Is the Foreign Exchange Market the New Playground for Central Banks?

Central banks have kept silent about this but it’s hard to believe that manipulating the foreign exchange market isn’t part of their policies; it’s probably also part of their new strategy.

Neither injecting liquidity nor keeping interest rates near zero have worked. All hopes for any economic recovery have vanished and growth is desperately at a standstill. Furthermore, there looms the threat of deflation, which would make the weight of debt totally unbearable. What to do? There is one instrument left: currency devaluation! It could have several advantages, expectedly: boosting exports, thus growth, importing inflation (through higher commodity prices) and, hopefully, keeping at bay the spectre of deflation... an ideal solution!

The Bank of Japan (BoJ), always ahead of the others, has been doing just that for quite a long time. The yen lost 20% of its value in comparison to the dollar in 2013, and 15% since January 2014. On Wednesday, October 1st, the dollar reached the symbolic number of 110 yens for the first time since the 2008 financial crisis. At the start of 2012, it was worth 76 yens... which gives a little perspective on the Japanese currency’s tumble. As regards the euro, the devaluation is more recent but as important, as it has already lost 10% to the dollar in the last four months, which is quite significant in those very large and usually very quiet markets. This movement can be explained by the statements from Mario Draghi and Janet Yellen regarding asset buybacks for the former and the end of QE for the latter.

But, as a matter of fact, does it work? Has growth picked up in Japan? Has the threat of deflation disappeared? Of course not, as everyone knows, but this won’t keep the BoJ from persevering... In reality, the “expected” benefits from currency devaluation are the result of (Keynesian) mirages that are just as much an illusion as the benefits expected from monetary printing (boosting growth) or zero interest rates (enticing businesses to invest). On some occasions, and on the short term, there could be some benefits, but if devaluating one’s currency were such a sure recipe for instantly bringing back productivity and growth, it would have been known for a long time!

On the other hand, this little sterile game could degenerate. A devaluated currency means losses for foreign investors holding assets denominated in such a currency, whether it be stocks or sovereign bonds, who are tempted to get rid of them. Things may get rocky! Japan is protected, as far as its public debt goes (held at 95% in Japan), but Europe is not.

Above all, the high risk may come from the United States, not used to having a strong dollar. Let’s just recall their tantrum against an under-valued Chinese Yuan... Japan is back at it, since the 2008 crisis, and now the ECB is joining the fun! The Fed cannot not react to a too strong dollar – which would be an excellent argument for Janet Yellen to prolong QE or keeping rates at zero. And if the Fed starts playing this game, emerging countries will have to do something, since most of them are relying on the US dollar. We may see a period of “competitive devaluations”, troubles, even currency wars, which would cause havoc in all other financial assets.

Because of their lax policies, central banks have already caused bubbles everywhere and crashed risk premiums, which has totally blinded the markets. The foreign exchange market was the last one remaining relatively calm, away from those turbulences... but this is about to change soon.