Currency war gets pushed to brink of nuclear option

FEB 17, 2015

BY MARK GILBERT

SWEDEN has fired another salvo in the escalating currency wars by joining Denmark, Switzerland and the European Central Bank in introducing negative interest rates. As this battle intensifies, some market soothsayers are starting to whisper about capital controls as a possible nuclear option for central banks determined to win the race to the bottom of foreign exchange rates.

The Swedish Riskbank has introduced what it called a "more expansionary" monetary policy, cutting its repurchase rate to minus 0.10 per cent from zero and announcing a bond purchase programme. Two-thirds of the 19 economists surveyed by Bloomberg News had predicted no change in rates. One US dollar now buys 8.5 Swedish krona; a year ago, that figure was below 6.5.


It's increasingly nonsensical to talk about "surprise" interest rate cuts, since they are coming at a rapid clip. As my colleague Simon Kennedy put it, central banks are now "open all hours". Official monetary policy calendars are being ignored as new tactics are assessed on the fly.

Once upon a time in economic history - well, a couple of years ago - central bankers used to harp about the zero bound for interest rates and how, in an echo of quantum physics, things were likely to get weird and scary in the realm of very small interest rates. Such inhibitions are no longer on display.

The US is finally starting to retaliate verbally against the dollar's unremitting ascent, which has seen the greenback strengthen by 16 per cent against a trade-weighted basket of its peers. In an interview broadcast by India's NDTV television, US Treasury Secretary Jack Lew said he'll "oppose and push back very hard" against devaluations designed to boost exports: "There is a very big difference between countries that use domestic tools for domestic purposes, macroeconomic tools to grow their economy which is something that in the world community we have agreed to and we in the United States have used in QE for example. On the other hand, it is another thing to target your currencies for the purpose of gaining unfair trade advantage."

Central bank quartermasters are stockpiling yet more ammunition for the currency wars. Switzerland, Denmark and Sweden have all said they see scope for even deeper rate cuts to deter investors from holding their currencies, never mind the crushing effect on domestic savers.

Denmark is so desperate to defend its peg against the euro that it has offloaded about US$30 billion (S$40.6 billion) worth of kroner since the start of the year to keep a lid on its currency; economists are now speculating about Denmark introducing the lowest interest rates in the world later this week, at minus 1 per cent or even minus 1.25 per cent.

If rate cuts and currency market interventions don't do the job, capital controls - the introduction of taxes and prohibitions to regulate the flow of money into and out of a nation - may creep higher up the agenda of desperate central banks.

Three years ago, the International Monetary Fund softened its strict opposition to such strategies, conceding that "in certain circumstances, capital flow management measures can be useful", with the caveat that "they should not, however, substitute for warranted macroeconomic adjustment".

In a 2009 paper examining Chile's experiences in the 1990s, Professors Sebastian Edward and Roberto Rigobon of the National Bureau of Economic Research had this to say: (a) A tightening of capital controls on inflows depreciates the exchange rate. (b) We find that the "vulnerability" of the nominal exchange rate to external factors decreases with a tightening of the capital controls.

Swiss National Bank president Thomas Jordan was asked in a Feb 7 interview with Swiss radio station SRF whether he would introduce capital controls. "It's not a measure that is at the forefront at the moment" was his less- than-dismissive response.

As interest rates drop to ever more absurd levels and central bank balance sheets swell with the accumulated cash from the proceeds of selling their own currencies on the foreign exchange markets, policymakers will have to rummage even deeper in the tool box. So don't be surprised if references to capital controls start to increase in the coming weeks. All's fair in love and currency wars.

BLOOMBERG VIEW