European Central Bank attempts to weaken euro could trigger currency war

September 16, 2014

Frankfurt (Sept 16)   Attempts by the  European Central Bank  (ECB) to weaken the euro have the potential to spark a currency war but policymakers across the world are keeping silent, knowing the ECB has scant alternatives to keep its economy afloat.   

 Eurozone central bankers have spelt out the need for a weaker euro to breathe life into the bloc's economy, which flatlined in the second quarter and is flirting with deflation.  

 Such comments are usually a no-go among the big industrialised nations for fear that one country's bid to become more competitive might trigger a race to devalue currencies and prompt other economies to resort to protectionism.

 But ECB measures that have helped push down the euro to below  $1.30  from just shy of  $1.40  in May have drawn little objection. These include verbal interventions, cutting interest rates close to zero and a pledge to flood the banking system with money via cheap loans and purchases of private sector debt.

 "People aren't criticising the ECB as triggering a currency war, because they are worried the eurozone may slip into deflation," said a Japanese policymaker with direct knowledge of exchange rate policy. "It's in the interests of the global economy for Europeans to do what's needed to avoid deflation."

 Japan  got a similar pass from its G20 peers last year when Prime Minister  Shinzo Abe  launched an aggressive mix of monetary and fiscal stimulus that pushed the yen sharply lower. Having urged  Tokyo  for years to do something to galvanise its listless economy, other major economic powers could hardly complain about such 'Abenomics'.

 The problem for the ECB is that its new funding may not pass through to businesses and households as intended. Many eurozone banks are still laden with bad loans and struggling to meet regulatory demands for more capital buffers, while uncertainty from the conflict in  Ukraine  and a sanctions war with  Russia  could spoil companies' appetite for new loans. A weaker euro might be a more effective remedy.

 "With the eurozone doing worse economically than  the United States  and  United Kingdom  , a weaker euro against the dollar and pound is just what the doctor ordered," said  Barry Eichengreen  , professor of economics at the University of  California  and one of the world's foremost experts on currency systems.

 "There would then be an end to the litany of financial shocks originating in  Europe  that have perturbed US financial markets for the last four years."

 The US has criticised currency policies in the past — urging  China  , for example, to move towards a market-determined exchange rate — but its bigger concern now is possible deflation in  Europe  .

 "Some recent steps and further discussion in  Europe  toward a more accommodative pro-growth strategy are encouraging, but boosting domestic demand is key and efforts to do so should be supported by decisive actions across a full range of economic policies — fiscal, structural and monetary," a US Treasury

 official said on Friday. 

 Raised eyebrows 

 Although ECB chief  Mario Draghi's  initial efforts to talk down the euro raised eyebrows in  Tokyo  , policymakers there have been silent on recent verbal interventions by ECB officials. After nearly two decades of deflation and economic stagnation — and with the yen at a six-year low against the dollar helping  Japan's  export-reliant economy — they know how important the currency channel can be.

 When the  Bank of Japan  (BoJ) launched its massive quantitative easing (QE) programme in April last year, a tumbling yen was regarded as a key transmission mechanism, driving up import costs and salaries at exporters. That helped push core consumer inflation to above 1 percent from below zero in a year.

 "The ECB's stance is similar to what  Japan  is doing and no-one can criticise that," Nomura currency strategist  Yujiro Goto  said. "If the euro continues to depreciate that might be a bit negative for Japanese inflation momentum, but at this moment people are more focused on dollar/yen, which is appreciating again."

 Japan's  stronger business ties with  Asia  and the US mean a weaker euro will affect it only marginally, although BoJ governor  Haruhiko Kuroda  has said he is ready to talk down the yen if the euro fall triggers a yen spike.

 Some Japanese policymakers see the ECB's explicit language on the euro as a sign of desperation, pointing to its depleted policy arsenal and high threshold for deploying QE. Worried that stagnant euro zone demand will drag on emerging Asian economies, they see merits in allowing  Europe  to take whatever steps are needed to revive growth, as long as there is no direct intervention in currency markets to weaken the euro.

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