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Refugees of the Currency War, Unite!

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BUENOS AIRES – Today’s global currency war resembles real war in two important respects: a face-off over the structural imbalances between two large opponents – China and the United States – has forced uncomfortable smaller allies to take one side or the other, and third parties that may not be directly engaged are suffering collateral damage from both sides of the dispute.

Latin America’s rapidly growing economies are particularly vulnerable, as they are forced to confront both China’s exchange-rate inflexibility and the impact of dollar devaluation arising from the US Federal Reserve’s expansionary monetary policy.

The mechanics are familiar: dollar liquidity flees to emerging countries in search of higher yields, putting upward pressure on their currencies. Brazil, Chile, and Colombia, among others, are now confronting these powerful forces of currency appreciation. This pressure is compounded in resource-rich Latin American countries by the increase in commodity prices caused by a similar search for yield and by the fall in the dollar’s value.

But why should Latin American countries care about these capital flows and the revaluation of their currencies? After all, capital inflows traditionally have been regarded as a positive transfer of savings from rich industrial countries to capital-scarce emerging markets.

The post-crisis scenario finds the region with much better macroeconomic fundamentals than the industrial world. Fiscal positions are solid and public debt amounts to only 32% of the region’s GDP. Moreover, global deleveraging is asymmetric, with Latin American economies growing fast and advanced markets lagging – all of which may call for a real exchange-rate correction and thus justify revaluation of the region’s major currencies.

But this sanguine view obscures the loss of competitiveness that real appreciation could provoke. Indeed, the “Dutch Disease” – named for the catastrophic drop in Dutch manufacturing competitiveness after the discovery of natural gas in the North Sea drove up the currency – has become a serious concern. Instead of natural resources hurting competitiveness, in Latin America (and other developing countries) it is financial flows that are causing the illness.

Increasing capital inflows weigh heavily on import-substituting and export sectors, and may even wipe them out if the appreciation is substantive and protracted. Some economies may sustain collateral damage from both sides of the war, because, in addition to the pressure coming from excess dollar liquidity, they may be confronted with tougher competition (domestically and in third markets) from China, so long as the renminbi remains quasi-pegged to the dollar.

A case in point is Mexico. In the last 18 months, the peso has appreciated 6% more than the renminbi, eroding Mexico’s ability to compete with Chinese exports to the US, by far Mexico’s largest export market.

But this is not the only consequence of financial Dutch Disease. The Fed’s policy of quantitative easing exacerbates the flow of excess liquidity, which could result in dangerous bubbles in emerging markets. By artificially inflating assets and wealth in recipient countries, capital inflows induce emerging economies to over-consume, creating the same type of conditions that led to the recent crisis – this time in economies that are far less equipped than the US to deal with the risks.

But what will happen when the US recovers, reverses quantitative easing, and starts hiking interest rates? Will we see a capital-flow reversal, resulting in severe exchange-rate gyrations? To the extent that this outcome remains a distinct possibility, the financial Dutch Disease represents a serious threat to fast-growing emerging markets.

If the G-20 is to play a serious role, it must broker a solution to this situation. Unfortunately, the standoff on global policy coordination during the recent International Monetary Fund/World Bank meetings may be a demonstration of the limits of multilateral surveillance and international coordination.

In a desperate, last-ditch effort, the IMF is now inventing “spill-over reports” for a few systemically important economies, to be conducted at the margins of its country (Article IV) consultations. This initiative is destined to fail – as did the IMF Multilateral Surveillance Exercise or the G-20 peer reviews in the recent past. Even if massive spillovers are clearly recognized, it is difficult to see how this exercise would solve the fundamental problem behind the currency war: the major players’ apparent unwillingness to reconcile vastly different national interests.

So what should Latin American economies do? They surely have a right to defend themselves, whether through foreign-exchange intervention and the consequent accumulation of reserves (a potentially profitable option if capital flows are indeed temporary), imposition of capital controls, or other currency-related macro-prudential policies aimed at countercyclical exchange-rate smoothing.

All of this could be done (and is being done) unilaterally. While Chile has not yet intervened in the foreign-exchange market, Colombia and Peru have increased their international reserves massively. Brazil has been aggressive in terms of capital restrictions, twice increasing its tax on financial inflows. But uncoordinated action could result in a vicious cycle of retaliation, turning the currency war into a full-blown trade showdown, with serious consequences for all parties involved.

Alternatively, Latin American economies could try to foster policy coordination at the regional level, where economic realities tend to coincide, interdependence is more directly felt, and the cost of spillovers can be internalized more easily. This type of regional coordination might also enhance the bargaining power of the countries involved, strengthening their global voice. If so, Latin America could go from being a casualty of war to playing an important role in the peace process.

Mario I. Blejer is a former Governor of the Central Bank of Argentina. Eduardo Levy Yeyati is Profesor of Economics, Universidad Torcuato Di Tella, Buenos Aires, and a former chief economist of the Central Bank of Argentina.

Copyright: Project Syndicate, 2010.

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