A new currency war is breaking out, as anxiety over the state of the global economy pressures the handful of countries where investors seek sanctuary when fear sweeps through financial markets.
Japan's central bank sold the yen Thursday, following moves by Switzerland a day earlier to keep its franc in check. The Bank of Japan's uncommon intervention in foreign-exchange markets kicked off a brutal trading day around the world.
Stocks tumbled in Asia, and continued falling through to the closing bell in New York, where the Standard & Poor's 500 index plunged almost 5 per cent, marking its worst day since February, 2009. The carnage went well beyond stocks, hitting commodities and many currencies. Canada's dollar fell 1.8 per cent against its U.S. counterpart. Oil plunged almost 6 per cent to $86.50 (U.S.) a barrel.
Investor confidence already was strained from signals that the U.S. economy is much weaker than many had assumed, and from re-emergent worries that European authorities have failed to contain their debt crisis.
While the Swiss broke the ceasefire, it was the Japanese intervention that confirmed policy makers are rearming to fend off volatile capital flows that threaten inflation in some economies, and painful contractions in others.
There's every reason to expect other countries to act unilaterally to protect their economies until markets settle down. Turkey's central bank held an emergency meeting Thursday, cutting its benchmark interest rate as insurance against a global slowdown, while taking separate steps to protect the value of the lira.
"They have a mixed record," said Susan Schadler, a senior visiting fellow at the Centre for International Governance Innovation and former senior official at the International Monetary Fund. "This is a very short period of unsettled conditions. We've had some bad news and markets have to work out a response to it."
The volatility in foreign-exchange markets already is leading to calls for some kind of joint intervention by the Group of Seven industrial countries, or the larger Group of 20. That's not likely in the short term. The G7 intervened jointly in March to stem an earlier surge in the yen, but Thursday, Japan's partners in the group remained on the sidelines.
The decision by Japan's government to weaken the value of the yen only added to the uncertainty by deterring access – at least temporarily – to a favourite safe harbour for global investors. A day earlier, the Swiss National Bank abruptly lowered interest rates to deter speculative interest in the franc, another financial sanctuary that had surged to record values in recent weeks.
"Japan sent the ball rolling for competitive devaluations," said Sophia Drossos, a currency fund manager at Morgan Stanley Investment Management in New York. "It's a race to the bottom."
In the autumn of 2010, Brazilian Finance Minister Guido Mantega declared the world's major economies were in the midst of a "currency war," with each economy attempting to keep its foreign exchange rates low in order to gain advantage in export markets.
Mr. Mantega's primary villain was the U.S. Federal Reserve Board, which had signalled it was about to create hundreds of billions of dollars to buy U.S. Treasuries, a strategy that would inevitably hurt the value of the greenback. Investors fled the world's largest economy in search of higher yields, zeroing in on fast-growing emerging markets such as Brazil.
Competing efforts to devalue currencies contributed to the Great Depression, giving Mr. Mantega's declaration added resonance. The angst eased toward the end of 2010 as the Fed's efforts at stimulating the world's largest economy helped stoke a surge in equity markets that got investors thinking that the worst of the financial crisis was finally over.
Unfortunately, the Fed's medicine appears to have had only a middling impact on its patient. Revised data last week showed the U.S. economy effectively stalled in the first quarter, and then recovered at annual rate of a 1.3 per cent – a pace of growth that some economists consider recessionary.
Washington's protracted squabble over lifting the legislative borrowing limit further soured investors on the United States, raising doubts about the ability of U.S. politicians to seriously tackle the country's longer-term debt issues. At the same time, yields on the debt of Italy, Spain and other countries rose to uncomfortable levels amid doubts the European Union would keep its weaker members from defaulting.
That's a lot of risk to endure, and investors in recent weeks flew to safety. They like the franc because Switzerland is a well-managed economy that runs a trade surplus, which protects the country from swings in the global economy. The yen is attractive because it ranks as a major funding currency and Japan's debt, while large, is mostly held domestically.
However, the Japanese and Swiss economies are heavily dependent on exports, so surging exchange rates threaten growth and jobs. The yen this week approached postwar highs against the U.S. dollar, hurting an economy that still is trying to recover from March's tsunami and nuclear disaster that caused an estimated $212-billion (U.S.) worth of damage.
The Bank of Japan, acting on orders from the Finance Ministry, reversed the flow of capital headed to its shores by selling massive amounts of yen from its vaults and using the proceeds to buy U.S. dollars, which authorities eventually will convert into Treasuries.
That's more aggressive than the Swiss National Bank, which sought to make Swiss assets less attractive by lowering its benchmark interest-rate target and pledging to pump tens of billions of francs into the markets. However, the SNB warned investors that it was prepared to intervene if the franc's value remained at extreme levels.
The yen was 2.6-per-cent lower against the dollar at the end of the trading day in New York, after falling as much as 4.1 per cent. That shows the difficulty central banks face when investors are placing a collective one-way bet. The yen rebounded as global stock prices continued to tumble. The franc rose against all its major peers.
"The Bank of Japan scared some of the speculators out of the market, at least temporarily," said Camilla Sutton, chief currency strategist at Scotia Capital in Toronto. "Intervention doesn't really last. Attempting to reverse the trend doesn't really work. At best, you can slow things down."