Are we in the middle of a currency war? Brazil's finance minister, Guido Mantega, did not mince his words when he sent a global "currency war" alert.
An increasing number of countries - from Switzerland to Japan - have recently been intervening in the foreign exchange markets in order to weaken their currencies against the dollar. Since January 2009 to the end of August 2010 the dollar lost 5.3% against the yen, 3.9% against the Taiwanese dollar, 13.4% against the South Korean won and 24.1% against the Brazilian real. These countries are using the exchange rate in order to support their exports. And they are also trying to curb capital inflows that are growing on the back of a weaker dollar.
Whilst putting pressure on China to considerably revalue the Renminbi, the US Congress is missing the big picture of many countries affected by the dollar malaise and their response to it, especially where economic growth is an issue. For instance, the euro area is facing the challenge of supporting growth - about 1% this year at best - compounded with the additional burden of internal rebalancing. Exports to external markets need to increase to counterbalance the limited absorption of output through intra-trade. This suggests that the euro area is no longer a neutral player in the process of rebalancing the world economy and the case for intervention may become stronger if the euro continues strengthening - since June it has appreciated by 12% against the dollar.
The ECB is agnostic vis-à -vis exchange rate policy and none of the euro area members of the G7 has a history of regular currency interventions. However, if the US Congress lets the genie of currency war out of the lamp, there is no guarantee that the Eurozone won't jump on the bandwagon of competitive devaluation.
Rather than China bashing, the US should lead efforts to co-ordinate exchange rate policies and focus on putting the issue of exchange rate on the global agenda. In a report published by Chatham House before the London Summit in April 2009, we urged the G20 to set a caucus on currency misalignments and for the promotion of monetary coordination. At that time we saw the risk of competitive devaluations as the euro area countries and others were sharing the burden of US expansionary fiscal and monetary policies that were putting downward pressures on the dollar. The recommendation is still valid.
Because of the role of the dollar in the world economy the US is the country that sets the pace on currency issues. South Korea, the host of this year's G20, is unlikely to put the exchange rate coordination on the Seoul's summit agenda. The US, however, can push the issue through. The opportunity to set a positive role model and defuse, once again, any protectionist treat is there. Exchange rates and currencies need to be part of the global agenda and cannot wait much longer, surely not until France takes up G20 chair in 2011.