One currency's gain is another's loss

When criticised about the US administration's exchange-rate policy vis-a-vis the yen, former US president George H W Bush apparently retorted in a fit of pique, "Let the Japanese handle their exchange rate and we will handle ours."

Unfortunately, this bit of curious Texan logic doesn't quite hold in the world of currencies. One currency's gain is tautologically another's loss. If the dollar loses, the rupee gains - there are no two ways about it.

Thus, in a world of interlinked economies and financial markets, the macroeconomic strategies of one economy impinge on another through the currency route. It is impossible for economic policy to be truly independent.

This inescapable connection between economies via currencies poses the risk of an impending currency war. The battle line has been drawn by the two-track growth environment that the global economy finds itself in.

The somnolent US economy is one side and the relatively fast-growing emerging economies the other. Faced with an obstinately high unemployment rate and slow growth, the US seems to follow a policy of passive devaluation of the dollar to export its way out of a recession.

It does this by keeping its policy rate, the Fed funds rate, interest rates at zero, and flooding the global markets with cheap dollars.

The US central bank, the Federal Reserve, seems reconciled to another round of quantitative easing (economist-speak for printing more greenbacks) and that could lead to a further fall for the dollar.

The problem is that these cheap dollars find their way into emerging markets like China and India (whose asset markets offer better returns), causing their currencies to appreciate and their export competitiveness to erode.

The dollar has thus become the principal "carry currency" that investors borrow in (at virtually zero cost) and fund investments in higher-yielding assets of the emerging markets. Europe and Japan are caught in the middle - saddled with sluggish economies but witnessing a rapid rise in their currencies against the dollar.

Japan has tried to thwart a steady appreciation of the yen by dropping its policy interest rate close to zero and intervening in the currency market. This hasn't quite paid off yet.

How will the war be fought? It is likely that the emerging economies will fight the loss of exchange competitiveness by attempting to curb inflows. Brazil, for one, doubled its tax rate on capital inflows to thwart appreciation.

Other emerging markets, including perhaps India, are also likely to use capital controls. Despite accusations of currency manipulation and the prospect of US legislation to penalise this, China is unlikely to either abandon its currency peg or let its currency appreciate significantly.

The US and Europe will take their battle forward by putting political pressure on emerging markets to let their currencies float.

There will be a growing threat of protectionism in the US and Europe, and the currency war could well spill over into a trade war. How will this finally resolve itself? Over the long term, economies that drive global growth, particularly those in emerging Asia, will see sustained inflows of capital.

This will mean a secular tendency for their currencies to appreciate against the dollar, the euro and the pound sterling. The competitiveness of their exports will then depend on their ability to enhance domestic productivity.

This is something that policy-makers in these economies need to reconcile to - capital controls will provide temporary breathing space.