The Fed and the threat of a global currency war: 5 things you should know

SINGAPORE - This week the US central bank acted to rein in the surging US dollar when it signalled it will delay and slow US interest rate increases.

Accompanying the Federal Reserve's latest monetary policy statement on Wednesday, its chief Janet Yellen spoke of the negative consequences of the dollar's strong gains against other currencies - weaker US exports and inflation.

The dollar's ascent has been fuelled by the Fed's plans to raise borrowing costs this year at a time when central banks around the world are moving in the opposite direction and weakening their currencies.

Sweden's Riksbank became this week at least the 23rd central bank to drive down its currency this year by lowering its key interest rate.

Why is this happening and does it mean we are in the midst of a global currency war?

Here are 5 things you should know:

1. What is a currency war and who started this?

The value of a currency can make or break a country's economy. If it is too high, it makes the country's exports less competitive. It is is too low, it makes imports too expensive and can trigger high rates of inflation.

A currency war, also known as competitive devaluation, refers to a situation where countries compete against each other to weaken their own currency in order to boost exports, and/or raise inflation.

There have been currency wars throughout history.

But this latest episode may have kicked off in October last year when Japan moved to kick-start its flagging economy by unexpectedly expanding its programme of quantitative easing to around ¥80 trillion (S$920 billion) each year. Printing these vast amounts of money to buy bonds drove down the yen, making Japan's exports competitively cheaper abroad.

Since then at least 25 central banks have cut interest rates or made other moves to bolster growth and weaken their currencies.

In a surprise move in January, the Monetary Authority of Singapore (MAS) acted ahead of its scheduled April meeting to tweak its exchange rate policy and ease the rise of the Singapore dollar.

And the European Central Bank (ECB) launched this month its own 1.1 trillion euro (S$1.62 trillion) bond buying programme that has sent the speeded up the euro's decline.

The euro and yen's big declines against the US dollar this year are also putting pressure on China to devalue the yuan - which would signal that China is joining the currency war.

2. Why is there a currency war now?

Two main causes coming together: Economies that never sufficiently recovered from the last great financial crisis with consumer and business spending still in the doldrums; and, falling or low inflation, and the risk of deflation, thanks largely to the sharp fall in oil prices since last June.

Some policymakers argue that their monetary or quantitative easing is meant to increase demand at home - and is not aimed at weakening exchange rates.

But when the economy is weak, policymakers face great pressure to devalue their currency from their exporters.

"If everyone else is pushing their currencies weaker and you don't, you will end up with a strong currency that will come at the expense of your competitiveness," said Bank of America Merrill Lynch strategist David Woo.

3. How do countries weaken their currencies?

The fastest way is by manipulating interest rates, i.e. monetary easing. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The opposite relationship exists for cutting or easing interest rates - that is, lower interest rates tend to decrease exchange rates.

What happens, though, when interest rates are already close to zero, or even negative?

There is quantitative easing. Think Japan and the European central banks buying huge amounts of bonds to boost the money supply base, thus weakening their currencies and boosting inflation.

A third way is for a central bank to intervene in the markets to sells its own currency to buy other currencies, causing the value of its own currency to fall. This may work in the short term but is a costly gamble in the longer run.

A fourth method is for authorities simply to talk down the value of their currency by hinting at future action to discourage speculators from betting on a rise, though sometimes this has little effect.

Singapore's situation is unique as its central bank makes use of the exchange rate, not interest rates, as a monetary policy tool. The Monetary Authority of Singapore steps in to buy or sell the Sing dollar when it goes too high or too low relative to a basket of currencies of our major trading partners.

4. Are currency wars good or bad?

A weak currency might provide a short-term boost to countries engaging in currency devaluation, as their exports become relatively cheaper in global markets.

However, imports become relatively more expensive, which can harm citizens' purchasing power.

The policy can also trigger retaliatory action by other countries which in turn can lead to a general decline in international trade - the so-called "race to the bottom" that will harm all countries.

Currency wars are especially intense when global trade is stagnant and one country's gains come at the expense of its rivals.

5. What will happen when the Fed finally raises interest rates?

In the face of global monetary easing, the US is still headed the other way. While the Fed has just signalled a later start and a slower pace for its interest rate rises, it is still expected to raise rates later this year.

Some economists say it is unlikely that these "currency wars" and interest rate cuts will persist when that happens. Should the Fed hike rates as expected, central banks in Asia face the risk that the outflow of capital - already happening because of the stronger US dollar - will become heavier as investors leave in search of higher returns. In that environment, they may calculate that risks outweigh advantages of lowering borrowing costs.

Other analysts, however, believe that in a global economy where growth is scarce and there are not enough policy instruments to achieve higher growth, the currency war may be here to stay.

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