World braces for next big battle in the currency war

The Nation

Bangkok, Friday 29 October 2010

The financial markets are now focusing on the 2 & 3 November 2010 meeting of the US Federal Reserve over how it will manage its monetary policy. Already, the markets have anticipated another round of quantitative easy, or money printing on a large scale, to purchase US Treasuries and hold down interest rates.

The printing of money will have far-reaching global implications, representing an indirect manipulation of the exchange rate as criticised by Germany at the recent G-20 meeting. The way we are going is clear: the US will continue to flood the global financial system with liquidity and the dollar will have ample room to devalue further.

The Group of 20 had little to say on exchange rate coordination. The currency war is continuing to rage unabated. Most countries would like to keep their currencies weak to prop up their exports. However the G-20 did agree to "move towards more market determined exchange rate systems that reflect underlying economic fundamentals and refrain from competitive devaluation of currencies". This means that the G-20 is trying to defuse the tensions caused by competitive devaluations.

The broader goal is to achieve greater stability in global growth and reduce global imbalances.

There is no reason to believe that the US will not continue to hold the dollar down. US Treasury Secretary Timothy Geithner failed to persuade other members to agree on specific targets for current account surplus. Strong exchange rate policy is one factor that could reduce surpluses, but there are other factors, including investment and consumption. China, Germany, Thailand and most other Asian countries enjoy current account surpluses, whereas the US and Turkey, for instance, report current account deficits. In the end, Geithner's call fell on deaf ears.

Against this backdrop, the Fed will go ahead with phase two of its quantitative easing.

In phase one, the Fed purchased about US$1.5 trillion in US Treasuries and mortgage-backed securities. This measure provided relief to the financial markets, but has failed to cure the fundamental ills of the US economy, which are underpinned by a lack of demand in the aftermath of the burst financial bubbles.

Instead of restructuring assets and managing the downturn so that the economy is allowed to get regain its equilibrium, the Fed has sought to pump up the economy again with almost "free" money and liquidity. Since the banks are holding toxic assets, the Fed hopes that the fresh liquidity will help arrest the falling prices. The Fed can't tackle the toxic assets with liquidity. It has to tackle the insolvency with restructuring.

The second round of money printing is likely to start before the end of the year. This time, it will amount to somewhere between US$1 trillion and US$3 trillion. The financial markets will continue to focus on the implications of second-phase quantitative easing (QE2) for the US dollar and inflation. A weak dollar will bring about higher inflation and therefore steepen the Treasury curve.

The G-20 countries have come to accept the reality of the impending QE2 and are now contemplating how they can adjust to the new conditions it will bring.

Closer to home, the Bank of Thailand decided to keep its benchmark rate unchanged at 1.75% last week. For the time being, it is ignoring the indications of inflation in favour of focusing more on the capital inflow. A lower rate, or at least an unchanged rate, will deter capital inflow. But given the massive inflow, the central bank must be realising that it is fighting a losing battle. Further capital control measures are on the cards.

At the same time, the economy appears on track for a period of robust growth, probably exceeding the central bank's projections of 7%.

Asia News Network