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The prospect of a currency war has been grabbing headlines since December, when Shinzo Abe won a landslide election to become Japan's new prime minister. Prime Minister Abe campaigned on aggressive policies aimed at defeating deflation and reviving the Japanese economy, and promised to hold the country's central bank accountable for achieving these goals. This has prompted concerns that other countries may respond by devaluing their currencies as well, potentially leading to a currency war. Some believe a currency war is already upon us (see, for example, Economic Insights, "The Winds of War," March 4, 2013). Weighing in on this topic is , Lord Abbett Partner & Director of Currency Management.
Q: Why has Japan been criticized so severely for wanting to devalue the yen? Haven't other countries, including the United States, pursued similar policies of currency depreciation?
Traub: I believe Japan's mistake was largely a public relations error. Prime Minister Shinzo Abe made the mistake of explicitly saying he wanted a weaker yen, and he said he wanted it to be around ¥90 to ¥95 to the U.S. dollar. It's kind of taboo to be so explicit. Look at the United States, for example. We've had a monetary policy that ultimately resulted in a weak dollar since the financial crisis, and even prior to that. But we don't explicitly say we want a weak dollar. In fact, we always say we want a strong dollar.
We have also pursued fiscal policies that suggest that we would like the dollar to be weaker. For example, President Obama set a goal of doubling our exports within five years. And we have even implemented policies such as quantitative easing that, although not intended to weaken our currency, have certainly had that effect. [Federal Reserve chairman] Ben Bernanke knows what the effects of his policies are, but the rationale for them is to stimulate the domestic economy and prevent deflation, not devalue the dollar.
Strangely, Japan is being criticized for finally proposing to do what other countries have been encouraging it to do for years, which is for the Bank of Japan to make larger asset purchases in order to pump more liquidity into the economy. In 2002, when Bernanke gave his famous speech about dropping money from helicopters in order to avoid deflation, he said that if he were the head of the Bank of Japan, he would be injecting a lot of money into that economy in order to get it out of deflation. So many people have been encouraging Japan to do exactly what Prime Minister Abe has proposed.
The proposal to use the Bank of Japan's quantitative easing program to purchase foreign bonds also appeared to contribute to the controversy. That was controversial because it would have affected the bond markets of other countries. The plan would have been seen as a more direct attempt to depreciate the yen and revalue other currencies higher. Japan has since backed away from that plan.
Q: So we aren't actually in a currency war?
Traub: No, I don’t believe we are in a currency war. In the past, currency wars have occurred at a time when currencies were already weak, and governments tried to weaken them further or prevent them from strengthening. In Asia, for example, after the crisis of the late 1990s, when the currencies of countries such as Malaysia collapsed, those governments kept their currencies cheap to the dollar in order to help their export-based economies recover. Those economies, including China, were all competing with each other and keeping their currencies cheap to the dollar. And they kept their currencies low long after the economic fundamentals justified some appreciation. That's a currency war.
Japan, on the other hand, is pursuing a weaker currency at a time when many people believe that, given the economic fundamentals, the yen ought to be weaker. The Japanese economy has very little growth, the trade surplus is declining, and interest rates are low, so depreciation is justified.
It was not that long ago—in 2007—that the yen was weaker than it is today; it was above ¥100 to the dollar. Back then, investors were using the yen to do carry trades—that is, borrowing in yen and investing in higher-yielding currencies. The yen was cheap because, much like today, Japan had a zero-interest rate policy and was doing quantitative easing. In 2007, it was the only country doing that. But with the financial crisis in 2008, all those carry trades unwound, causing the yen to strengthen. Today, the financial crisis is easing, and the fundamentals of Japan's economy suggest that the yen should be weaker.
Q: What is the likely impact on emerging market currencies of a weaker yen?
Traub: It's likely to be mixed. Export-oriented economies that compete with Japan, such as South Korea, do not favor a weaker yen because it gives Japanese exports an edge. A weak yen means not only that some flows that would have gone to Japan will now go to other Asian markets but also that there are likely to be stronger outflows as Japanese investors seek stronger returns outside the country. If the yen depreciates, Japanese consumers could lose purchasing power. To protect themselves, they will seek to put some money into foreign markets. That would probably contribute to yen weakness and strengthen those other Asian currencies.
On the other hand, some emerging markets could benefit from a weaker yen. If Prime Minister Abe's new policy strengthens Japan's economy—the world's third-largest—then the global economy will experience stronger growth, and many emerging markets may benefit as a result.
Q: Some investors fear that a currency war could occur when the U.S. Federal Reserve begins to raise interest rates. They believe higher rates could result in foreign outflows from the U.S. bond market, hurting the dollar. Foreign central banks might then sell dollars, causing the dollar to fall further. Other highly indebted countries would then respond by devaluing their currencies as well. What is the likely impact when the fed does begin to raise rates?
Traub: The main question is, what will cause the Fed to begin raising interest rates? If the Fed begins to tighten policy because the economy is strengthening, that wouldn't necessarily hurt the dollar. A strengthening economy could attract foreign flows, and that could bolster the dollar.
It may also attract money into Treasuries. Of course, if investors buy Treasuries today, they will lose money when rates rise. But once rates adjust, and investors could get 3–4% on the 10-year Treasury instead of 2% as they do today, that could attract inflows, and that would be positive for the dollar.
In fact, rising rates in the United States may be more of a risk for emerging market currencies. With the 10-year Treasury at about 2%, it may be more attractive to invest in Brazil, for example. But if Treasury yields rise to 3% or 4%, and if an investor can get only a 5% yield in Brazil, then that may not appear quite as attractive given the currency risk that comes with investing in a foreign market.
On the other hand, if Treasury rates rise in response to some kind of shock, then the impact on the dollar could be different. If another credit rating downgrade occurs, for example, or a mistake occurs in fiscal policy, and this causes investors to flee Treasuries, that could hurt the dollar. But I put a very low probability on that scenario. So the impact of rising Treasury yields on the value of the dollar will depend on the reason for the rise.
Meanwhile, people do worry about China or Japan selling massive amounts of our Treasuries. But why would the People's Bank of China, the Bank of Japan, or any other central bank do that? If Treasury yields rise, that would decrease the value of their dollar reserves; but if these central banks responded by selling their Treasury holdings, that would only exacerbate the problem. That wouldn’t make any sense, unless they thought the U.S. government was going to default. But that is not going to happen. It’s impossible to conceive of the U.S. government defaulting.
Q: In this environment, where are you finding opportunities in emerging market currencies?
Traub: The emerging market currencies that are benefiting right now are the ones with strong fundamentals—those with organic growth and inflows of foreign capital.
We like Latin America because, for the most part, the region is growing steadily. Mexico, Chile, Peru are all doing well. A lot of the growth is coming from domestic demand. In addition, Mexico has become more competitive relative to China, which has seen its wages rise significantly over the past 10 years. Mexico is also more tied to the U.S. economy, which has performed better than many others, particularly Europe. Brazil did a lot to depreciate the real last year, and now Brazil's officials are doing a lot to stimulate growth. They are also allowing some appreciation of the currency as inflation has picked up. Intervention by central bankers is always a risk in Latin America, as it is in Asia, but as long as some growth is occurring, they will be careful about tinkering with their currencies too much.
In Asia, countries such as Thailand and the Philippines are benefiting as flows leave Japan for these economies. We're more worried about Europe because of the lack of growth. Core Europe [e.g., Germany, France, Italy] is not growing much, so emerging Europe isn't growing either. Emerging Europe [e.g., Czech Republic, Hungary, Poland] is also cutting interest rates, so those currencies don't have much going for them.
I believe this so-called currency war is forcing countries to focus on fundamentals. If the fundamentals are working in their favor, countries are likely to allow some appreciation in their currency, though they might try to control volatility somewhat. If the fundamentals are not working in a country's favor, then a country is likely to be more active. Colombia is a good example. Growth is slowing, and strikes in the mining sector are hurting foreign direct investment, which has been a big source of capital inflows. So the government and the central bank don't want to see any appreciation in the currency. As a result, we've underweighted the Colombian peso.
I don't believe we will see countries weaken their currencies if their economies are doing well. If we were to see that, then we would start to worry about a currency war. That could lead to a cycle of devaluations. But I don’t see any signs of that yet. So I'm relatively unconcerned.
Q: Thank you.
Leah G. Traub, Ph.D., Lord Abbett Partner & Director of Currency Management, is the lead Portfolio Manager of the emerging market currencies strategy and Director of Currency Management. Ms. Traub joined Lord Abbett in 2007, and was named Partner in 2012. Her prior experience includes: Research Economist at Princeton Economics Group; Research Assistant at the National Bureau of Economic Research; Research Assistant at Rutgers University; and Capital Markets Assistant at the Federal Reserve Bank of New York. Ms. Traub received a BA from the University of Chicago and an MA and a Ph.D. from Rutgers University, and has been in the investment business since 2001.
Risks to Consider: The value of investments in fixed-income securities will change as interest rates fluctuate. As interest rates fall, the prices of debt securities tend to rise, and as interest rates rise, the prices of debt securities tend to fall. Investments in high-yield securities (sometimes called junk bonds) carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks.
Foreign securities generally pose greater risk than domestic securities, including greater price fluctuations and higher transaction costs. Foreign investments also may be affected by changes in currency rates or currency controls. With respect to certain foreign countries, there is a possibility of nationalization, expropriation, or confiscatory taxation, imposition of withholding or other taxes, and political or social instability that could affect investments in those countries. The securities markets of emerging countries tend to be less liquid, to be especially subject to greater price volatility, to have a smaller market capitalization, and to have less government regulation, and may not be subject to as extensive and frequent accounting, financial, and other reporting requirements as securities issued in more developed countries. Further, investing in the securities of issuers located in certain emerging countries may present a greater risk of loss resulting from problems in security registration and custody or substantial economic or political disruptions. Foreign currency exchange rates may fluctuate significantly over short periods of time. They generally are determined by supply and demand in the foreign exchange markets and relative merits of investments in different countries, actual or perceived changes in interest rates, and other complex factors. Currency exchange rates also can be affected unpredictably by intervention (or the failure to intervene) by U.S. or foreign governments or central banks, or by currency controls or political developments.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
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