Question

Read the article of “Currency wars: Lose-lose or win-win?”

THE term "currency wars" has been bandied about ever since Guido Mantega, the Brazilian finance minister, used it in 2010. He was complaining that quantitative easing (QE) by the US was weakening the dollar, and prompting a response from other countries that did not want to lose export competitiveness. This time round, the dollar is strengthening, but the term is being used again. Currency volatility is on the rise, albeit from a low base. And David Woo of BofAML thinks this is a bad thing. In a research note, he argues that For many countries facing zero interest rates and binding fiscal constraints, the only policy tool left at their disposal to stimulate growth is a weaker exchange rate. So the ECB and the Bank of Japan's QE programmes are designed, he thinks, to weaken their currencies; after all, bond yields are already so low that it is hard to see borrowing costs as a constraint for the corporate sector. (Incredibly, the yield on Nestle bonds turned negative yesterday.) Clearly, all currencies cannot decline, so it might be tempting to think this is a zero-sum game. But it is possible to argue that it is actually a win-win for the global economy; in attempting to depreciate their currencies, central banks reduce real interest rates and these lower real rates stimulate demand and investment. But Mr Woo argues instead that currency wars are a lose-lose. He writes that Higher currency volatility will increase both the riskiness and the cost of crossborder transactions, whether it is trade in goods or capital flows. Specifically, higher FX volatility means it costs more for companies to hedge; that may cause them to focus more on their home markets than on exports, leading to a slowing in the growth of global trade (which has recently been sluggish for other reasons). Secondly, higher volatility will discourage foreign direct investment (the building of factories etc). This will make it more expensive for countries with a current account deficit to finance themselves. Economic growth will thus be more sluggish if the wars continue.

(a) “David Woo of BofAML argues that many countries facing zero interest rates and binding fiscal constraints, the only policy tool left at their disposal to stimulate growth is a weaker exchange rate.” Does the Interest Rate Parity (IRP) holds in this phenomenon? Please comment.

(b) Currently, the Japanese yen is expected to weaken against the US dollar over the coming years. Explain how this will affect the consolidated earnings of Japan-based multinational corporations (MNCs) with subsidiaries in U.S.

(c) “Specifically, higher FX volatility means it costs more for companies to hedge……” Do you agree with this statement?

(d) Presume that “currency wars” can be assessed by the country risk analysis, discuss two techniques that can be applied by an MNC to assess the risk.

Answer 1

a) Due to the fact that interest rates are near zero in major economies of the world and the currency demand and supply are driven by non-conventional policies such as open market operations and quantitative easing, the interest rate parity does not reflect the currency relationship between various economies. Under such abnormal economic situations, the interest rate parity does not hold.

b) With weakening of Yen versus Dollar, the Yen denominated earnings of the US based subsidiaries of Japanese companies are expected to increase because of this change in exchange rates. Thus the the consolidated earnings of Japan-based multinational corporations (MNCs) with subsidiaries in U.S. are expected to improve and go up.

c) Higher foreign exchange volatility means greater uncertainty in the foreign exchange future and forward market as well derivatives market. Due to higher volatility, the price of the derivative instruments goes up and hence the cost of hedging also goes up.

d) Currency wars can be assessed through country risk analysis and the techniques used to analyse the same are:-

• Prospecting for the growth of economy which in turn would determine the long term movement of the currency.

• The nature of control on the currency such as – fixed, pegged, float, controlled float etc. which would determine the kind of interventions that the government would make in the currency market.