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A Growing Currency War?

A growing number of global policymakers have warned that an international currency war could trigger protectionist reactions and stumble the economic recovery. The most notable is China's peg to the U.S. dollar. Some commentators have said the Yuan could be as much as 40% undervalued against the dollar.
Many countries are tempted to intervene to try to keep their currencies from appreciating, though some prefer to do so quietly to avoid embarrassment at international gatherings. Switzerland, South Korea and Taiwan have intervened, as has Japan. Brazil, Mexico, Peru, South Africa, Singapore, Indonesia, Thailand, Russia and Poland have or plan to take steps to weaken their currencies.
The trauma of the 1997-1998 Asian financial crisis is seared in the memories of emerging market countries. They recall booms when hot money rushed in, causing their currencies to strengthen and their trade sectors to become uncompetitive and the painful busts when that same hot money rushed out after foreign investors had a change of heart.
Interest rates in the developed world at rock bottom, it is natural for private capital to flow to emerging markets where assets earn much higher interest rates.  A common response is to fight the currency rise through sterilization, since policymakers fear excess liquidity growth will fuel inflation and asset bubbles. The central bank attempts to leave the monetary base unchanged by selling domestic securities and buying foreign securities, which causes its foreign reserves to grow. China has over $2 trillion worth of foreign exchange reserves.
But sterilization can be very expensive. The operation basically involves exchanging higher-yielding domestic assets for lower-yielding foreign assets. Estimates of these costs range from 0.25% of GDP to 0.5% in Latin America, and even higher in Singapore and Taiwan. As a result, many sterilization programs tend to be of limited duration.
For Japan and China, there are silver linings if they let their currency strengthen. It would accelerate the transition from export-led growth to growth driven by domestic consumption. Many Chinese export companies are neither viable nor sustainable. They and their migrant workers would have better and more stable income prospects if they shifted to activities that met the needs of the domestic population.

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