UPDATE 1-Bundesbank warms to capital controls in currency war debate

Thu Jan 24, 2013 10:02am EST

* Buba breaks with long-held opposition to capital controls

* Capital controls can be considered if other measures fail

* Comments part of broader German unease about BOJ move

FRANKFURT, Jan 24 (Reuters) - A top Bundesbank official signalled a break in the Germany central bank's long-held opposition to the use of capital controls as a foreign exchange tool on Thursday, saying limited use could sometimes be appropriate.

Countries from Brazil to Indonesia, South Korea, Peru and Thailand have all imposed controls to limit currency inflows since 2009, while a few countries such as Argentina, Iceland and Ukraine have sought to stem large or sudden capital outflows.

Concerns about a global currency war, meanwhile, have gained momentum. Bank of England Governor Mervyn King, for example, has warned that more central banks might seek deliberately to weaken their currencies this year to spur growth.

Tuesday's decision by the Bank of Japan to pump more money into the economy and double its inflation target added fuel to the fire.

In a guest column published in German financial daily Handelsblatt, German central bank board member Andreas Dombret said direct capital controls could be considered if other measures such as increasing reserves or making foreign exchange rates more flexible proved insufficient.

"If measures to limit capital flows are applied in exceptional cases, they should be temporary, transparent and targeted and as much as possible should not harm others," Dombret said, adding they could not replace economic reforms.

Policymakers in advanced countries, particularly Japan and the United States, have been pursing aggressive action to reflate their economies. This has the effect of weakening their currencies on foreign exchange markets.

As well as boosting a country's outward trade, it also makes locally-made goods more attractive by pushing up the price of imported goods.

Investment, meanwhile, shifts into higher-yielding currencies, particularly in emerging markets, making them even less competitive.

Combined with the response from Brazil and others, the reflationary moves have raised concerns among some economists that this could trigger a global currency war.

Michael Hartnett, chief investment strategist at Bank of America-Merrill Lynch, said in a note on Thursday that a currency war was one of two big threats facing the world's transition to normal growth, interest rates and investment risk appetite. The other was a bond crash.

"LESSER OF TWO EVILS"

Germany has observed developments in Japan with unease.

Bundesbank President Jens Weidmann warned earlier this week the pressure Japan's new government had put on the Bank of Japan endangered the central bank's independence, echoing similar comments by German Finance Minister Wolfgang Schaeuble.

Michael Meister, a senior member of German Chancellor Angela Merkel's party, indicating Germany may retaliate if the Japanese efforts to cheapen the yen continue.

The euro, for example, has risen by about 28 percent against the yen since last July.

While Germany has little reason to feel threatened by Japan given its economic strength and position as one of the world's top exporters, fear that the European Central Bank could be forced to engage in exchange rate targeting could be a driver.

Joerg Asmussen, member of the European Central Bank's executive board, sought to alleviate such concern in an interview with Reuters this week, stressing that for the ECB exchange rates were not a policy target and that the Group of Seven was the appropriate forum for discussion.

Gilles Moec, senior European economist at Deutsche Bank, said it was a "choice of two evils" for the Bundesbank - to accept a stronger central bank involvement or to give up a long-held opposition to capital controls.

"If you have capital controls, it frees monetary policy world wide to focus more on preserving price stability, but at the cost of a potential fragmentation of financial markets and capital mis-allocation," Moec said.

There is also less of a stigma to resorting to capital controls since the International Monetary Fund gave its endorsement and in December unveiled principles for how countries should manage international capital flows.

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