The world economy is on the brink of a “currency war”. Some policymakers have threatened “retaliation”. This is hyperbole, for not only is war is an odd term to refer to a situation where somebody sells you something at a discount, which is effectively what you do when you keep your exchange rate at “competitive” levels. But a good, old-fashioned term like “beggar-thy-neighbour” policies would do just fine to describe what is going on. International monetary relations are fraught with tensions, which the G20 summit in Seoul, unsurprisingly, left unresolved. In times of low growth, economic uncertainty and/ or high unemployment, tapping external demand through a “competitive” exchange rate becomes both an attractive policy option and a bone of contention.
In this context, the US Federal Reserve has been pursuing a policy of quantitative easing aimed at pushing down bond yields, raise US asset prices and weaken the exchange rate. In doing so, the Fed is seeking to both fend off deflation risks and support economic activity. Other countries fear that lower interest rates and a weaker dollar will put appreciation pressure on their currencies and increase capital inflows – especially countries with flexible exchange rates, an open capital account and high interest rates.
A country can respond to capital inflows in several ways. (1) It can absorb the capital inflows into official reserves via FX purchases. If left unsterilised, this will raise domestic inflation. If fully sterilised, this may or may not push up interest rates, but it will typically addition to the fiscal costs of carrying reserves. (2) It can let the exchange rate appreciate. While this may diminish the attractiveness of local assets in the eyes of foreign investors, it is likely to lead to an “overshooting” of the exchange rate, slowing economic growth and a deterioration of the current account. (3) It can try to limit capital inflows through capital controls or macro-prudential measures. If implemented successfully, this will reduce secondary market liquidity and push up domestic yields. All these responses carry economic, financial and/ or, in the case of controls, implementation risks. Policymakers facing surging capital inflows and an appreciating currency find themselves between the proverbial rock and a hard place.
While Fed quantitative easing has a very significant impact on other, especially smaller economies, any “retaliatory” measures these may take have virtually no economic or financial impact on US. Several factors explain this asymmetry. (1) The dollar exchange rate and, even more so, any bilateral exchange rate is far less important to the US than for its trading partners, with the possible exception of the EU given the importance of bilateral trade. (2) Capital controls in other countries do not impose any tangible economic or financial costs on the US – other than perhaps opportunity costs for individual US investors. (3) Sanctions by other countries targeting US exports are neither credible, for, assuming the US responds in kind, these typically more trade-dependent economies would incur relatively greater economic costs than the US.
“Currency war” therefore seems a misnomer. It may feel like war to smaller countries, as they feel compelled to take “defensive” action to fend off capital inflows. But if this is a war, the US has not noticed. The US pursues an economic policy it deems to be in its interest and however these countries respond to it is of little consequence to the US. This is a prime example of continued US “structural power”. Structural power is the power of a state to indirectly influence others by controlling the structures within which they must operate. This differs from “relational power”, or the ability of one state to influence another state's behavior directly. This describes the situation quite accurately, for Washington is not seeking to influence other countries’ behaviour. If one prefers to stick to martial metaphors, US policy may be said to cause “collateral damage”.
US structural power is attributable to the dollar’s status as a reserve currency, the US government’s ability to issue debt in its own currency and the large size of the US economy on which other countries are – or perceive themselves to be – depend in terms of generating economic growth. Keen to maintain a competitive exchange rate, the other economies have little choice but to absorb US capital outflows into FX reserves. This is not to say that some of these countries could not inflict meaningful costs on the US by, for example, dumping US assets or imposing protectionist measures on US exports. However, both the economic and financial costs of such measures would be far greater for these countries than for the US.
In other words, the US retains maximum policy flexibility, while its own choices have a very tangible impact on, and create significant constraints for, other countries. As long as other economies depend more on the US market for their exports than vice versa, they will not only be highly constrained in terms of policy options, but they will also wield little in the way of bargaining, let alone retaliatory power vis-à-vis the US. Even holding large amounts of US debt will provide them with very little leverage as long as they are reluctant to let their currency appreciate. True, the US has thus far failed to get other countries, notably China, to appreciate their currencies. Whether one attributes this to a lack of US relational power or a reluctance on the part of Washington to yield its power, US structural power remains the defining characteristic of today’s global monetary and financial system.