Why Easing the Threat of Currency War Is So Difficult

Currency war: yuan and dollars
Currency war: yuan and dollars

In the wake of a severe worldwide recession, spiking prospects of currency wars are now threatening the fragile global economy. In response, high-profile policymakers are rushing to try to restore calm.

Officials at the International Monetary Fund and World Bank became the latest to attempt an easing of the escalating tensions. Their comments echo remarks by European Central Bank head Jean Claude Trichet against disorderly moves in currency markets. U.S. Treasury Secretary Timothy Geithner has also called for greater cooperation as relations between the U.S. and China become more tense.

Investors would be wise to take this type of lip service with a grain of salt. Despite the calls for order, policymakers are dealing with an increasingly haphazard scenario loaded with counterproductive results and unintended consequences. And that could mean a slide toward protectionism even though it would hurt all parties involved.

Still Trying to Weaken the Yen

While officials may posture, the levers that they have to influence the finicky and massive global currency markets remain limited. These markets also tend to be highly responsive to what other countries are doing, thereby curbing and confounding the influence of each individual party.

Japan, for example, has been trying to weaken the yen for months. But even the recent direct intervention often credited with setting off the current bout of competitive devaluations has had very limited success. Investors are still hanging on to yen as a safe haven currency in anticipation of deflationary conditions that boost purchasing power over time and massive current-account surpluses.

The reverberations are being felt in Europe as well. It was fashionable to talk about the end of the euro at the start of the year. But now the currency is surging as the European Central Bank takes a less aggressive monetary policy stance than its rivals.

Yet, the tensions within Europe are likely to be profound as well. High savings rates in Germany mean printing money is hardly desirable for the euro's politically powerful cornerstone. On the other hand, a surging currency could quash a broader export-led recovery that's keeping battered Southern European economies like Greece afloat.

Carrot-and-Stick Diplomacy

Meantime, the U.S. dollar has slid against a basket of currency as the Federal Reserve makes increasingly clear its intentions to drive down interest rates by purchasing bonds. And as congressional elections approach amid the weak American economy, investors have understandably focused on the high-profile row materializing between the U.S. and China.

China is engaged in classic carrot-and-stick diplomacy. Chinese Premier Wen Jiabao recently assured Europe that his country would be helpful in everything from propping up the yuan to buying Greek bonds.

Sponsored Links

But the fast-growing giant also has its hands tied. Letting the yuan appreciate too fast would hammer the razor-thin margins of Chinese exporters, Wen warned. That could lead to a wave of bankruptcies in the sector and create enormous social upheaval as workers migrating from rural China are unable to be absorbed into the urban population.

Exactly the opposite, though, has occurred, thanks to the dollar's slide. With the yuan effectively pegged to the greenback, any advantage China has because of its cheaper currency compared to regions like Europe has only been enhanced.

As tensions mount, the growing roster of dignitaries urging calm should rise as well. Ultimately, though, investors should recognize that only highly scattershot policies are likely to unfold.