The Yuan-yen currency war: at the heart of the fight is the diminishing marginal efficiency of monetary stimulus.

• Author: Lo, Chi

The uncertainty about the effectiveness of "Abenomics" reviving Japanese inflation to a sustainable 2 percent within two years suggests that the yen may soon become another potential force driving the currency war that was started by quantitative easing in the developed world in 2010. The inflation Japan has recently experienced is not the kind that will allow the Bank of Japan to stop its money-printing press. If Abenomics fails to deliver the expected results soon, the yen will likely weaken further and for longer, creating pressure for more competitive devaluation. China is nervous about yen weakness since it adds appreciation pressure to the renminbi at a time when Beijing is pursuing structural reforms which will hurt short-term growth. If China were to retaliate, that would aggravate global market volatility as more Asian currencies are now tracking the renminbi's movement than ever before.

The latent force behind the currency war is the diminishing marginal efficiency of monetary stimulus. The global economy is facing disinflationary/deflationary risks, with China already experiencing outright deflation at the producer price level. The prevailing disinflation and a tail risk of deflation reflect the ineffectiveness of quantitative easing to deliver the intended reflationary results. On the contrary, quantitative easing has had the unintended result of transmitting deflationary pressures from the host country to countries that have not pursued quantitative easing. Japan's recent embarking on the quantitative easing trail is likely to prolong this deflation-exporting process. This is making China nervous and raising the risk of another round of competitive devaluation.

DEFLATIONARY CONTAGION

With interest rates at or close to zero, quantitative easing works through two channels to stimulate economic growth: asset price inflation and exchange rate depreciation. When the growth impact of the former is uncertain and unstable, the onus for boosting growth rests with the exchange rate. However, as the exchange rates of countries engaged in quantitative easing fall, they impose deflationary pressures on the countries not pursuing quantitative easing because a rising exchange rate lowers import prices, profit margins, and real wages in the non-quantitative easing countries.

Under normal circumstances, growth should return to the quantitative easing countries at the expense of the non-quantitative easing countries, and deflationary pressures...