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The recent IMF meeting in Washington ended without any firm results despite intense discussions. There were a few important points on the agenda but probably the most important one was the discussion about the threat that a global currency war is about to break out. With many countries facing record amounts of debt, interest rates at virtually zero and economic growth being weak, these countries are trying to devalue their currencies in an attempt to make their economies more competitive and therefore kick start the economy again and finally create jobs.
This is nowhere more obvious than with the situation between Japan and the United States. With the Japanese Yen recently hitting fresh highs versus the Dollar it is becoming increasingly difficult for Japanese companies to export to the United States; the weakening U.S. Dollar is eating into their margins. Despite the Bank of Japan’s intervention in the currency markets, it has not been successful in breaking the trend. At the same time, the U.S. Federal Reserve made it very clear that it will do everything it can to prevent the economy from slipping into deflation. Their priorities are clear and that means that job creation and getting the economy back on track is the primary mission.
In this context, it is interesting to look at the U.S./China dispute over China’s currency policy. The U.S., as well an increasing number of other countries, are calling for China to let their currency appreciate to a level that reflects fundamental economic reality. It is just interesting that the U.S. is trying to make pressure on China, since the U.S. has been benefiting for decades from its role as the world’s reserve currency. It kept the U.S. Dollar artificially strong for a long-time and gave the U.S. a competitive advantage for many years. This can be seen even today as the U.S. Dollar is still the largest and most liquid currency in the world. However, the importance of its role is diminishing and investors worldwide are looking to further diversify their currency holdings. The incentive to do so is bigger than ever as the Federal Reserve is implementing measures that will ultimately devalue the U.S. Dollar further.
China will eventually let their currency appreciate, no doubt about that, but they will do it when they are ready and when it helps them, not when other countries press for such a move. Such pressure might even be counterproductive given the fact that China is one of the largest holders of U.S. Treasuries. Now they see that the value of their investment is at risk since the Federal Reserve is doing everything it can do devalue the currency. There is a risk that China will move more and more of its investments away from the U.S. Dollar and further diversify their currency reserves. The latest statistics point to reduced treasury purchases by China and that seems to be the start of a longer-term trend.
What the Federal Reserve does is the same as what other central banks do but a number of additional factors are influencing the valuation of a currency. Even the question of how much gold each one owns in order to back their currency is only a minor factor that determines the value of a currency. As noted above, the price of a currency needs to be seen as a combination of numerous factors. These include political stability, economic competitiveness, secure legal system, protection of currency rights, degree of regulation, just to name a few.
In light of this, the current strength of the Yen vis-à-vis the U.S. Dollar is a clear sign that there are other factors driving the Yen. It is obvious that the large deficit of Japan is not exactly giving the Yen any advantage over the U.S. Dollar but we believe that the very large amounts of private sector savings are bolstering the currency. This is something that is quite worrisome in the U.S., since an increasing number of U.S. households are dealing with a heavy debt burden. A lack of fundamental support for the U.S. Dollar may serve to drive regulators into a misguided devaluation solution.
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Source: Is a Global Currency War About to Start?