Julia Leung
Academy Fellow (2014)
Against a backdrop of slower economic growth in China and weakened world economic demand, the drumbeat of a new currency war is getting louder.
Haruhiko Kuroda, governor of the Bank of Japan, speaks during a news conference at the central bank's headquarters in Tokyo on 31 October 2014. Photo by Getty Images.Haruhiko Kuroda, governor of the Bank of Japan, speaks during a news conference at the central bank's headquarters in Tokyo on 31 October 2014. Photo by Getty Images.

The Bank of Japan’s (BoJ) announcement on 31 October to expand quantitative easing (QE) was shocking to the global financial market, a desperate attempt to achieve its declared 2% inflation goal. While it is doubtful whether the target can be achieved, yen fell 3% on the day of announcement. It has continued to weaken to more than 120 yen to the dollar recently, down 30% from three years ago.

The BoJ’s move to expand QE is putting pressure on the European Central Bank (ECB) to expand its asset purchase programme to reduce pressure on the euro to appreciate. These two central banks are pressing on with more QE at a time when the US has just ended its QE and is normalizing its monetary policy. The divergent paths taken by these three major economic areas would have knock-on effects on global equity and bond markets, particularly those in Asia. Central banks in the region, which have been battling the influx of capital inflow and its outflow since 2009 to achieve exchange rate and financial market stability, were hoping for normalcy to return with end of asset purchases in the US. Now, they are bracing for a longer period of uncertainty in uncharted territory.  

The gain and loss of international currencies seem like a zero sum game. The weakening of the yen would likely lead to pressure on the euro to appreciate. That is why many economies appear to be engaged in a competitive monetary easing exercise. While ostensibly QE is adopted to counter deflationary pressure and stimulate economic recovery, the discernable impact is often a weakening of the currency. Since the adoption of the first phase of QE in 2009, the balance sheets of the US Federal Reserve and Bank of England have each expanded four times, while the balance sheet of ECB has doubled. As a percentage of GDP, their balance sheet sizes amount to 20% to 25%. The BoJ’s QE program is most aggressive, with its balance sheet having expanded five times, amounting to 60% of GDP.

G7 countries prohibit competitive devaluation, which refers to the adoption of a policy to weaken the exchange rate to improve export competitiveness. But isn’t the adoption of ever larger QE to reduce pressure to appreciate another form of 'currency war'? This 'competitive monetary easing' was popularized as 'currency war' by Guido Mantega, the Brazilian finance minister who took issue with the Federal Reserve’s QE in September 2010 on the grounds that it was causing substantial damage to emerging market economies by dispatching harmful capital flows and causing destabilizing currency appreciation.

Six years later, the world economy has not emerged from the long shadow of the global financial crisis. Fiscal deficits in Western economies have limited the room for fiscal tools to stimulate the economy, leaving monetary easing as the only tool. With interest rates near zero, injection of a large quantity of liquidity through bond purchases is deemed the only workable stimulus. QE might have helped the US recover, but the liquidity unleashed by the policy has flooded Asia and posed the biggest risks to financial stability when the tides of capital recede.

Amid a zero interest rate environment, the robust economic fundamentals and open capital markets of Asia have attracted large capital inflows in search of higher return. The inflows have pushed up exchange rates in Asia and fuelled credit and asset booms. To reduce excessive pressure for appreciation, many Asian central banks have adopted large-scale intervention in the foreign exchange market. Some, such as Indonesia, have even adopted targeted capital control measures to prohibit inflows into the short-end of the government bond market, lest their outflow destabilize the financial market. Regulators in Hong Kong, Singapore and South Korea have tightened loan-to-value ratios in a bid to cool the overheated property markets. Such moves are aimed at curbing the credit and asset bubbles from getting larger and at reducing the risk of bursting in the event of a reversal in capital flows and a sharp rise in interest rates.

Ultra-loose monetary policy has been sustained for more than six years. It is unconventional and unprecedented. Nobody knows how a currency war would end, but there would be no winner − only those with robust macroeconomic fundamentals could muddle through.

A version of this article has been published by FT Chinese.

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