Highway to the Target Zone

Or The Case for International Currency Cooperation

Ever since Brazilian Finance Minister Guido Mantega used the phrase currency war in 2010 to refer to unwanted (by him) BRL appreciation in the wake of the Fed’s QE2, the term has proven to be catnip for headline writers responding to the interaction of official policies and FX markets. But I would argue that more than currency war, there is a strong case for currency peace — coordinated, rule-bound official action in FX markets — that is already increasingly recognized by the world’s major central banks, but still has room to go. In particular, I will use this piece to argue that rather than pushing for an end to forex intervention, the US and other countries should engage in more of it and more often.

I was involved in one form or another in currency markets for about 20 years and I would say that most market-practitioners in currency markets realize that currencies typically overshoot notional “fair valuation,” that such overshoots can persist for long stretches of time, and that overshoots can lead to large spillovers into real economies. These overshoots are typically the result of large/sudden shifts in the behavior of portfolio investors that can be amplified by herding behavior, the mechanics of leverage and asset-liability matching, trend-following etc. Market-determined exchange rates are not just stabilizing moves in response to trend shifts in current account behavior or relative cyclical performance but also frequently reflect fast and destabilizing reactions of cross-border portfolio flows to news or opinions about the preceding “fundamental” factors.

Complicating matters further, there are significant differences across countries as to whether and to what extent a weaker domestic exchange rate leads to a tightening or a loosening of financial conditions. A weaker currency might lead to gains in export share that boost the economy, but this is by no means assured across all countries. In particular, many EMs seem much more likely to experience currency depreciation as an added cyclical burden. These differences stem from the size of the export sector and its ability to gain global market share from FX depreciation; the currency composition of local public and private debt; the role and risk-sensitivity of foreign investors in domestic bond markets; the extent of passthrough from exchange-rate weakness into domestic inflation and inflation-expectations; the local propensity for currency substitution and availability of vehicles to indulge in the same, etc.

In addition, the circumstances of single countries can change over time. For example, it seems as though, relative to the botched mini-devaluation of the RMB in 2015, Chinese financial conditions are less sensitive to CNY depreciation, as judged by the contemporaneous behavior of USDCNY and key domestic interest rates. This is not surprising given various efforts to deanchor expectations from the currency, the sheer weight of CNY-denominated debt in the national stock of public and private debt (c. 95%), and internal and external constraints on Chinese capital account flows. However, the same might not be true of other emerging markets (including US allies) susceptible to real economy or financial contagion from a weaker CNY. This reminder is intended as a caution against the periodic temptation in some corners to use USD strength as a geopolitical tool against China.

One of the constant US complaints against China has been currency manipulation, but here too I would suggest that the theory and practice of reserve accumulation in the countries that practice it is more nuanced. The experience of managing large portfolio inflows and outflows in emerging markets over the last 20 years has led to a increase in the scale of reserve accumulation by EM CBs. This practice is most evident in East Asia in the aftermath of the searing 1998 crisis but has also been the case in other large EMs like Brazil, India and Russia. In many of these instances, higher CB reserves represent a growth in the Net Foreign Asset position of the public sector that offsets (often insufficiently) an increase in the Net Liability Position of the private sector. As such, this may be considered “prudential reserve accumulation”.

At the same time, it is also the case that the alibi of precautionary reserve accumulation in a hostile and unstable world can serve as a pretext for overtly mercantilistic reserve accumulation. Complicating matters further, an empirically proven ”correct” sequencing of integration into global goods and financial markets may lead to EMs experiencing trade surpluses BEFORE they have achieved sufficient financial depth and capital-account convertibility to permit the domestic private sector to recycle such surpluses. Under such circumstances, the task of surplus recycling will fall to central banks and/or sovereign wealth funds. Under such circumstances, it may be even harder to continue with idealized distinctions between beneficial “market-determined exchange rates” and predatory “currency manipulation.” There are edge cases that are clearly problematic (Taiwan e.g.) but there are also many cases where prudential reserve accumulation can be defended.

There have been major rethinks on the issue of capital account convertibility and exchange rates at two major institutions — the IMF and the US Federal Reserve. The IMF has spent much of the past decade retreating from its prior orthodoxy on the importance of all countries moving towards more open capital accounts. Meanwhile, the Federal Reserve has become increasingly conscious of the non-trade channels through which the USD affects global financial conditions and has incorporated these views in its own reaction function on at least two fronts — an acknowledgement of a Monetary Conditions Index (MCI) approach to rate-setting and the increased availability of USD swap lines to other central banks in moment so stress. This has already had a salutary effect in dampening the ill-effects on the real economy of excessive foreign exchange volatility. But in my opinion, the Fed could do still more.

Despite the increased importance of the USD exchange rate in the Fed’s reaction function, it engages only very rarely in intervention in foreign exchange markets, but I believe there are sound arguments that intervention should become a more customary tool. Although it is only the rare DM central bank that engages in regular intervention in forex markets, the above considerations on market-driven overshoots and their costs suggest that it might be opportune for more central banks to do so, provided that such behavior is coordinated and rule-based.

Historic instances of coordinated multilateral intervention — the Plaza and Louvre accords, the intervention to lower USDJPY in June 1998 to forestall Yen weakness that might lead to a CNY devaluation, the decision to support the Euro in 2000 — seem to have been driven by internationally shared concerns about exchange rate developments. These included the worries that currency moves might a) increase local or global financial instability with systemic spillovers; b) lead to political backlash that interrupted cross-border goods trade c) prevent one or more major central banks from engaging in cyclically-appropriate monetary policy. It is likely the case that one or more of these conditions is satisfied much more frequently than is commonly perceived.

More generally, under open capital accounts, the combination of cyclical and monetary policy divergence; cross-border capital flows and consequent exchange rate moves; and currency- driven private preferences for tradeable vs. non-tradeable investment will likely lead very often to contradictions between an economy’s needs of internal balance and external balance. We might indeed be living through one such moment as the Biden administration undertakes an extremely large fiscal expansion that could result in fixed income and currency market spillovers into the rest of the world with attendant financial and political risks. Concerns about “fiscal leakage” into increased imports and a wider US trade deficit are likely to spur further rounds of trade friction above and beyond the already evident push for national supply-chain resilience. There are obvious candidates (the EU above all) whom the US can push for an increased fiscal expansion effort that prevents global imbalances from deteriorating again. Indeed, I would suggest that the US be prepared to threaten forex intervention to weaken the USD against countries (or currency areas) where countercyclical expansion relies too much on monetary (and implicitly exchange rate) policy and insufficiently on fiscal space. The Eurozone is obviously such an area, as is my personal bugbear — Sweden. But there are sizeable chunks of the global economy (especially EM) where the interaction of currency and fixed income markets in the wake of a large US fiscal expansion could lead to a contraction of market-granted fiscal space that exacerbates global demand divergences and consequent trade imbalances.

In view of the above considerations, and amid a broader reconsideration within the US of the costs and benefits of the centrality of the USD in the international financial system, I would suggest that the US Treasury and the Federal Reserve join other DM central banks in dropping the taboo against intervention in FX markets. Beyond offsetting destabilizing market moves, reserve accumulation by the US would confer the imprimatur of the US on other currencies as viable international vehicles, potentially sharing the exorbitant privilege that is now seen in more quarters as an excessive burden. Our evolving understanding of the dynamics of exchange rate markets: cross-border spillover mechanisms; and the pros and cons of unrestricted capital account convertibility all suggest that it might to be time to move towards an internationally-agreed rule book on when central banks might individually and collectively use their cross-border balance sheets to lean against the wind via forex intervention.