State intervention in the foreign exchange market is a taboo subject. On the one hand, each nation holds and reports reserves of foreign currencies that are seen as critical to financial and economic stability. On the other hand, if a nation uses those reserves too aggressively then it risks being labelled a currency manipulator. The US Treasury takes this very seriously and under its Competitiveness Act of 1988 it seeks to name and shame these countries for their efforts in “gaining unfair competitive advantage in international trade”. The repercussions do not stop at a mere pointing of the finger. Once labelled a currency manipulator the United States will pursue the elimination of this unfair advantage with the International Monetary Fund. The line to be trod between intervention and manipulation is therefore a very important one.
The United States and other developed nations care so much about currency manipulation because if foreign currencies are ‘undervalued’ the goods that trade within them are relatively cheaper. Take an identical good sold in China and the United States. If the good is worth $100 and sells for ¥700 then provided the USDCNY exchange rate is 7 then those goods are equally competitive – the consumer’s decision of whom to purchase from will not be influenced by price. However, if the People’s Bank of China steps in and sells CNY like there’s no tomorrow and buys USD in exchange and the USDCNY exchange rate moves to 8 then there’s a difference. Provided the Chinese vendor keeps the price at ¥700 then the relative value of that product in US Dollars in $87.5. Under these conditions the US claims an unfair advantage and pursues you with the combined weight of the US Treasury and the IMF. In truth then, currency manipulation only becomes the subject of politics and international relations when a country is seeking to devalue its own currency. It’s a little crude, but observation dictates that devaluation is manipulation and currency support is intervention.
Due to the huge sell off in emerging market currencies towards the beginning of the pandemic we have seen increased ‘interventions’ in the foreign exchange market. Whilst a currency devaluation like the one in the example above is good for competitiveness as far as price is concerned, sharp swings lower in the value of one currency destabilise investor/consumer willingness to trade with that country. If a currency loses 50% of its value against the Dollar, for example, you might say that is was a bargain. But at the same time, you’ll question what’s wrong with it and reconsider your purchase of the currency in question on the grounds that it could go lower.
We did in fact see these kinds of movements amongst the emerging market currency basket. The Brazilian Real, the currency of a nation that we now know to have the second highest COVID-19 death toll in the world, lost more than 50% of its value versus the US Dollar at the peak of the pandemic. South Africa’s Rand and the Mexican Peso lost close to 40% each versus the Dollar. The deteriorating sentiment towards these nations and the risk of capital flowing abroad prompted FX market interventions from these countries as well as others.
As of the beginning of June emerging market economies had burned through over $240bn in foreign currency reserves since the beginning of the pandemic. The main protagonists were China, Hong Kong, Saudi Arabia, Brazil and Turkey who had the largest changes in their net foreign currency reserves. Many emerging market nations are still fighting foreign currency outflows with Turkey alone in the last week spending around $1.5bn of its already depleted reserves in order to support the Lira. Due to the improvement in risk sentiment the market is helping to restore some of the value in emerging market currencies that was lost during the pandemic.
Discussion and Analysis by Charles Porter