(July 5, 2011) –  Efforts by nations to manipulate the exchange value of their currencies to favor domestic industries will ease in the years ahead, Pacific Investment Management Co. (PIMCO) portfolio manager Richard Clarida has said.

Predicting a “two-speed global recovery with emerging markets (EM) leading the way,” Clarida explained that global market forces will likely continue to tempt countries into manipulating their currency valuations to benefit domestic industries. Because capital is flowing to countries whose central banks are confident enough to raise interest rates, however, the problem will be under control.

“Some countries are resisting the upward pressure that these capital flows are putting on their exchange rates,” Clarida said. “They are placing controls on capital or intervening significantly in currency markets with an eye to maintaining economic competitiveness. We do see this dynamic as a source of long-term global tension, but we believe it is a tension that most likely will be manageable.”

Clarida pointed to the experience of the central banks of the United States and the United Kingdom, which are currently winding down their monetary stimulus programs that have “exacerbated the situation.” Rate hikes, he claimed, could be possible in those countries in 2012.

As to the future of the U.S. dollar as the world’s reserve currency, Clarida contended that the dollar’s preeminence will remain for at least three to five years, if only for lack of a better alternative. “If foreign central banks were to decide that they did not want to hold dollars as a reserve, they would have to hold some other currency. And right now there is not a single viable alternative to the dollar.”

Clarida also underscored the volatility of currencies by cautioning potential currency investors as to its risk. “The primary risk, in our view, is that there are periods in which volatility spikes and in which there are potentially significant drops in a currency’s relative valuation. There is a saying in the foreign currency markets that currency trades work until they don’t. And so certainly anyone thinking of investing in currencies should also consider if portfolio managers are appropriately factoring in such tail risk.”

Click here to read “Your Largest Unmanaged Exposure,” from the summer issue of aiCIO Magazine, which explores the potential dangers that currency exposure poses for asset owners.