Currency Wars: The Phantom Menace

By Kieran Osborne, CFA, Co-Portfolio Manager, Merk Mutual Funds
8 October 2010

The last thing the global economy needs right now is anything that would hamper or derail economic growth. Unfortunately, there appears a growing specter of this occurring. Brazil and Japan's recent decisions to intervene in the currency markets follow a disturbing trend. If policy makers are not careful, present dynamics may precipitate a worldwide economic slowdown, brought about by protectionist pressures and exacerbated by political motivations globally.

Competitive currency devaluation appears to be the name of the game for many Treasury departments and central banks alike. It may also be a key driver of the recent strength in gold; in such an environment, an asset that retains its intrinsic value is increasingly sought after. Vietnam instigated a devaluation of the dong earlier this year, Switzerland, a country renowned for stability and neutrality, attempted to devalue the Swiss franc relative to the euro, rhetoric out of Washington has intensified surrounding China's decision to continue to peg its currency closely to the U.S. dollar, and now Japan and Brazil have both decided to take unilateral action, intervening to weaken their respective currencies.

For many countries, the motivation to devalue the currency is to spur export growth. Devaluing a countries' currency is akin to providing a subsidy to the export sector, as it makes that country's exports relatively cheaper. The flip side, is that it intensifies inflationary pressures, as a devalued currency means that imported goods become relatively more expensive; for a high-growth developing economy, the combination of an undervalued currency and increased production and labor costs can cause substantial domestic inflationary pressures, as evidenced in China.

Moreover, devaluing a currency may lead to escalating international political strains, global criticism and intensification of protectionist pressures. Maybe the most prevalent example being the U.S. criticism leveled at China, culminating in the passing of legislation aimed at pushing up the value of the yuan. When one currency is artificially weak, other countries may be put at a disadvantage, as other countries' goods and services may be less competitive in the global market. Such a situation can and has encouraged retaliation, whether through competitive currency devaluations or outright trade wars, in the form of additional import taxes and duties levied, or sanctions placed, on specific exporting countries deemed to be manipulating their currencies. Trade wars are good for no one: they create inefficiencies and slow down global growth. In a period of lackluster global growth, this is the last thing we need. Recent references of a "race to the bottom" and worldwide "currency wars" should not be taken lightly - given that the global economic recovery remains on unsteady ground, the implications of another slowdown in growth could be disastrous.

We have discussed at length the very questionable currency policies pursued by the Swiss National Bank (SNB) - see our analysis here - and have been heartened to see that the SNB appears to have come to its senses and discontinued this approach.

We have long argued that China should allow its currency, the yuan or renminbi (CNY), to appreciate, as it may help alleviate much of China's domestic inflationary pressures. China has continued to rely on rather rudimentary banking regulation to curb lending and growth in monetary aggregates to rein in inflation, and recently announced a plan to allow the currency to trade within a wider trading band. It turns out that "wider band" is a relative term; the CNY has appreciated by a little over 2% since the announcement in June. The Chinese are unlikely to allow the currency to float freely overnight, as even small moves to the currency affect many businesses throughout the Chinese economy; the process is likely to play out over many years. This hasn't stopped U.S. politicians from taking a swipe.

While Treasury Secretary Geithner's recent testimony to congress fell short of labeling China a currency manipulator (and was much less aggressive than many politicians had hoped for), the message out of Washington is clear: the U.S. is increasingly unhappy with China's exchange rate policies. In our opinion, however, China is unlikely to allow the currency to appreciate simply because of threats from Washington; rather, they will act in the best interests of China. Moreover, the debate over China's currency policies is to some extent misguided: many politicians argue that a stronger CNY will generate jobs in the U.S. To a degree, this may be true: U.S. based companies may think twice before making the decision on additional hires should the CNY appreciate. But it is unlikely that much of the jobs that already left as part of the outsourcing bubble that occurred throughout the last decade will return to the U.S.; the U.S. simply cannot compete on cost; these jobs are likely to migrate to lower value producing countries, like the Philippines, Vietnam or Thailand.

These countries produce goods at the low-end of the value chain, have limited pricing power and are therefore forced to compete predominantly on price. As such, and in our opinion, these countries are more likely to instigate competitive devaluations of their currencies. With an ever-deteriorating consumer outlook in the U.S., the incentive for these countries to instigate competitive devaluations of their currencies grows significantly. Indeed, Vietnam has already intervened in the currency market, actively weakening the value of the dong (VND). With a continued weak consumer outlook in many western nations, it is quite likely that further competitive currency devaluations occur in the lower-value producing Asian nations.

Brazil's economic expansion, and the substantial appreciation of the Brazilian Real (BRL) share similarities to the Australian experience. Rich in commodities and natural resources, both countries have benefited from insatiable demand out of Asia, particularly from China. Both economies have rebounded strongly and in both nations, the unemployment rate has declined steadily, and remains well below the levels seen throughout much of the western world. Both central banks have led the world in interest rate increases, with the Reserve Bank of Australia raising the target rate by 1.5% since the latter half of 2009 and Brazil's central bank raising rates by 2%. Increased investment demand has flowed into both nations and as such, both nations' currencies have appreciated substantially: relative to the U.S. dollar, the Australian dollar (AUD) has appreciated 39.9% for the period March 31, 2009 to September 30, 2010; during the same period, the BRL appreciated 37.7%.

When it comes to exchange rate policies, the similarities stop there. Brazilian finance minister Guido Mantega has been particularly vocal about the government's concerns surrounding the strength of the BRL, describing the present situation as an "international currency war". Brazil previously imposed a 2% tax on foreign purchases of fixed income securities and stocks in October 2009, in an attempt to curb gains in the currency. Brazilian policy makers have now stepped up their offensive, increasing the tax on inflows to 4% and buying billions of dollars in the market in an attempt to stave off further currency appreciation. Speculation is rife that further steps will be taken, or that direct capital controls may be implemented. The government is certainly not taking this issue lightly, sending the ominous message that they are "not going to lose this game."

Conversely, Australia has been a leading proponent of the virtues of a free-floating currency, namely protection against inflationary pressures and boom-bust cycles. The Reserve Bank of Australia has lauded the flexible exchange rate as one of the great success stories of Australian economic policy making. In their opinion, Australia's free floating currency has helped mitigate exaggerated economic booms and busts and has protected against high, and volatile, inflation. Currency price movements helped the economy adjust more smoothly to the current boom in the resource sector, helped protect the economy in 2008 when global risk aversion was at its peak, and during the Asian financial crisis and the bursting of the U.S. tech bubble.

Brazilian policy makers may do well to heed their Australian counterparts: the appreciation of the BRL has undoubtedly helped alleviate inflationary pressures in Brazil, helping bring inflation back towards the target rate of 4.5% from over 6% previously, and could help bring the rate to a more price stable level. While Brazilian policy makers may or may not succeed in destroying the currency, one thing is for sure: they run the very real risk of alienating Brazil from global markets. In our opinion, Brazilian politicians' motivations are flawed: on the one hand they believe the strong appreciation of the BRL will stifle economic growth; on the other hand the talk of imposing rather draconian measures to stem demand for the currency will likely drive investment away. These are the same investment flows required to drive economic growth in Brazil.

Potentially more damaging globally is if these actions prompt other nations to follow a similar path. Already we have seen South African, Peru, and Mexican politicians (amongst others) uttering misgivings about the strength of their respective currencies. Should we enter a period of competitive currency devaluations globally, the risks of trade wars may increase substantially, which could come with serious consequences for global markets.

Countries that run current account deficits, including the U.S., may be at the greatest risk should a global trade war scenario play out, as these countries are reliant on foreign investors to finance their deficits. Should additional tariffs, capital controls or sanctions take effect (a very real threat given recent legislation surrounding currency manipulation), the U.S. may lose the trust of international investors, who may in turn pull funds out of its markets, putting pressure on the U.S. dollar.

Currency Wars

By Dr. Jim Willie:

Some prefatory stories are highly revealing. Bank of America is badly on the ropes. On the same weekend at the end of July, when the Bank For Intl Settlements executed a 340 ton gold swap contract, two other events happened. The London metals exchange apparently suffered coordinated delivery raids, all legal, but painful nonetheless, stripping the embattled exchange of much gold bullion. My source from the German banking fortress shared that the BIS might have rescued the London Bullion Market Assn, and thereby prevented a near default at the exchange. Spurious stories about aiding commercial banks, even the Portuguese central bank, were floated to distract the masses. The second event was that on the same weekend, Bank of America suffered a failure. But the USFed pulled it out of the fire by Monday morning with fresh huge infusions of funny money. This week, another $13 billion infusion came to BOA by way of much darker corners of USGovt agencies, from nether recesses. It is getting that bad! So BOA had been propped by the USFed and the USCongress in the past, but by the syndicate now. In time, they will remove the valued assets and exit the burning building. Unexpected consequences are sure to come, a fact of nature. The BOA story came after a prompted inquiry as to which banks might next succumb to the rising gold & silver prices. BOA was at the top of the list of banks mentioned, but others were mentioned too. They appear in the September Hat Trick Letter, the usual suspects.

QE2: A JUSTIFIED CANCER
My best description of QE2, the Quantitative Round #2 Launch, is simply stated a monetary cancer, an admission of failure, and the trigger for the next breakdown in the global monetary system. The QE2 Launch is a US flag flying upside down at the central bank command center. Imagine trying to justify printing money to cover debts, and retaining credibility. The belief stated by USFed Chairman Bernanke, that zero cost comes from printing money, is pure heresy with dire consequences. The cost is lost confidence in the monetary system, in the currencies, and in the central bank franchise system. The QE initiatives kill the requisite confidence. Thus the rise in the Gold price in response. The financial news anchors struggle to hide their growing awareness that gold is the safe harbor from a destroyed monetary system, wrecked currencies, discredited central banks, and insolvent banks. They are awakening, as are those in the investment community.

Three additional sides are revealed on the Quantitative Easing desperation. The Bank of England has a US plant residing within. Adam Posen is an American who sits on the Monetary Policy Committee at the bank. He inflamed concerns about monetary instability with a speech to the Chamber of Commerce in Hull on Tuesday. He urged the major central banks to pursue more aggressive bond buying in order to rescue the world economy from stagnation that persists. He spoke of the fear of looking ineffective from inaction, mitigated by usage of extreme tools. He actually said, "Thus, policymakers should not settle for weak growth out of misplaced fear of inflation." So there you have it, inflation full speed ahead. A clarion call to inflate. The risk is hyper-inflation. Their policies in the last cycle produced unforeseen problems. In fact, the central banks, in particular the USFed, fight the last war only to create the most monster, on a consistent basis, in a pattern of serial events. Their colossal monetary inflation is breaking all historical records. It is given political cover by virtue of doctored price inflation statistics to hide its chronic 5% to 7% range. Posen pushed for further monetary easing undertaken in the United Kingdom, even to the extent of corporate debt purchases. Of course, to keep the order, they should begin with simple UKGilt (bond) purchases. He acknowledged that a QE program will not be able to create sustained recovery on its own. He fears a 1990s Japan style scenario, when a collapse of the Western monetary system is the more possible ugly outcome. He advises more effective coordination of large scale asset purchases by the central banks working together. This is a trumpet call to the Competing Currency War, where peace is declared at first, but which will vanish in the din of a threatening crisis......read on

Capital controls eyed as global currency wars escalate

By Ambrose Evans-Pritchard:

Stimulus leaking out of the West's stagnant economies is flooding into emerging markets, playing havoc with their currencies and economies.

Brazil, Mexico, Peru, Colombia, Korea, Taiwan, South Africa, Russia and even Poland are either intervening directly in the exchange markets to prevent their currencies rising too far, or examining what options they have to stem disruptive inflows.

Peter Attard Montalto from Nomura said quantitative easing by the US Federal Reserve and other central banks is incubating serious conflict. "It is forcing money into emerging market bond funds, and to a lesser extent equity funds. There has truly been a wall of money entering many countries," he said.

"I worry that we are on the cusp of a competitive race to the bottom as country after country feels they need to keep up."

Brazil's finance minister Guido Mantega has complained repeatedly over the past month that his country is facing a "currency war" as funds flood the local bond market to take advantage of yields of 11pc, vastly higher than anything on offer in the West.

"We're in the midst of an international currency war. This threatens us because it takes away our competitiveness. Advanced countries are seeking to devalue their currencies," he said, pointing the finger at America, Europe and Japan. He is mulling moves to tax short-term debt investments.

Goldman Sachs said net inflows have been running at annual rate of $520bn (£329bn) in Asia over the last 15 months, and $74bn in Latin America. Intervention to stop it creates all kinds of problems so the next step may be "direct capital controls", the bank warned.

Brazil's real has been one of the world's strongest currencies over the past two years, aggravating a current account deficit nearing 2.5pc of GDP. The overvalued exchange rate endangers Brazil's industry, especially companies that compete with Chinese imports. The real has appreciated to 1.7 to the dollar from 2.6 in late 2008, and by almost the same amount against China's yuan.

"Everybody is worried that global growth is fading and they are trying to use exchange rates to protect exports. Brazil has watched as the Asians intervened and feels it can't stand by," said Ian Stannard, a currency expert at BNP Paribas.

Brazil has used taxes to slow the capital inflows but the allure of super-yields and the country's status as a grain, iron ore, and commodity powerhouse have proved irresistible. It is a textbook case of the "resources curse" that can afflict commodity producers.

A $67bn share issue by Petrobras has been a fresh magnet for funds, forcing the central bank to buy an estimated $1bn of foreign bonds each day over the past two weeks. Such action is hard to "sterilise" and can it fuel inflation.

Japan has begun intervening to stop the yen appreciating to heartburn levels for Toyota, Sharp, Sony and other exporters. A strong yen risks tipping the country deeper into deflation.

Switzerland spent 80bn francs in one month to stem capital flight from the euro, only to be defeated by the force of the exchange markets, leaving its central bank nursing huge losses.

Stephen Lewis from Monument Securities said the Fed is playing a risky game toying with more QE. There are already signs of investor flight into commodities. The danger is a repeat of the spike in 2008, which was a contributory cause of the Great Recession. "Further QE at this point may prove self-defeating," he said.

Meanwhile, Dominique Strauss-Kahn, managing director of the International Monetary Fund, tried to play down the fears of a currency war, saying he did not think there was “a big risk” despite “what has been written”.