* February 9, 2011, 12:08 PM GMT
The Euro Could Lose the Next Currency War
The euro may have had a good currency war last time around, but don’t count on it this time.
In the past, as central banks have accumulated dollar reserves from their intervention to keep their currencies down, they have often diversified these holdings into the euro. In fact, diversification has often been a big force in determining the direction of major currencies.
And the diversification issue is now set to return.
As global inflation pressures rise and many, particularly Asian, central banks embark on a new round of monetary tightening, another currency war is likely to ensue as many of these countries intervene to keep their currencies down.
A surprise rate rise from China on Tuesday provided a reminder of the rising risks of increased intervention.
With commodity prices still on the rise and with a drought in the north China plain putting the winter wheat harvest there at risk, both food and non-food prices are expected to continue rising.
If anything, the People’s Bank of China could prove even more aggressive with monetary tightening in the future. However, there is little sign that the bank will allow the hot money flows that higher interest rates will attract to push its currency much higher.
Despite the recent rise in rates, financial markets are only discounting a 2.4% appreciation in the yuan against the dollar in the next 12 months. In other words, the market is expecting renewed hefty dollar buying by the PBOC to preserve the yuan’s gradually rising peg.
Many other emerging markets in Asia are facing similar pressure. Thailand, India and Indonesia have already raised their interest rates this year and South Korea is widely expected to follow suit. However, likely intervention to keep their currencies from rising against the dollar and damaging export growth will probably bring another surge in dollar reserves.
The key question, though, is whether or not reserve managers in these countries will be as keen to diversify these reserves out of the dollar as they often have been in the immediate past.
Over the past couple of years, as the U.S. Federal Reserve has pursued a policy of extraordinarily loose monetary policy and as financial markets have worried about the funding of the U.S. fiscal deficit, the dollar’s role as the world’s primary reserve currency has taken a battering.
More often than not, the euro was the main beneficiary as reserve managers looked to diversify their portfolios away from the U.S. currency.
But that may not happen this time around.
With sovereign-debt concerns still hanging over the euro zone, with the succession of the European Central Bank presidency now in doubt and with talk of euro-zone stagflation on the rise, the economic recovery in the U.S. is starting to look more attractive and the dollar itself a better reserve option after all.
A rise in U.S. Treasury yields, as markets start to discount a tightening in U.S. policy, could also cement the deal, ensuring that any new currency war this year is good news for the dollar, not for the euro.