US.

6. A country whereemployment has evolved ina similar way to the US isSpain, where employershave made use of theflexibility offered bytemporary contracts.

12


In the 2000s, households went much more intodebt in the US and the UK than in the euro area.The contrast is striking, with the rise in householdindebtedness as a share of GDP in the US and theUK three times larger than for the euro area – andin 1999 the initial levels of household debt in theeuro area was already significantly smaller thanin the US. The change in non-financial corporateindebtedness offers a more comparable transat-lantic picture, though the lower increase in the USmay be explained by the greater reliance on capi-tal markets by US firms.

There are signs that the deleveraging process forhouseholds and perhaps non-financial corpora-tions has begun in the US, though on a limitedscale so far. It is not clear that such a process isinevitable for the euro area as a whole – though ofcourse the divergences in indebtedness amongmember countries are quite enormous (anddeleveraging has begun in Ireland and Spain). Onthe whole, balance sheet data justifies more con-cern about the risks of sluggish demand andrecovery in the US and the UK than in continentalEurope, while also underlining the greater unsus-tainability of borrowing patterns in the US.

2.3 The quantitative easing debate

Whatever the US domestic debate, the rest of theworld is highly doubtful about the US FederalReserve programme of asset purchases (QE2).The Europeans have been especially vocal butthere are also fears about its consequences inJapan and the emerging world. Critics argue thatQE2 leads to the weakening of the dollar vis-à-visfloating exchange rate countries, and to capital

Table 5: Level and changes in indebtedness (percent of GDP)

Households Non-financial corporations

US UK Euro area US UK Euro area1999 69.0 68.5 49.5 62.8 71.6 66.92003 83.3 82.8 53.5 64.3 86.3 81.52007 96.6 98.4 61.2 74.1 106.6 90.92009 95.3 103.3 65.5 76.1 120.6 100.5Change 1999-2007 27.6 30.0 11.7 11.3 35.0 24.0Change 2007-09 -1.3 4.8 4.3 2.1 14.0 9.6

Source: Table 1 from Pisani-Ferry and Posen (2010).

outflows especially to emerging countries. Capitalflows to emerging countries either push up theirexchange rates, or, if emerging country centralbanks intervene in the foreign exchange marketto resist appreciation and are not able to sterilisethe resulting money creation, inflation pressureswill raise. Inflation pressures will necessitateinterest rate hikes, thereby providing furtherincentives for capital inflows.

The question is, can QE2 be characterised asbeggar-thy-neighbour?

In a recent speech, Bernanke (2010) said thatasset purchases by the Fed are only the continu-ation of conventional monetary policy by othermeans, the difference being that they affect theinterest rates of longer maturity securities,whereas conventional monetary policy primarilyaffects the short end of the yield curve. If this def-inition is accepted, then it follows that the crite-rion for determining whether QE can be consideredbeggar-thy-neighbour is the same as for conven-tional monetary policy.

There is no explicit criterion for assessing thecooperative character of monetary policy and theresulting exchange-rate developments. There wasone in the post-war fixed exchange-rate regime ascurrency devaluation was subject to the IMF andto the scrutiny of partners. Parity adjustmentswithin the earlier European Monetary System werealso assessed by partners (and are still subjectto approval in the current EMR-2 system). Therewas also a brief interlude in the second half of the1980s during which the G7 targeted exchangerate developments7. But no such criterion exists

7. From 1980-85 the USdollar appreciated sharply

(see eg the euro/dollar realexchange rate on Figure 4)

largely due to the Fed’saggressive anti-inflationary

monetary policy. On 22September 1985 at the

Plaza Hotel in New York City,France, Germany, Japan,

the UK and the US agreed tocoordinated central bank

intervention to depreciatethe US dollar (the ‘Plaza

Accord’). The US dollarconsequently started to

depreciate. But the speedand the magnitude of thedollar’s slide was seen as

excessive. Therefore, on 22February 1987, at the

Louvre in Paris, the fivecountries plus Canada

reached an agreement tohalt the decline of the US

dollar and to stabilise theinternational currency

markets (the ‘LouvreAccord’).

13


in a floating exchange rate regime based on theprinciple of monetary policy autonomy.

An implicit criterion however has emerged fromthe central banks’ practice of the last two decades:as long as monetary policy remained gearedtowards price stability as usually defined – say,an inflation objective in the 1-3 percent range – ithas been generally assessed in line with therequirements, or at least the spirit of internationalcooperation.

If this implicit criterion is also accepted the ques-tion becomes twofold:

• First, what does this definition become in acontext in which inflation objectives are fre-quently undershot? If the inflation objective is,say, two percent, but actual inflation one per-cent for an extended period because of theextent of economic slack, one central bank(say, the ECB) may conclude that it has toaccept that it is temporarily unable to reach itsobjective, whereas the other (say, the Fed)may conclude that it needs to commit evenmore strongly to reaching the inflation objec-tive, possibly by adopting a price-level insteadof a price-change target. This would lead to sig-nificant monetary policy divergence withimmediate consequences for the exchange rate(even if these consequences would be offsetin the medium term by inflation differentials).This is entirely a monetary policy issue thatarises from the lack of a commonly agreed def-inition of cooperative policy in a deflationaryenvironment.

• Second, is monetary policy geared towardsprice stability in the medium run? This boilsdown to determining if there is a risk of fiscaldominance, ie of an unsustainable fiscal policyultimately leading to an irresistible pressure tomonetise the public debt. The problem here isnot the monetary policy stance itself, rather its

sustainability in the absence of a frameworkguaranteeing fiscal discipline.

The exchange-rate consequences of differentmonetary policy attitudes in a deflationary con-text are limited. They may drive a temporarydepreciation of the dollar exchange rate vis-à-visthe euro and other currencies, but they areunlikely to result in major misalignments. Forexample, the estimates presented in Neely(2010) suggest that the Fed’s first asset-pur-chase programme (QE1) between November2008 and March 2009 had a cumulative down-ward impact on the dollar of 6.5 percent againstvarious currencies of advanced countries. The cal-culations of Joyce et al (2010) suggest that theBank of England’s asset purchase had a three per-cent cumulative effect on the exchange rate ofsterling (four percent initial impact of which onepercent was corrected later). These estimates,which should be cautiously assessed, do not sug-gest that QE had a significant impact on exchangerates. Furthermore, Neely (2010) finds that theFed’s QE1 did not decrease US yields only, but alsohad a sizeable downward impact on yields of otheradvanced countries8. And US 10-year bond yieldsare not extraordinary low by international com-parisons (Figure 7 on the next page).

At least in principle, spillovers to other advancedcountries can be limited by discussions betweencentral banks on the interpretation of their pricestability mandate in a deflationary context. Themore difficult issue is clearly related to increasedcapital inflows to emerging countries with flexibleexchange rates and the associated problems theinflows cause. But as we argued, the acute natureof this issue is primarily the consequence ofasymmetric openness of emerging countries:since some major players, such as China, retainbroad-based capital controls, capital inflowsimpact those emerging countries that have moreliberalised capital accounts.

‘In principle, spillovers to advanced countries can be limited by discussions between central

banks on the interpretation of their price stability mandate in a deflationary context. More

difficult is increased capital inflows to emerging countries with flexible exchange rates.’

8. For example, he finds thatQE1 between November2008 and March 2009lowered US 10-yeargovernment bond yields by107 basis points, but at thesame time it lowered the10-year yield in Australia by78 basis points, in Canadaby 54 basis points, inGermany by 50 basispoints, in Japan by 19 basispoints and in the UK by 65basis points.

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But the consequences of an expectation of debtmonetisation would be much more severe as itseffects would extend beyond the relatively short-term monetary policy horizon. It would in all like-lihood lead market participants to short thecurrency, triggering a major real depreciation inthe short term. In Europe, all governments haveplans to restore budgetary sustainability. In theUS, partisan strife over budgetary policy leads toconcern that the Fed will ultimately have to inflatethe problem away, even though longer-term USinflation expectations remain near historic lows(Table 6). Recent reactions to fiscal consolidationproposals9 suggest that the US has got perilouslyclose to the ‘war of attrition’ situation oncedescribed by Alesina and Drazen (1991). This,more than the Fed’s stance, is the real danger.

3 CONCLUSIONS AND IMPLICATIONS FOR THEEURO AREA

There are different elements of the currency wardispute, which have different impacts on the

9. On 10 November 2010the co-chairs of the

bipartisan Simpson-BowlesFiscal Commission

appointed by PresidentObama presented

preliminary findings andrecommendations for

deficit reduction. A few dayslater, on 17 November, the

Domenici-Rivlin panelappointed by the Bipartisan

Policy Center alsopresented recommend-

ations for deficit reduction.Both sets of proposals

failed to commandconsensus, on the contrary

spending cuts were flatlyrejected by senior

Democrats while taxincreases were rejected by

senior Republicans.

10. Note however thatparts, components and

semi-finished goods are alarge share of US imports

from China. An appreciationof the renminbi against the

dollar would increase thecost of these intermediate

inputs; therefore it is notclear what impact a

renminbi appreciationwould have on US growth

and jobs. Using acomputational model of

global trade Francois(2010) even concludes

that a renminbi app-reciation or a trade war

between the US and Chinawould lead to US job losses,

but would improve the UStrade balance.

global economy and on Europe:

1 The most significant is the fundamental issueof the long-term currency peg of some impor-tant countries, most notably China.

2 There have been several recent attempts toimpact the exchange rate of countries havingfloating exchange-rate regimes.

3 The third is quantitative easing by the FederalReserve, the Bank of England and the Bank ofJapan.

We are concerned about the first element of cur-rency war for three reasons:

1 First, while estimates of equilibrium exchangerates from different models vary widely, thetypical result shows undervaluation of theChinese renminbi. This by itself would justifysome nominal appreciation and will lead togradual real appreciation through higherChinese inflation if the nominal exchange rateis kept stable10.

Table 6: US inflation expectations (percent)Jan

2007July

2007Jan

2008July

2008Jan

2009July

2009Jan

2010July

2010Nov

2010

1 year 2.7 2.6 2.5 3.0 0.5 1.6 1.7 1.0 1.410 years 2.5 2.6 2.2 2.3 1.6 2.0 2.0 1.7 1.5

Source: Federal Reserve Bank of Cleveland. Note: See the description of the methodology in Haubrich (2009).

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6 USUKJapanEuro (synthetic)Germany

Figure 7: 10-year benchmark bond yields, 3 January 2005 - 29 November 2010

Source: Datastream.

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2 Second, the crisis impacted emerging andadvanced countries in an asymmetric way.Non-European emerging countries were not hitmuch by the crisis, while advanced countriessuffered much more. In advanced countries,private deleveraging and public consolidationare likely to continue to represent a drag ondomestic demand. This fundamental asymme-try will need to be compensated for by someform of adjustment in relative prices, eventhough exports from the block of advancedcountries to the block of emerging countriesstill represent only a small share of GDP11. Thereal effective exchange rate of emerging coun-tries sharply depreciated after the collapse ofLehman Brothers and so far it has reverted toits pre-Lehman level. But further adjustmentmay be needed and there is also an asymme-try within the emerging country group: whileChina and some Middle Eastern countries pegtheir currencies to the US dollar, which is weak-ening partly due to US monetary policy, emerg-ing countries with floating exchange rates andopen capital accounts have to face increasingcapital inflows. With a view to economic growthand competitiveness relative to China, many ofthese countries would like to resist capitalinflows by employing various policy actions,which have led their participation in the secondform of currency war.

3 There is a risk that the US may retaliate againstChinese currency fixity with tariffs and possi-ble other trade measures, which may give riseto the adoption of protectionist measures else-where in the world as well. The experience ofthe 1930s suggests that this would prolongeconomic stagnation.

We are less worried about the second and third ele-ments of currency war, even though about 20 float-ing exchange rate countries have adopted measuresto resist currency appreciation or weaken theircurrencies, indicating that the ‘war’ is widespread.

The US and the UK implemented quantitativeeasing primarily for domestic policy purposes andnot with the prime purpose of influencing theexchange rate: although we do not deny that they

may adversely impact other countries, ourassessment is that at present these policy meas-ures remain broadly in line with domestic eco-nomic developments. As observed by Eichengreen(2010), simultaneous monetary easing by quan-titative easing and unsterilised foreign exchangeintervention is not a zero-sum game and theresulting monetary stimulus may have a positiveimpact on growth, benefiting also those countriesthat have not participated in this ‘war’.

Concerning emerging countries that try to resistcapital flows, their efforts are also justified for twomain reasons: (1) quantitative easing in the US islikely to induce capital inflows to these countriesand (2) China keeps a peg to the dollar. While acollective appreciation of the whole emergingcountry region against advanced countries maybe warranted, no emerging country would like toappreciate against China.

Our more benign view of these second and thirdelements of currency war is also supported byrecent developments in real effective exchangerates, which do not indicate significant impacts,at least so far: countries participating in this warhave not achieved a marked depreciation of theircurrencies and in fact most of them are still expe-riencing appreciation. These developments sug-gest that the weapons used to fight the war maynot be very effective in most cases.

Concerning the euro, its exchange rate has notbeen impacted much by the recent ‘currency war’,at least so far: it continues to be overvalued, but toa lesser extent than before Lehman’s collapse. Theeuro exchange rate is also significantly impactedby market perceptions concerning the sovereigndebt crisis of some periphery euro-area members.A sizeable depreciation of the euro earlier this yearwas the result of this internal crisis and the recentrecovery of the euro can also be the consequenceof brighter market perceptions about the future ofthe euro area.

The implications for Europe of the three elementsof ‘currency wars’ follow our assessments.European policymakers should not criticise float-

11. The exports of the blockof advanced countries to allother countries make up7.6 percent of advancedcountries GDP, of which 2.9percent goes to the group ofemerging countries used inour study and 4.7 percentto other countries. Note thatexport is a gross measureand therefore the GDP shareof added value in exports iseven lower.

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REFERENCES

Alesina, Alberto and Alan Drazen (1991) ‘Why Are Stabilizations Delayed?’, American EconomicReview vol. 81, No. 5, pp. 1170-1188

Avent, Ryan (2010) ‘Of course you realise this is nothing like war’, The Economist Free exchange,http://www.economist.com/blogs/freeexchange/2010/10/foreign_exchange

Bayoumi, Tamim, Jaewoo Lee and Sarma Jayanthi (2006) ‘New Rates from New Weights’, IMF StaffPapers 53(2), 272-305

Bernanke, Ben (2010) ‘Rebalancing the World Economy’, speech at the Sixth European Central Bank-ing Conference, Frankfurt, 19 November

Bruegel and WIIW (2010) Whither Growth in Central and Eastern Europe? Policy lessons for an inte-grated Europe, report written by Torbjörn Becker, Daniel Daianu, Zsolt Darvas, Vladimir Gligorov,Michael Landesmann, Pavle Petrovic, Jean Pisani-Ferry, Dariusz Rosati, André Sapir and BeatriceWeder Di Mauro, Bruegel Blueprint Volume XI

Darvas, Zsolt and Jean Pisani-Ferry (2010) ‘Future development of global imbalances’, Briefingpaper prepared for the European Parliament's Committee on Economic and Monetary Affairs, March2010

Eichengreen, Barry (2010) ‘Financial Shock and Awe’, Foreign Policy, 6 October

Evenett, Simon, ed. (2010) ‘The US-Sino Currency Dispute: New Insights from Economics, Politics andLaw’, A VoxEU.org Publication, CEPR

Francois, Joseph (2010) ‘Deconstructing Sino-US codependence: revaluation, tariffs, exports andjobs’, in: Evenett, Simon, ed. (2010) ‘The US-Sino Currency Dispute: New Insights from Economics,Politics and Law’, A VoxEU.org Publication, CEPR

ing exchange rate emerging countries that try toresist capital inflows, at least while China keepsits exchange rate system unchanged. TheEuropean critique of the Fed’s recent quantitativeeasing measures is also not well grounded whilethe Fed’s monetary policy remains gearedtowards price stability and does not amount to amonetisation of the public debt. But central banksshould agree a consensus about the definition ofinternationally acceptable policies in a time ofdeflationary pressures. In particular, major centralbanks should agree on whether or not a price leveltarget is warranted (which would compensatetemporary below-target inflation with temporaryabove-target inflation later).

The most delicate issue remains the dollar peg ofa large number of emerging countries. Goldberg(2010) reports the shocking number than 50 per-cent of all countries of the world use the dollar, orpeg to the dollar, or tightly manage the exchange

rate to the dollar, and these countries constitute36 percent of world GDP. Of these countries Chinaand some Middle East countries stand out by theirsize. This issue is undoubtedly related to therenewed debate on the international monetarysystem, in which Europe has so far kept a low pro-file. The recent crisis has clearly showed seriousflaws of the current ‘non-system’ (Darvas andPisani-Ferry, 2010). It is in Europe’s best interestto foster a reform of the international monetarysystem, including the design of mechanisms thatcan help to correct global imbalances.

Zsolt Darvas ([email protected]) is aResearch Fellow at Bruegel, a Research Fellow atthe Hungarian Academy of Sciences Institute ofEconomics and an Associate Professor at Corvi-nus University, Budapest. Jean Pisani-Ferry([email protected]) is Director of Bruegel and Pro-fessor at Université Paris-Dauphine.

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Goodman, Wes and Candice Zachariahs (2010) ‘The Aussie Dollar Soars, Central Bank Shrugs’,Bloomberg Businessweek 18 November 2010,http://www.businessweek.com/magazine/content/10_48/b4205022086975.htm

Goldberg, Linda S. (2010) ‘Is the International Role of the Dollar Changing?’, Current Issues in Eco-nomics and Finance vol. 16, no. 1, Federal Reserve Bank of New York

Gouardo, Christophe and Jean Pisani-Ferry (2010) ‘Currency Wars: What do Effective ExchangesRates Tell Us?’, mimeo, Bruegel

Haubrich, Joseph G. (2009) ‘A New Approach to Gauging Inflation Expectations’, Economic Commen-tary, Federal Reserve Bank of Cleveland, 29 October 2009,http://www.clevelandfed.org/research/commentary/2009/0809.pdf

International Monetary Fund (2010a) ‘Unemployment dynamics during recessions and recoveries:Okun’s law and beyond’, chapter 3 of April World Economic Outlook

International Monetary Fund (2010b) ‘Global Economic Prospects and Policy Challenges’, report pre-pared by the staff of the IMF for the meeting of G-20 Finance Ministers and Central Bank Governors,October 21-23, 2010, Gyeongju, Korea

Joyce, Michael, Ana Lasaosa, Ibrahim Stevens and Matthew Tong (2010) ‘The financial marketimpact of quantitative easing’, Bank of England Working Paper No 393, August

Kaminska, Izabella (2010) ‘25 interventions in a one week band, redux’, 13 October 2010,http://ftalphaville.ft.com/blog/2010/10/13/368416/25-interventions-in-a-one-week-band-redux/

Meier, André (2009) ‘Panacea, curse or nonevent? Unconventional monetary policy in the UnitedKingdom,’ IMF Working Paper no 09/163, August

Neely, Christopher J. (2010) ‘The Large-Scale Asset Purchases Had Large International Effects’, Fed-eral Reserve Bank of St. Louis Working Paper 2010-018B, July

Pisani-Ferry, Jean and Adam S. Posen (2010) ‘From Convoy to Parting Ways? Post-crisis DivergenceBetween European and US Macroeconomic Policies’, paper prepared for Bruegel-PIIE conference,Washington DC, 8 October

Wilson, Daniel (2010) ‘Is the Recent Productivity Boom Over?’, FRBSF Economic Letter No 2010/28,September

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