The Currency Wars - An Ebury Partners Report
A special report discussing the currency wars currently gripping the markets. We look at how it started and the prominent players such as the US, Eurozone and China.
Economic Background
Prior to the financial crisis and the subsequent Great Recession, world trade was dominated by two complementary economic blocks. One the one hand, Northern Europe and East Asia consistently run large export surpluses and current account surpluses. On the other, the United States, Southern Europe and some other smaller economies (Australia and New Zealand, among others) run the necessary trade deficits. The net effect of this setup was the continuous accumulation of financial claims on the second block countries by the first block. This accumulation took the form of bulging FX reserves in the case of East Asia, and the accumulation of (mostly) private debts of the deficit countries in the balance sheets of Northern European banks.
The financial crisis of 2008, followed by an unprecedented collapse in world trade, saw a dramatic rebalancing of the world trade accounts. The terrifying few months – from the Lehman collapse in September 2008 to the equity market bottom of March 2009 – saw an unprecedented collapse of world trade and therefore the surpluses and deficits run by both blocks. The coordinated reaction from fiscal and monetary authorities worldwide first stopped, and then reversed the slide. This was obviously a desirable outcome, with the sudden rebalancing of the world accounts through a stoppage of trade flows.
The recovery from the crisis added another cleavage to the above-mentioned economic divide. The economies of developing markets recovered from the crisis much faster than the advanced industrial economies, powered by strong domestic demand and/or significant infrastructure spending packages that the developed countries could not or would not match. As a result, most emerging economies (with the exception of some of the Eastern European countries) have already surpassed their pre-crisis production levels. None of the major G10 countries have done so, and some of them are still far below.
The United States
The US was the epicenter of the world financial crisis. Other countries like Japan and Germany suffered an even greater initial collapse of economic activity than the US. However, the wholesale collapse of the construction sector in the US, plus the very limited effects that the recovery in world trade has had so far on US exports, have caused the unemployment rate in the US to more than double, and, critically, there are no signs that it will come down anytime soon. No other country has seen its employment situation deteriorate to the same extent, with the exception of other European peripheral countries with similarly bloated construction sectors and real estate bubbles.
The dire employment situation, together with an uncomfortably low rate of domestic inflation – combined with the political inability to implement any further fiscal stimulus –has pushed the Fed ever closer to a second round of monetary stimulus. With rates already at zero, this can only take the form of Large Scale Asset Purchases financed with freshly printed money. Of course, flooding the world with newly-printed dollars would have the effect of putting further downward pressure on the dollar. This would tend to both put upward pressure on US inflation and provide further stimulus to the US economy – all to the good, from the US perspective.
The front lines
The United States has long contended that the currencies of some of its developing trade partners, China in particular, were seriously undervalued, amounting to an unfair subsidy to their domestic exporters. The recovery from the crisis has provided further ammunition for US complains. FX reserves of most emerging countries – which had stopped growing or even shrunk during the crisis – are growing again at record pace, as domestic authorities struggle to stop the tremendous appreciating pressure on their currencies brought about by either persistent trade surpluses (e.g., China), massive capital flows from developed-market investors attracted to their strong economic performance (e.g., Brazil) or both (e.g. South Korea).
China runs the largest single trade surplus vs. the United States. Not surprisingly, it has been the focus of much US political anger. US authorities point to the immense and growing Chinese FX reserves, which it acquires by buying up dollars and thus putting downward pressure on the Yuan as proof that the Yuan is “artificially” undervalued. China disputes this assertion, pointing to the fact that is has resumed allowing the Yuan to appreciate very slowly, and also that other countries (Germany and Japan, primarily) have no trouble maintaining or even expanding trade surpluses in spite of appreciating currencies.
US Treasury Secretary Tim Geithner provided a very useful taxonomy for understanding the different currency blocks, following the rough outline given above:
1. Deficit Countries: The US dollar
Obviously, the United States dominates this category. Sterling also belongs here, although the near closure of the British trade deficit and the massive budget cuts that are on the pipeline distinguish the UK situation from the US. Were they not part of the Euro currency area, one would have to include here most of Europe’s southern periphery. One may be tempted to include Australia and New Zealand, but their role as commodity producers and China suppliers make their situation a special case.
2. Developed Surplus Countries: Japan and Northern Europe
After a decade of almost uninterrupted appreciation against the dollar, no one is seriously arguing that the Japanese yen or the euro (and its peripheral currencies, such as the Scandinavian crowns and the Swiss franc) are undervalued against the greenback. Recent dollar depreciation against these is driven by different approaches to monetary and fiscal policy, rather than capital flows or FX intervention
3. Emerging Currencies with Flexible Exchange Rates
Brazil and South Korea would be representative examples. While the Brazilian real and the South Korean won exchange rates are both set in forex markets, both countries are intervening or imposing taxes in order to at least slow down the rate of appreciation. These currencies’ appreciation is driven more by capital inflows (i.e., foreign investors chasing what are perceived as better investment opportunities) than trade flows. Brazil, for instance, is actually running a trade deficit now. Secretary Geithner made it clear that the US does not oppose this kind of intervention to prevent asset bubbles and currency overvaluation.
4. Severely Undervalued, Non-Trade Currencies
Clearly, China is the poster child of this category. It runs huge trade surpluses, particularly against the USD. Also, while there is much dispute about the Yuan’s level of undervaluation, almost no one disputes that the Chinese currency is too cheap relative to most developed market currencies.
We believe there are three potential outcomes to the currency war - listed below in order of desirability:
1. Plaza II
This scenario would require concerted, agreed-upon gradual US dollar devaluation against developing currencies while the US dollar holds its range against most G10 currencies. We think that it would require a G20-level general currency agreement on par with the Plaza accord in the 1980s. This devaluation would correct the secular cheapness of emerging currencies relative to developed currencies, and would increase the general standard of living in emerging countries while providing much needed export stimulus to stagnant first world economies. An accord of this nature would probably require, at a minimum, China to speed up the revaluation of its currency against the dollar and for the Fed to start taking into account the effect on the dollar of its monetary policy. Obviously, neither development is likely to take place and we do not ascribe high probability to this scenario.
2. Muddle Through
In this scenario, the G20 does not agree on any Plaza-like accord to manage US dollar devaluation, but neither does it break down completely in acrimony and beggar-thy-neighbour competitive devaluation. The outcome would be a continuation of the trend of the last few years. China (and therefore other Pacific Rim countries) would continue to allow very limited and slow appreciation of its currency, though at a speed that is insufficient to provide significant short-term boosts to developed countries’ export sectors. Emerging economies with market-traded currencies are forced to resort increasingly to capital controls (such as the portfolio inflow taxes that Brazil has implemented recently) in order to slow currency appreciation. In this scenario, we would not expect there to be any massive shift towards protectionism in developed countries, as the constituencies that would benefit from such a shift (most workers and some manufacturers) lack the political clout to do so. However, we could see a number of localized currency and trade conflicts flaring up, suck as the tow already taking place between South Korea and Japan. We regard this as the most likely scenario
3. Disorderly Devaluation
We think that there is a small but far from insignificant chance of a much worse scenario than those described above. Prompted perhaps by a double dip recession, US authorities may lose patience with China and other countries running current account surpluses, and take a course of openly competitive devaluation against market-traded currencies and at least the threat of tariffs against countries with managed currencies. This would almost certainly cause a very fast devaluation of the greenback in forex markets, perhaps compounded by potential capital flight from the United States and/or US asset sales by countries with significant FX reserves. Such a scenario would likely imply another sharp reduction in worldwide trade flows, another round of financial crises, a general hit to consumer and business confidence, and very possibly, a global double-dip recession. We think that the chances of this coming to pass are quite low, but the consequences would be dire enough that even this low probability is worth watching out for.
After the latest events, we can almost rule out the first, most positive scenario of “Plaza II”. We have in mind, in particular, the surprisingly sharp rebuke that US monetary authorities have received from some of their counterparts. The Brazilian finance minister, Guido Mantega, who was the first to warn of a “currency war”, stated that “everybody wants the US economy to recover, but it does no good at all to just throw dollars from a helicopter.”
He added: “You have to combine that with fiscal policy. You have to stimulate consumption.” The German finance minister was even more aggressive, going as far as openly accusing the United States of breaking its promise made last June at the G20 summit in Toronto, to refrain from competitive devaluation.
More conciliatory talk just out of the Pacific Rim countries, in particular China and Thailand, makes us confident that the “muddle through” scenario is still the more likely one. However, it is clear that the events of the last week have increased the probability of the “disorderly devaluation” scenario, albeit to still low levels.
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