For the decades under inflation-targeting, currencies were hardly mentioned for fear of moving the FX market. Along with the change in monetary policy regimes to include macroprudential regulation, currencies are no longer taboo to mention, though it still only occurs occasionally as central bankers are rightly concerned about igniting a currency war.
Exchange rate volatility or even a crisis has risen to the forefront of macro policy concerns. As with all such risks, whether a sufficient policy response exists matters a great deal. On this criteria, policymakers face a set of challenges. Top of the list is China. The RMB is one of the currencies that's generating the most concerns. Until recently when the ceiling on the benchmark deposit rate and the floor of the lending rate were lifted, there was no market-clearing interest rate. The gap between the two may have helped the net interest margin that raises revenue for the mostly state-owned commercial banks but it prevented the accurate pricing of risk and the efficient allocation of capital. And, it made it difficult, if not possible, to determine the long-run value of the exchange rate since currency movements are linked to the real interest rate. Now that the interest rate has been liberalised, the RMB is beginning to find its footing, helped by a stabilising current account balance even though global prices provide an ongoing challenge. More fundamentally, China's central bank hasn't relied a great on the interest rate to set monetary policy as a result so its gradual shift will bear watching. In the meanwhile, offshore currency traders are bring wrong-footed during this volatile period. Nearly $600 million worth of bets on the RMB weakening past 6.6 to the U.S. dollar, its low point during last year's surprise devaluation, have expired and become worthless. Currency trades are bilateral and not just over time. The other major global currencies are also being tugged and pulled by divergent monetary policies. Stimulative policies by the ECB and BOJ are juxtapositions against the normalisation of U.S. monetary policy to the Fed. The resultant weakening and strengthening of their respective currencies, the most traded in the world, is making it challenging for the rest of the global economy. In other words, most emerging markets have pegged their currencies to the dollar and also to the euro. Some Asian economies, due to the predominance of regional supply chains, keep a close eye on the RMB as well as the yen. Yet, the Fed has raised rates while the ECB has just unleashed a slew of loosening policies, including more cash injections or QE. In Asia, China is cutting rates now but it still is sufficiently above the zero bound for interest rates while Japan is deep in negative territory for rates. Such divergences among the dominant currencies add to global volatility because they lead to divergences among the economies that are pegged to them. So, some emerging economies are seeing their currencies rise while others are experiencing devaluation. For those central banks, their main monetary policy aim is targeting the exchange rate. So, this has become more challenging. It's especially the case for commodity exporters, who tend to be pegged to the dollar as the currency in which commodities are priced, and are seeing their exchange rate appreciate alongside the dollar when they could use a weaker currency. For what it's worth, it's even more challenging for major economies with free floating currencies. After all, the notion of a fully flexible exchange rate is that that there is no need to manage it. But, one of to members of the reserve currency club is now the RMB and there are those who worry about the Chinese currency's volatility as a risk to be managed when there really aren't many tools to do so. Still, exchange rates are also driven by financial flows, so the new macroprudential powers have an indirect effect, similar to interest rates. Still, central banks rightly remain reluctant to target currencies explicitly. It means that we should not be surprised that at a time of divergent monetary conditions and Chinese reforms that currencies are volatile and there is little that can be done by central banks. |