Just as in the early 1970s it is intervention or the lack of it from those central banks with surpluses (European central banks back then, and emerging ones today) which will determine how and when such adjustment takes place. Although HIDC policymakers may genuinely believe themselves to be the dominant decision makers – and may have hoodwinked some in emerging markets to think likewise – this is largely a conceit.
Emerging central banks hold the key to the large global foreign exchange shifts in the medium term. Those without reserves can persuade and bargain, but – having few reserves – they cannot pull the intervention trigger themselves.
So the fate of HIDC currencies rests with emerging market central banks. There are three scenarios for them:
- Firstly, we might see a continuation of heightened risk aversion and the status quo of emerging currency range trading;
- Secondly, we could yet see a rush for the exit and a dollar crash (fortunately a low probability scenario);
- Thirdly, we may see a reduction of risk aversion leading to the start of rebalancing. This seems increasingly to be the new reality.
The only way to avoid the need for 20 years of HIDC fiscal surpluses is a combination of devaluation and inflation even, given such large debt loads, if this results in stagflation rather than growth.
Unlimited spending
ECB President Draghi’s commitment to buy unlimited eurozone sovereign bonds from countries in an ESM (or equivalent) programme if needed has reduced tail risks in the eurozone. It may end up buying a vast volume of government bonds, and it may even end up doing so in unsterilized fashion and create inflation and devaluation.
Draghi has signalled that responsibility for the possible break-up of the euro will not be his. His messages are: the euro might devalue if non-sterilized intervention replaces sterilized intervention; and the chance of near-term euro catastrophe is reduced.
This was followed by Federal Reserve Chairman Bernanke’s QE3 – his commitment to continue buying bonds up to and beyond a clear future economic recovery. This signals that he is not only still worried about the parlous state of the deleveraging US economy, but possibly also that the US banking sector is sufficiently repaired and now robust enough to weather more currency turbulence. He is signalling a weaker dollar is now acceptable, even desirable.
Emerging currencies have been allowed to drift by their central banks, but this may now be changing. We hear of more and more central bank swap lines between emerging market central banks, and more direct investing in each other’s sovereign bonds. This is complementary to the shifts of some of the more export-oriented emerging economies towards domestic demand-led growth and South-South trade.
Once a few central banks see their neighbours’ currencies start to move up against the dollar, euro and sterling, it is easier to let theirs rise also. This spares the cost of acquiring and holding large HIDC-currency reserves. And none wants to be the last holding depreciating dollars.
But could the pace quicken?
Barring panic we hope and expect that if the pace becomes a little too rapid for comfort then intervention to buy dollars will slow it down again. This may confuse some market commentators and be interpreted as a preference for the status quo.
What should be more apparent, whether all market participants and policy-makers realise it yet or not, is that the key to foreign exchange dynamics lies with the emerging market central banks today more than ever before.
