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Currency War and Peace

WASHINGTON, DC – Much of the hype surrounding last month’s meeting in Moscow of G-20 finance ministers and central bankers was dedicated to so-called “currency wars,” which some developing-country officials have accused advanced countries of waging by pursuing unconventional monetary policies. But another crucial issue – that of long-term investment financing – was largely neglected, even though the endgame for unconventional monetary policy will require the revitalization or creation of new long-term assets and liabilities in the global economy.

The collapse of Lehman Brothers in 2008 drove up risk premia and triggered panic in financial markets, weakening assets in the United States and elsewhere, and threatening to provoke a credit crunch. In order to avoid asset fire-sales – which would have led to the disorderly unraveling of private-sector balance sheets, possibly triggering a new “Great Depression” or even bringing down the eurozone – advanced countries’ central banks began to purchase risky assets and increase lending to financial institutions, thus expanding the money supply.

While fears of meltdown have dissipated, these policies have been maintained or extended, with policymakers citing the fragility of the ongoing economic recovery and the absence of other, equally strong policy levers – such as fiscal policy or structural reforms – that could replace monetary policy quickly enough.

But several years of ultra-loose monetary policy in the advanced countries has led to significant liquidity spillover abroad, putting excessive upward pressure on higher-yielding developing countries’ currencies. With developing countries finding it difficult to deter massive capital inflows or mitigate the effects – owing to economic constraints, like high inflation, or to domestic politics – the “currency wars” metaphor, coined in 2010 by Brazil’s finance minister, Guido Mantega, has resonated widely.

Moreover, only a small portion of the liquidity created by unconventional monetary policy has been channeled toward households and the small and medium-size enterprises that generate most new jobs. Instead, crisis-affected global financial entities have used it to support their efforts to deleverage and to rebuild their capital, while large corporations have been building large cash reserves and refinancing their debt under favorable conditions. As a result, economic growth and job creation remain lackluster, with the availability of investment finance for long-term productive assets – essential to sustainable growth – severely limited.

Some believe that the elimination of macro-financial tail risks, the gradual strengthening of global economic recovery, and the increase in existing asset prices will eventually convince cash hoarders to increase their exposure to new ventures in advanced economies. But such optimism may not be warranted. In fact, at the recent G-20 meeting, the World Bank presented an Umbrella Report on Long-Term Investment Financing for Growth and Development. The report, based on analysis from various international organizations, highlights several areas of concern.

For starters, banks’ current retrenchment of long-term investment financing is likely to persist. After all, many of the advanced-country banks, especially in Europe, that dominated such investment – for example, financing large-scale infrastructure projects – are undergoing deep deleveraging and rebuilding their capital buffers. So far, other banks have been unable to fill the gap.

Furthermore, the effect of internationally agreed regulatory reforms – most of which have yet to be implemented – will be to increase banks’ capital requirements while shrinking the scale of maturity transformation risks that they can carry on their balance sheets. The “new normal” that results will likely include scarcer, more expensive long-term bank lending.

The World Bank report also points out that, as a consequence of banking retrenchment, institutional investors with long-term liabilities – such as pension funds, insurers, and sovereign wealth funds – may be called upon to assume a greater role in funding long-term assets. But, to facilitate this shift, appropriate financing vehicles must be developed; investment and risk-management expertise will have to be acquired; regulatory frameworks will have to be improved; and adequate data and investment benchmarks will be needed. These investors must focus on the small and medium-size enterprises that banks often neglect.

Finally, local-currency bond markets – and, more generally, domestic capital markets – in emerging economies must be explored further, in order to lengthen the tenure of financial flows. Local-currency government-debt markets have performed fairly well during the crisis, while local-currency corporate-debt markets have played a more modest role as a vehicle for longer-term finance. This suggests that domestic reforms aimed at reducing issuance costs, improving disclosure requirements, enhancing creditors’ rights frameworks, and tackling other inhibiting factors could bring high returns.

Anxiety over unconventional monetary policies and “currency wars” must not continue to dominate global policy discussions, especially given last month’s pledge by G-20 leaders not to engage in competitive currency devaluations. Instead, global leaders should work to maximize the liquidity that unconventional policy measures have generated, and to use it to support investment in long-term productive assets. Such an approach is the only way to place the global economy’s recovery on a sustainable footing.