The Bank of Japan’s surprise announcement that they were massively increasing their Quantitative Easing program should be viewed as the first shot in what could become a prolonged currency war. Japan’s goal is to stimulate their economy by depreciating their currency in an effort to boost their export sales. Their strategy is as follows:
Why do I view this as the first shot in a currency war? With world economic growth slow (Europe) or slowing (Asia) all countries are looking for ways to increase their economic growth. Increased export sales is a natural place to look and currency depreciation is the historical strategy to increase export sales. This is especially important for countries that are export based economies. China, Korea and Germany are three economies that historically compete with Japan for export sales. Now, think of these countries like a business. If you are a business, would you idly sit by and watch one of your competitors dramatically drop their prices in an effort to take market share from you? Probably not. It is difficult to see China, Korea and Germany (and other export driven countries) simply sitting back and watching the Yen depreciate. We have already seen China and Korea respond by cutting their interest rates. Germany is stuck between a rock and a hard spot. Germany has been consistently pushing for austerity in Europe in order to fix Europe’s budget and debt problems. They have consistently battled the European Central Bank over Quantitative Easing. The reality is that the German economy has now been hurt by the reduction in exports to Russia due to the sanctions in place against Russia. A depreciating Yen is another attack on their exports from a different front. This may result in Germany changing their stance regarding Quantitative Easing. It is one thing for Germany to advocate policies that impose harsh conditions on the weaker economies of Europe if it does not hurt their economy, but quite a different position once their own economy starts to be impacted. The Bank of Japan has given all indications that they are willing to let their currency depreciate as much as needed to increase exports and help their companies create more jobs. If that is the case, then the actions of the Bank of Japan are only the first shot in a currency war. If the other export driven economies decide to match Japan’s efforts at currency depreciation, this could be a drawn out process.
What are the implications for the U.S.?
The major implication is that we should see the U.S. dollar appreciate against the other major currencies as long as this currency wars continues.
Some of the benefits of an appreciating currency are:
Some of the drawbacks:
Another implication of a stronger dollar could be that U.S. interest rates may be either remain low longer or a rise in interest rates will be more muted. This would result if demand rose for U.S. securities. If foreign money flows into U.S. bonds, then the higher demand would mute the impact of the Federal Reserve raising interest rates. Why would foreign money flow to the U.S.?
We continue to see the “rules” being re-written when it comes to economic theory. The size and scale of Japan’s recent actions may mean that the emerging currency war may yet be another economic “laboratory test” whose chapter in the history books is yet to be completed.
Steve Scranton is the Chief Investment Officer and Economist for Washington Trust Bank and is a CFA charter holder with over 30 years of investment experience with equities, tax-exempt and taxable fixed income securities. Steve actively participates on committees within the bank to help design strategies and policies related to client and bank owned investments. Steve also serves as the economist for the Bank and has been a featured speaker for both client and professional organization events throughout the Northwest.