Governments and central banks many times attempted to manipulate the currency value by interventions and adjustments of interest rate in the past, but normally these attempts were episodic and asynchronous, thereby having no significant impact on the global economy. The only widely acknowledged currency war occurred in the 1930s and turned the American great depression into the global one. The recent events outlined below forced the economists and politicians to speak of a threat of a new global currency war, which can complicate the recovery of the world economy from the financial crisis.
Global background
A currency war may be also called a competitive devaluation as countries intentionally take measures to devaluate their currencies to revive their economies. A lower exchange rate implies rising export volumes what boosts domestic business activity and leads to improvement of macroeconomic indicators.
An immediate reaction of the major economies to the credit crunch in 2008 was harsh interest rate cuts and several quantitative easing waves. Although these measures to some extent achieved the foreseen goals, they also had an important in context of this essay adverse side-effect. An excessive money supply conditioned by these measures created disbalances between the economies as investors directed their money, borrowed at extremely low rates in developed countries, to emerging markets in search for higher yields.
This mismatch between interest rates stimulated appreciation of local currencies thus undermining the main competitive advantage of developing countries - cheap exports. As a result during 2010, apart from disputes between China and the US regarding undervalued yuan, we have seen numerous instances of state interventions aimed at devaluation of home currencies. Israel, Thailand and Indonesia were selling record amounts of their currencies to keep the exchange rates low. Brazil, Columbia and Peru as well as South Korea and Thailand introduced measures to stem capital inflows. Even high-profile economies like Japan and Switzerland had to step into the foreign exchange (hereafter forex) market in attempt to cease a rise of their currencies (Lauricella et al., 2010).
In contrast to earlier episodes of state interventions this autumn's events were simultaneous and were accompanied by aggressive rhetoric on the part of policymakers. It seemed that a global fight between countries for their competitiveness in terms of exchange rates was inevitable. In this connection Brazilian Finance Minister Guido Mantega stated that the world is "in the midst of an international currency war" (Deans, 2010).
Brazilian Story
As any emerging economy Brazil suffered from the financial crisis more than developed countries. Backed by record high oil prices the Brazilian real reached its peak against the US dollar on 31 July 2008 trading at 0.6393$ [1] . However as the global financial turmoil was unfolding the real plummeted down stopping its freefall at 0.3965$ four months later. The currency suffered a 38% devaluation. Like the US and Europe, but with a little delay, the Brazilian government began gradually cutting the interest rate in February 2009 to stimulate the economy. It dropped down to 8.75% [2] in August 2009 from January's 13.25%. However, to withheld inflation and keep the economy from overheating, Brazil had to start raising the rate and now it stands at 10.75%, whereas Europe and the States kept it at the same low levels (Lauricella et al., 2010). As a result the carry trade money inflows from developed world invaded the country. According to Bloomberg foreigners were holding a record 89$ billion of Brazilian bonds as of August what constituted 10.1% of the country's outstanding debt. Along with recovering commodity prices this pushed the exchange rate back to the pre-crisis levels - in the middle of October 2010 the real cost 0.6037$.
On the day when Mr Mantega stated a global currency war he also complained that the monetary policy in the US and Europe is "taking away Brazil's competitiveness". The head of Brazilian Central Bank Henrique Meirelles added that "Brazil cannot pay an excessive price for the fact it's doing well while others are doing badly [and] needs to take its measures to protect itself from [the] imbalances" (Ye Xie, 2010). The discontent of Brazilian policymakers was understandable - neither the US, nor Europe and Japan were giving any signals that they were going to start raising interest rates or stop providing financial institutions with liquidity. On the contrary the ECB's head Jean-Claude Trichet and his American colleagues assured investors that the status quo would remain intact in the nearest future (Randow, 2010; Sano, 2010). China was also reluctant to revaluate the yuan despite the pressure of the US. Japan announced in the beginning of October that it trims down the interest rate to almost zero (AP, 2010).
Meanwhile the real was climbing up remaining the most overvalued currency in the world as it had been labelled by Goldman Sachs a year before (Winterstein and Correa, 2009). A negative international economic environment tampered competitiveness of Brazilian exports making them more expensive in comparison to those of other countries. As a result a five quarter rising trend of GDP growth reversed after 1Q 2010 and is still showing a negative dynamic [3] . A continuation of the trend will mean a recession in the country. The following section focuses on the measures Brazil took to overcome the rise of the real and their consequences.
Brazilian Response
Brazilian government was first concerned with an excessive appreciation of the real in autumn 2009 when it imposed a 2 per cent tax on foreign portfolio investments. The motivation was to stem the rise of exchange rate by decreasing incoming capital flows from the countries with low-yield currencies. However this measure only insignificantly and temporarily affected the real's value, whereas the Brazilian stock index, BOVESPA, experienced a sharp fall (Wheatley and Beattie, 2009). It was also reported that at that time the Brazilian central bank spent 6.7 billion dollars on interventions into forex market (Weinstein and Correa, 2010).
This autumn, after the verbal attacks of Brazilian officials did not take effect, the Brazilian government returned to fiscal and monetary measures in attempt to devaluate the currency. First of all it raised the tax on foreign capital inflows by another 2 per cent, but this time only on fixed-income investments, to prevent another stock market drop. When it turned out that this hike had not discouraged investors from investing money in Brazil's government bonds the tax was set at 6 per cent. The government also allowed the Treasury Ministry to pre-fund external liabilities coming due in the future thus increasing a money supply (Carvalho, 2010). As to forex market interventions, the central bank was buying about 1 billion dollars daily - 10 times more than the daily average - for two weeks in September to offset foreign investments in the Brazilian bond and stock markets.
The question is whether these steps helped accomplish the goal of depressing the real. The fiscal measures taken by the Brazilian government can be characterised, to a certain extent, as an introduction of the Tobin tax - a tax on market transactions. The rationale behind the introduction of the tax is the reduction of volatility and short-term speculative operations as well as improvement of market efficiency. Theorists often suggest that the tax can be a solution for emerging economies to protect themselves from speculative attacks (Terzi, 2003, 368). However there is no consensus between economists on efficiency of the tax. Some of them claim that it can even cause an opposite effect and bolster markets' volatility (Reisen, 2002). The case of Brazil supported neither side: an IMF [4] study showed that the 2 per cent tax in 2009 had not affected an aggregate capital inflow in the country, although it had changed a composition of this inflow and had insignificantly affected interest-rate arbitrage. This autumn confirmed the observation - the further increase of the tax had just an initial and short-lived impact. The situation was best described by Marcelo Carvalho, the head of Latam Economic Research at BNP-Paribas, who said that the "tax restrictions can throw sand in the wheel of foreign capital inflows, but they do not prevent the wheel from turning".
Evaluating the direct market interventions of the Brazilian government it is worth looking at the similar experience of other countries. A paper of Disyatat and Galati gives a comprehensive overview of how exchange rates were influenced by state interventions in the past. The evidence on effectiveness of such measures is quite mixed and differs for developed and emerging markets. However an important similarity in case of emerging countries is that the interventions are more effective when they are aimed at stemming the appreciation of the currency rather than its depreciation, exactly what Brazil was interested in. Researchers also point out that usually the effect of the interventions is significant, but short-term. Nevertheless in September 2010 we saw a steady upward trend for the BRLUSD rate, what means that the interventions of Brazilian central bank did not take any effect. It was possible to reverse the trend only after introduction of the fiscal measures in the middle of October discussed above. Summarising one can say that the effectiveness of state interventions is determined by volumes the central bank is prepared to spend for selling or buying the currency. However as the total volume of forex market transactions is permanently growing a fight of central banks against the market becomes more and more unequal. Last year it was illustrated not only by Brazil, but also by Switzerland and Japan, which eventually abandoned their attempts to struggle against the market's fundamentals (Deans, 2010).
As we have seen the steps taken by the Brazilian officials barely reached the objective of the real's long-term devaluation. On the contrary they have an important negative implication. The actions of Brazilian policymakers considerably increased the volatility of financial markets in the country. Bloomberg reported that in September the one-month implied volatility of real/dollar options, which reflects a grade of uncertainty among the forex market's participants, made the biggest jump since May and reached 13.7 per cent. Strong fluctuations of the market may be good for speculators, but not for the economy in whole. In general academic literature does not provide a definite support of this point, stating that the influence of exchange rate volatility on trade flows can be both positive and negative and is market-specific (McKenzie, 1999). Nevertheless there is still evidence that an unstable currency may be detrimental for international trade volumes (Bahmani and Hegerty, 2009) as well as for flows of foreign direct investments (Kyereboah and Agyire, 2008). This is a bad news for Brazil. Another interesting finding was very recently made by Chit and Judge who argued that "a stable exchange rate seems to be a necessary condition to achieve export promotion via a currency depreciation". Thus it appears that Brazil chose a wrong way to retain its competitiveness as the good intentions of the government and the central bank may lead to exclusively negative consequences, whereas the real remains as strong as it was before Mr Mantega declared the currency war.
Conclusion
The buzz in mass media around the currency war has settled down, but the problems which have caused this threat still exist. Despite the assertions that the crisis is over, the developed countries are still keeping the interest rates low and are reluctant to revise their loose monetary policy. In turn the rest of the world perceives it as an attempt to resolve the western world's problems at expense of the emerging economies. Nevertheless, since exchange rates are just relative prices, any currency war is theoretically a zero-sum game. However in reality it becomes a negative-sum game, as history proved that the global protectionism makes everyone worse off. Unfortunately, despite numerous warnings, currently we see how valuable resources which could be spent on development of internationally coordinated measures to revive the global consumption are recklessly squandered on tit-for-tat strategies.
