Sunday, October 3, 2010

On competitive currency devaluation

Asia Time Online - Daily News

Circular firing squad

By Chan Akya

Leave it to an emerging power to let the cat out the bag. On Monday, September 27, Brazilian Finance Minister Guido Mantega issued a "currency war alert", in effect disclosing to the general public what had been suspected in financial circles for a while. As the Financial Times reported on the day:
Mr Mantega's comments in Sao Paulo on Monday follow a series of recent interventions by central banks, in Japan, South Korea and Taiwan in an effort to make their currencies cheaper. China, an export powerhouse, has continued to suppress the value of the renminbi [or yuan], in spite of pressure
from the US to allow it to rise, while officials from countries ranging from Singapore to Colombia have issued warnings over the strength of their currencies.
"We're in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness," Mr Mantega said. By publicly asserting the existence of a "currency war", Mr Mantega has admitted what many policymakers have been saying in private: a rising number of countries see a weaker exchange rate as a way to lift their economies.

A weaker exchange rate makes a country's exports cheaper, potentially boosting a key source of growth for economies battling to find growth as they emerge from the global downturn.
Here is a graph from Bloomberg (the professional service) that shows relative currency movements from the beginning of May this year to the end of September.

Mr Mantega is on to something for sure. Even as the Japanese yen (JPY) rose over 10% in nominal terms (ie real rather than annualized terms) against the US dollar (USD), the Chinese yuan has barely budged while both the Korean won (KRW) and Indian rupee (INR) are slightly weaker against the US dollar for the period even though a pronounced strengthening after an initial selloff is visible.

In a word, this is impossible due mainly to the dynamics of Asiantrade and the generic correlation in the exports of all these countries to non-Asian economies. Furthermore, investment flows cannot account for any major discrepancy here due to the simple fact that China is the biggest recipient of inflows even as Japan is (at times) a net exporter of capital.

Looking outside the Asian zone, it is clear that many other currencies have become more volatile against the US dollar - in particular commodity-based currencies such as the Brazil real (BRL), Canadian Dollar (CAD) and Australian dollar (AUD); which are shown in the following chart, again from Bloomberg, against the "base" performance of the euro (EUR). While the Australian dollar is the best performer as it has seen the balance of commodity prices and Asian demand, others such as the real haven't lagged behind by much once the risk appetite jitters commenced in earnest at the end of June.

A word here about the euro. This is a currency that this column has not been incredibly fond of for a while now. Still, when readers consider that the primary concerns in Europe range from a sovereign debt crisis to public anger over proposed (and fairly mild rather than draconian) austerity measures, it sometimes defies belief that any central banker would increase his allocation to an alleged reserve currency called the EUR.

I predict that in years to come at least a few Asian central bankers will be stoned to death or meet some such unsavory fate for their decision to cram euros into their bank's foreign exchangereserves. That of course is a matter for discussion another day.

Turning back to the focus of this article, namely the currency manipulation of the Asian economies, the US House of Representatives acted against China on Wednesday by passing by wide margin legislation aimed at imposing tariffs on Chinese-made goods. It is unlikely that the legislation actually becomes law - and it has yet to go through the Senate - but it nevertheless highlights the growing friction between Group of 20 governments as everyone attempts the same solution of "exporting their way to growth".

As the Wall Street Journal reported on September 30:
WASHINGTON - The House of Representatives by a wide margin passed legislation to penalize China's foreign-exchange practices, sending a powerful warning to Beijing but risking a response that could harm US companies and consumers.

The measure would allow, but not require, the US to levy tariffs on countries that undervalue their currencies, which makes their goods cheaper relative to American products. A majority of Republicans lined up with Democrats to pass the bill on a 348-79 vote, highlighting lawmakers' long-simmering frustration with Chinese trade practices as well as their sensitivity to the faltering US economic recovery with an election looming.

The vote marks the strongest trade measure aimed at China to make it through a chamber of Congress after more than a decade of threats by lawmakers. But despite the broad support Wednesday, dim Senate prospects make it unlikely the measure would become law this year. Chinese Commerce Ministry spokesman Yao Jian said Thursday it would be a breach of World Trade Organization rules to conduct anti-subsidy investigations based on exchange-rate concerns, according to the official Xinhua news agency. He said China is willing to take joint actions with the US to help balance trade flows between the two countries, but he said China doesn't undervalue its currency to obtain a competitive advantage.
This column has previously cited the faulty logic behind the notion of export-led recoveries that were being engineered (ostensibly at least) by a good 70% of the world's major economies after the recent G-20 meetings. A sample set of economic observations reveals:
  • No growth in consumption across the major Western economies whether you look at the US or Western Europe (Germany is an exception, but it is not sufficient to pull the entire continent out of trouble).
  • Volatile business confidence - some say it is rising and others that it is declining. All we know is that there is no follow through towards new business investments anywhere in the world outside the command economies such as China.
  • Lack of credit for small businesses being made available by banks that were (ironically) bailed out with taxpayer money less than two years ago.
  • Continued decline in home prices afflicting the most leveraged and bubble-prone economies of the US, Spain, Ireland and the UK (as well as continuing bad news in the likes of China and Japan on that score at least).
  • Central banks are once again talking up the use of quantitative easing (QE) instead of admitting that they were wrong the first time around and simply giving up the ghost on the idea (seeUnintended consequences, Asia Times Online, August 9, 2010 and Double or quits, Asia Times Online, October 6, 2009).

    True, it is not all doom and gloom out there. For example, a look at the stock markets from Bloomberg for the third quarter shows a picture not so much of gloom but of serious rallies, to some extent supporting the view of the monetarists (and in this case Keynesians) that adding money to the economy certainly helps in pumping up asset prices:

    Equally though, one can argue that stock market rallies represent the opposite side of the credit market weakness, namely that wealth being borrowed by the governments is becoming more expensive, as shown by credit default spreads from Bloomberg for three European countries that have become the byword for the sovereign debt crisis globally - namely Ireland, Greece and Portugal:

    Strangely, the worsening crisis outlook for Ireland and Portugal has actually helped Greece as traders cover their profitable positions (short) in Greece to buy more insurance (protection) in higher-rated countries such as Ireland and Portugal. Considering that all three countries use the euro for their internal transactions, my earlier statement about the idiocy of using that currency as a reserve comes to mind here.

    As I wrote last week, (Salami tactics, Asia Times Online, September 25, 2010), it appears that investors are being fooled into the markets by their incessant barrage of "news" whether any of it has actual relevance for investing or not. In that environment, it sometimes proves interesting if not profitable to take a step back and think about a more logical sequence of events that have followed:
  • A lot of hot air about coordinated intervention to save the global economy.
  • Deficit-inducing measures that aimed to increase the public sector's role against the collapsing private sector.
  • Flooding the market with liquidity; which helped to push down yields on government bonds.
  • Rising government debt that investors soon tired of and demanded to be protected from.
  • Refocus away from the public sector to export-oriented growth.
  • Competitive devaluation.
  • Trade wars as the next step?

    While the primary purpose of the G-20 meetings was to set governments in a straight line all firing at a common target, namely the global recession, it appears that the primal centrifugal forces of trade have helped to twist that line into a circle; creating in effect a circular firing squad.
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