Currency wars and inflation

Jan 11, 2011

In the last week, two major South American economies have decided to intervene in their currency markets. Brazil and Chile have both taken steps to prevent the continued appreciation of their currency. Brazil imposed tighter restrictions on its own banks to discourage them from shorting the US dollar. Meanwhile, Chile intervened more directly, selling its own currency in the market in order to reduce its value.

The benefits of having a weak currency are always well flouted by governments that intervene. It makes their exports cheaper and improves their competitiveness on a global scale. It is also done to discourage hot money flows from developed economies looking for higher returns.

Unfortunately, there are two sides to every policy. Like any medicine, there can be nasty side effects. In this case, it is inflation. This week, record food prices have made headlines around the globe. On top of that, other commodity prices like oil are rising too. Why does weakening a currency make inflation worse?

Most commodities are priced in US dollars. So when a currency is weakened against the dollar, the commodity becomes more expensive in the local currency. And the more the dollar weakens, the more expensive the commodities become. This ends up resulting in high inflation. China is a good example of a country that is facing high levels of inflation because its currency is pegged to the dollar. The quantitative easing policies by the Fed also only make this problem worse.

Countries keeping their currencies low against the dollar are only delaying the inevitable. The dollar has to weaken over time because of the large trade imbalance in the US. The US imports much more than it exports, and has a huge trade deficit. The only way this can get corrected over time is if the dollar weakens. Keeping a currency artificially weak only delays this process.

The market also seems to follow this. There is usually always downward pressure on the dollar and upward pressure on emerging market currencies. One of the reasons the Reserve Bank of India has not been attempting to weaken the rupee is that India is facing high levels of inflation, especially food prices. Food price inflation was 18% in 2010, and the general inflation rate is around 10%. A significantly weaker rupee would make the inflation problem worse.

The Central Banks of many emerging countries will eventually need to make a decision as to when they let their currencies appreciate against the dollar. The correct approach is to allow a slow appreciation over time so that volatility is minimized, and the economy has time to adjust.

Disclosure: I do not hold the currency/commodity viewed/opined in this column