We read dire warnings about coming, or already ongoing currency wars, in which countries supposedly embark on policies with the explicit aim of devaluing their currencies in the forex markets. There is a book, highly popular in some circles, by James Rickards called "Currency Wars: The Making of the Next Global Crisis."
According to the author, these 'wars' have already begun:
Currency wars "have already begun," according to Rickards, citing comments from Brazil's finance minister in 2010. The Fed started this currency war with its initial response to the 2008 financial crisis and ongoing "extraordinary" measures. All the Fed's efforts - from zero interest rate policy to quantitative easing - are largely designed to weaken the dollar, putting pressure on foreign central bankers to competitively devalue their own currencies, according to Rickards.
We're not convinced (to put it mildly), so what's the damage of these currency wars, who are the perpetrators and who are the victims? Well, the damage:
Historically, currency wars lead to trade wars, which often lead to hot wars. In 2009, Rickards participated in the Pentagon's first-ever "financial" war games. While expressing confidence in America's ability to defeat any other nation-state in battle, Rickards says the U.S. could get dragged into "asymmetric warfare," if currency wars lead to rising inflation and global uncertainty.
Trade wars?! Hot wars?! Terrible! We'd better stock up on canned food and water bottles. Who are the perpetrators of this disastrous development? While the quote above points at the US, we think chronologically, China should be put first, which arrives at the following list (by no means complete):
- The US
- The UK
Well, this is a rather impressive list. These happen to be the major world currencies, only the euro is absent. The Germans would be proud. Let's start with China.
China started this currency war by keeping its currency tied to the US dollar. And indeed, that did produce a substantial misalignment, the currency was too cheap, giving China a competitive price advantage. This manifested itself in a large current account surplus:
However, this is a rather recent phenomenon, as Timothy Taylor noted (and you can see in the chart above):
Start with the claim that China's economic growth has been driven by huge trade surpluses. China's major economic reforms started around 1978, and rapid growth took off not long after that. But China's balance of trade was essentially in balance until the early 2000s.
Lately, the Chinese current account surplus has been rapidly diminishing.
The surplus has fallen from 10% of GDP in 2007 to just 2% in 2012. Why? Well, that too is fairly easy to show:
First, the yuan has actually been rising since 2006 even in nominal terms:
But in real-terms, the rise is much more dramatic due to rapidly rising wages:
Basically, this currency war is flaming out. What the people who beat this drum conveniently forget is that competitiveness is a function of the real exchange rate, not just the nominal one. Unlike the nominal exchange rate, the real exchange rate takes differences in inflation (as measured by CPI, or unit labor cost) into the equation, and that rather changes the picture.
China has rapidly rising labor cost and higher inflation than the US, resulting in an appreciating real exchange rate. So rapid has this adjustment proceeded that it's now China itself that is complaining about unfair exchange rate practices by other countries:
Beijing has issued a new warning against competitive devaluations by rich countries, saying that emerging markets will pay the price for so-called currency wars
So moving from accused to accuser. China is right in at least one aspect, mainly developed countries embark on these policies, and there are indeed some spill-over effects for emerging economies, as these can be on the receiving end of 'hot money' inflows, a distinctly dubious pleasure.
While China, due to strict capital controls, has less to fear from those inflows than perhaps other emerging economies, they do have another reason to worry:
China also holds more than $3tn in foreign exchange reserves, the world's largest, making the country particularly vulnerable to depreciation-related losses. [FT]
Verdict: not guilty, at least not recently
The US is blamed by many because of its unprecedented loose monetary policy, a combination of record low interest rates and several bouts of quantitative easing (QE). Lots of people are screaming "currency debasement" and politicians even published an open letter to the Fed president, urging desisting such policies.
But the policies are still continuing, interest rates are still at record lows and the Fed is buying $85B a month in public debt and mortgage backed securities. How is that "debasement" going? Well:
The above figure shows the US dollar trade weighted real exchange rate, that is, the US dollar against the currencies of its main trading partners, corrected for inflation differentials. It might just be us, but we could see little of a trend, let alone any debasement here.
The dollar went up as a result of its save haven status in the financial crisis, but that has sort of corrected itself. Since 2011, the trend is actually up.
Verdict: not guilty
The UK is in a similar position to that of the US. It has its own currency, it embarked on restrictive fiscal policies and in order to compensate for these (and the deleveraging of the private sector as a result of the financial crisis), the central bank embarked on super expansionary monetary policies.
The amount of long paper bought by the Bank of England (BOE) has reached 25% of GDP, a significant amount by any measure. It is difficult to argue what exactly it has achieved. The UK economy is essentially flat-lining, but this is the result of many factors. It could be a lot worse in the absence of QE, we don't know for sure.
One thing is pretty certain though, the pound sterling has significantly decreased in value, both against the euro and against the US dollar:
It's the worst performing major currency in 2013 so far and just about nobody we talk to expects it to pick up any time soon. Recent conversations about the pound have contained a liberal sprinkling of expletives, with a decreasing safe haven bid and internal problems mounting.
But one has to put things into perspective here, and then it turns out that the recent move is not terribly significant:
One can see that there was a plunge of about 25% (trade weighted) from late 2007 to early 2009. The funny thing is, the BOE began its asset purchasing program in January 2009, so it's a bit difficult to hold them responsible for that big fall in the British pound. In fact, since, it has rebounded moderately.
British exports are also rather price insensitive:
Export volumes (goods and services) in Q4-12 were just 2.5% up from five years earlier (Q4-07), compared to growth of 3.1% in France, 9.7% for the Netherlands, 10.5% in Germany and 13.0% for the US. [Ft Alphaville]
So one could argue that deliberately depreciating sterling is a bit of a senseless policy. Alternatively, one could argue that they just need a bigger depreciation to get any traction. Whichever way, we see little in terms of "currency debasement."
Verdict: not guilty
The Japanese economy has been stuck in a balance sheet recession for the best part of two decades, where the private sector had to absorb the tremendous damage to their balance sheets caused by huge declines in asset prices (shares, land, real estate) and the debt these sustained. In order to repair balance sheets, they cut back lending and repaid debt, no matter how low the interest rates went (sounds familiar, this story?).
Despite huge government deficits in order to make up for the deleveraging of the private sector, and periods of expansionary monetary policy, this situation resulted in deflation. Lately, the new Abe government has done a "Mario Draghi" of their own and promised to "do whatever it takes" to end this deflation.
What they have to do is rather simple. The Bank of Japan has to buy up large quantities of Japanese debt. This helps in several ways:
- It is a form of monetary easing.
- This form of monetary easing could lead to the end of deflation, through the monetary easing itself and the resulting currency depreciation, which increases import prices.
- The end of deflation makes Japanese public finances more sustainable, as part of it is 'inflated away' and, if successful, leads to reduced real interest rates and rising incomes.
- It could even be used to retire the sovereign debt on a permanent basis, thereby softening the debt problem more.
We have to say, ever since announcing these policies, the results have been rather spectacular, although the fall of the yen set in well before that. Even so, to accuse Japan of currency manipulation is going a bit overboard. They simply had to address the deflation problem and the current account has moved from surpluses to deficits.
Verdict: not guilty
Switzerland, the forgotten manipulator
The one country that has specifically targeted the exchange rate with policy measures is Switzerland. It could therefore be legitimately called the true currency manipulator, capping the rise of the Swiss franc at 1.20 euro with unlimited currency interventions. This policy has been credible because it needs supply of Swiss franc, which the Swiss central bank can create in unlimited quantities, thereby scaring off speculators.
So the Swiss central bank buys up foreign currencies with gusto, putting the proceeds in euro dominated bonds:
Analysts say the SNB has already bought $80bn of EMU bonds, enough to cover half the budget deficits of Euroland over the last year. It has been acting essentially as a conduit for capital flight from Italy to Germany. [Evans-Pritchard]
But now also apparently in British bonds:
The latest IMF data of central bank holdings (`COFER') shows the biggest jump in sterling bonds by advanced central banks ever recorded. It jumped from $79bn to $98bn in the third quarter. These holdings are usually stable so it is obvious that the SNB is responsible. [Evans-Pritchard]
There is more damaging evidence than this though, here is Daniel Gros:
Switzerland has pegged its currency to the euro at a level that helps it sustain a 12% current-account surplus and one of the lowest unemployment rates in Europe.
And since a current account surplus has to be accompanied by a capital account deficit, it's not hard to figure out who the culprit is. The official account, that is, the Swiss central bank rather than the private sector, is amassing a $400 billion foreign currency reserve in the process, amongst which 173 billion euro in the last three years.
While we have some sympathy for the Swiss (the franc would skyrocket without these interventions), this is clear manipulation in the face of a 12% current account surplus and the lowest unemployment in Europe. It is also exporting deflation mainly to the eurozone, which is just about the last thing they need over there.
While the Swiss are avid buyers, Asia is a net seller of euro assets, so the euro area doesn't bear the full brunt of the Swiss manipulation, or at least there are offsetting developments. There is little doubt that, with the bond markets still being national, and bond buying only used as a conditional measure of last resort when yield differentials spiral out of control, the euro area is the least monetary expansionary place in universe of advanced nations.
If you look at credit conditions, these are terribly tight in many parts of the eurozone, especially those which can least take it.
Lending to firms dropped by 2.5% in the euro area but that overall figure masks a wide dispersion. Whereas lending rose by 0.9% in Germany, it fell by 3.2% in Italy, by 6.6% in Portugal and by 11.4% in Spain. [The Economist]
So the area most in need of monetary expansion is the one getting least of it. People have wondered why the euro hasn't been weaker (or collapsed altogether), here is part of the explanation. QE would be rather complex in the eurozone, because of all kinds of political implications, as bond markets are national.
Which bonds would the ECB buy? A weighted average would be 'politically neutral,' but credit conditions and interest rates vary widely in the eurozone, so this has disadvantages as well. The ECB also likes to keep the bond buying conditional, to keep countries from 'misbehaving,' that is, sticking to any IMF/ECB/EU reform and austerity program.
Buying foreign bonds (that is, intervening in the forex markets) would be another, more direct route of getting the euro down, but we can't see this happening anytime soon.
So one could argue that the main victim of any currency wars is the eurozone. However, insofar as these expansionary monetary policies that might lead to currency depreciations are successful in other parts of the world, they'll sooner or later tend to create their own reversal.
We can already see that happening in EUR/USD, where the dollar is strengthening a bit on a return of growth and job creation (relative to the eurozone) and starting to price in expectations of an end to QE as a result. Although the Japanese stock market has gone on a wild rally and the yen has fallen a lot since Japan announced these intentions, we don't yet see much, if any impact, in the real economy there, so it's a little early for any yen reversal (apart from any on a technical basis).
Apart from the Swiss, we see little evidence of deliberate currency "debasement." Expansionary monetary policies in times of debt deleveraging is highly appropriate. These policies aren't beggar my neighbor policies like the protectionism of the 1930s. Insofar as monetary easing leads to increased spending, even trading partners will benefit, as they will receive some of that increased demand, at least partially compensating some currency effects.
Also, if all advanced economies embark on it, then none achieves any lasting advantage, and the net effect is a monetary stimulus to the world economy. many warn of a looming runaway inflation, but we've heard that for at least four years now.
In times of overcapacity and a world savings glut caused in part by debt deleveraging, the risk of inflation accelerating is rather small. That risk will become bigger if capacity utilization and credit conditions normalize and the money created actually enters the economy. But these would be the circumstances under which central banks would start to withdraw the stimulus, so we're not too worried about any looming hyperinflation.
We've seen under comparable circumstances of the 1930s that countries that threw off the straitjacket of the gold standard first, where first to recover, that particular 'currency war' had beneficial effects.
Unfortunately, the area most in need of these expansionary monetary policies is the only exception here. The European Central Bank (ECB), for a host of reasons (some of which explained above) isn't embarking on any QE. They did assist banks, and did buy some 200+ billion of bonds of peripheral countries, but the monetary effects of the latter were largely sterilized.
Bill Gross of Pimco, the biggest bond fund in the world, has suggested shorting currencies of serial QE offenders:
observe QE purchases as a percentage of gross domestic product or outstanding debt, and sell the most serial offender or obsessive-compulsive printer.
Interesting thought. It would be interesting to construct a portfolio on these metrics, but we have a feeling it wouldn't work very well:
- For instance, Gross notes the large yen depreciation, without there actually having been any shot fired, at least not yet. So mere announcements will do.
- Switzerland, the biggest offender, has to battle to keep its currency from moving up, rather than being the weakest of the bunch.
- The big fall in the pound Sterling happened largely before QE happened
- The dollar hasn't displayed any trend, basically
We have our doubts. Apparently, there's more than just QE what influences currency values.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.