Source: The Financial Times                     Date: 20 October, 2010

Concerns about currency tensions are intensifying as the U.S. trade deficit rockets and the Federal Reserve mulls another round of quantitative easing (QE). But it is not the U.S. and other developed countries that should be worried.

The main source of contention is currencies, in particular the value of China’s renminbi. Holding down the value of currencies against market pressures – as practised by Beijing on a huge scale – creates distortions and should be stopped. But this would treat the symptom rather than the cause. Global imbalances are largely the result of poorly coordinated macro economic policies. The U.S. runs large trade deficits with European countries whose currency floats. Letting the renminbi appreciate will make little difference if countries cannot learn to cooperate better on other economic policies.

With the U.S. unable to rely on foreign demand and Federal Reserve chairman Ben Bernanke publicly flirting with an explicit inflation target, further monetary easing seems likely. The prospect has sent the dollar plummeting against most major currencies. There could be yet further falls if QE is stepped up, accelerating the flight from the dollar.

How effective more QE would be is questionable: long-term interest rates in the U.S. are already extremely low. With U.S. assets offering low returns and the financial system in weak health, much of the new money will find its way to high-yielding emerging markets. There will be little additional benefit to the U.S. economy.

The good news for countries such as the U.S. and Britain is that a monetary tsunami makes the prospect of a global double-dip recession more remote. The bad news for emerging markets is that the next major threat to the global economy could originate in their own back yards.

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Emerging markets are not enthusiastic about further QE. They fear that the resulting increase in capital inflows will push up their currencies, undermining the competitiveness of exporters. From Brazil to Malaysia, currencies have shot up against the dollar this year. Continued appreciation could encourage further currency interventions.

A flood of liquidity could also create huge asset bubbles in emerging markets. Some are taking precautionary measures. Capital controls may help to temper inflows, but they are easily circumvented and could be overwhelmed by large inflows.