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News : Global Economy Last Updated: Nov 10, 2010 - 6:42:47 AM

Some of the largest countries are intervening in foreign exchange markets to weaken their currencies
By Finfacts Team
Nov 9, 2010 - 4:35:00 AM

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More than a dozen countries, including some of the largest, have been intervening in the foreign exchange  markets to weaken their currencies. This raises fears of “currency wars” like those that devastated the world economy in the 1930s.

A new study by the Peterson Institute for International Economics, based in Washington DC, distinguishes sharply between those countries whose intervention is justified, because their currencies are already stronger than called for by the economic fundamentals, and those who are violating their international obligation to avoid “competitive devaluation” because their exchange rates are now substantially undervalued.

The study updates the Institution’s estimates of “fundamental equilibrium exchange rates” and concludes that the major countries in Chart 1 above, should be censured for their intervention policies because they are already undervalued by the amounts indicated (in percentage).

China’s undervaluation has increased since it announced “greater flexibility” for its currency in June because its appreciation against the dollar has been more than offset by its depreciation against other currencies as it “rode the dollar down” against them.

On the other hand, several countries that have been intervening are doing so because their currencies are already overvalued by the indicated amounts or are very close to equilibrium: see Chart 2 above.

These distinctions have crucial implications for several major policy decisions that may be made over the coming days and months:

  • the G-20 summit in Seoul, in pursuit of its agreed rebalancing of the world economy to reduce excessive current account surpluses and deficits, may seek to limit currency interventions that impede achievement of that goal;

  • the US Congress, in considering legislation that would authorize trade sanctions against countries that deliberately undervalue their currencies, must take full account of the distinction; and

  • the US Treasury, in preparing its next Report to Congress on International Economic and Exchange Rate Policies and considering whether to designate countries as “manipulating” their currencies, must do so as well.

Neither the United States, the Eurozone, Canada nor the United Kingdom has intervened in the exchange markets. The new estimates suggest that all four are modestly overvalued on a trade-weighted basis: the dollar by 2½%, the euro by 5½% and the pound and the Canadian dollar by about 1½%. The latter two are also slightly overvalued against the dollar with the euro most misaligned at about 5½%. Australia and New Zealand, who also have refrained from intervening, have the two most overvalued currencies at about 20 and 25%, respectively.

William R. Cline and John Williamson, the authors of the new study Currency Wars?, argue that intervention is unjustified f a currency is substantially undervalued and a country is aggressively intervening to prevent appreciation. If instead the currency is already overvalued relative to its estimated equilibrium rate, “intervention to prevent further appreciation may be seen as benign and consistent with cooperative international behavior.”

Table 2 of the study categorizes the 30 countries studied against two metrics: the position of the currency vis-à-vis its equilibrium level and whether the country has been reported as intervening to affect the market level of its rate. Of the 17 economies that have reportedly been intervening, China and the five others listed in the initial table above fall into the category of “competitive undervaluation” while 11 are operating consistently with their international obligations.

The authors conclude that “It is quite wrong to condemn countries for resisting appreciation irrespective of their situation. Any agreement at Seoul to prevent an exchange rate war should be based on a distinction between countries with overvalued and undervalued currencies, and should be designed to seek appreciation of the latter but not to debar the former from actions to prevent a further magnification of disequilibrium."

“We are in a situation where global flows of capital are making it impossible for central banks to control their currency,” Luca Silipo, chief economist at Natixis told CNBC on Oct 25th, after finance ministers at the G20 vowed to avoid currency wars:

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