Are We in the Midst of a Currency War?

Published on 14th September 2015

Not so long ago, most of us would still harp about how the twenty first century belonged to the emerging economies led predominantly by the giants of Asia. It was a simple story really. The Chinese and Indians would be growing richer each year, thereby increasing their demand for commodities, which in turn would benefit other emerging economies such as South Africa, Brazil and Russia amongst others. In a post 2008 financial crisis world, it was not too hard to come up with the conclusion that western consumers lived beyond their means and that their central banks would only succeed in creating more inflation. Economic power was gradually shifting from west to east, we were told, and strategies had to be adopted in order to profit from this trend.

The picture today is perhaps more of a bitter taste of reality, for we had perhaps forgotten one important concept in economics: unless the market views your currency as being a reserve currency, you would always remain an export driven economy. In fact, even the Chinese figured this out. For years, politicians in the west and economists in general had been calling on China to revalue its currency and focus much more on stimulating domestic demand in order to soft land its economy and switch to a more sustainable economic model over the longer term. The Chinese, however, understood quite early in the game that without upsetting the Americans, they needed to slowly but surely internationalise their currency first, and that they simply could not ignore the high employment and high volume generating albeit low margin business that was their export model. Stability in the middle kingdom came after all from the jobs the export sector generated and still generates.

All that was needed to change the shape of the game in fact was a moderate US recovery and the end of quantitative easing in the United States. All President Obama had to do was to push domestic oil shale producers in pumping out more oil, and all the Federal Reserve had to do was to simply announce that it would eventually hike interest rates in the most dovish of fashion by historical standards to change everything. The dollar rose, commodity prices fell, the Russian bear was silenced while at the same time the Europeans and the Japanese played the game well by engaging in more aggressive monetary policy designed to weaken their currencies and stimulate both growth and inflation. They have yet to stimulate inflation, but the Europeans and the Japanese have managed to stimulate their export sector.

The Chinese currency, which had always been quasi pegged to the dollar, thus also appreciated against its main trading partners, bringing about a loss of competitiveness that in turn led to troubles in corporate balance sheets at home. The domestic construction bubble born out of the stimulus of the last global financial crisis only made matters worse. As a less competitive China slowed and as commodity prices and inflation fell globally, emerging market economies found themselves with no other choice than to get their central bank to sound even more dovish, pushing their currency downwards against the dollar too. China with its quasi peg to the dollar simply imported global deflation, and as its economic cycle slowed while that of the US moved on moderately higher, it had no choice but to allow what the interbank foreign exchange market in China had been wanting for some time now, not a stronger currency but a weaker one.

Of course a strong dollar does not benefit US exports, but then again the US has the reserve currency of the world and is a consumer driven economy. Most of the rest of the world remains export driven. The US can thus have a more nuanced approach to this currency war than the others. The US remains in the driver’s seat despite the fact that the economic rate of growth remains moderate at best while the Japanese and the Europeans are playing the dovish game. With inflationary expectations in the west so low and with medium term inflation targets being constantly revised downwards, there is no reason why the European Central Bank (ECB) and the Bank of Japan (BoJ) should not be anything but very dovish.

Make no mistake, the US and its allies are currently winning the geopolitical war out of which the currency war is but a mere subset. The Chinese are facing a slow deleveraging process which will require fiscal stimulus and perhaps pressure to allow the currency to adjust downwards too to restore some export competitiveness, the Russians are dead, the Middle East is divided along sectarian lines following the Iran deal, India is repositioning gradually westwards while the Malaysians and Brazilians are marred in political crisis as falling commodity prices bring all things previously hidden to light.

Global asset volatility

What is currently troubling financial markets globally is the mere fact that central banks in general (especially those in the emerging markets space and the Middle East) will see their international reserves decline or stagnate at best compared to the USD 10 trillion increase seen between 2000 and 2015. Since most of these reserves tended to be invested in short term Government bills and notes in the US in particular and in the EU, lower demand in future years will continue to put upward pressure on yields especially in the US, equivalent to a de facto tightening. There is no doubt that the BoJ and the ECB need to counteract this by adding more of their own version of loosening in a global context.

The quantitative tightening versus quantitative easing debacle is a driving force behind the current heightened levels of cross asset volatility globally. This is why the ECB is sounding dovish again these days. While the Fed is likely to tighten monetary policy somewhat by March 2016 in the most dovish of cases, they need to be careful of not allowing financial conditions which are already tightening to be squeezed further and allow quantitative tightening to win out.

All of this matters to Mauritius not because it is good to understand the great game that is being played a bit better, but because it seems other emerging markets have understood that even if they do not like it, a currency war is a war which they must play unless they wish to see their competition gain their export market from them. The logic within the emerging markets space is that if they do it, I do it too. Everyone understands that in the long run, higher levels of productivity will be important, but what is a country to do in war?

The debate within emerging markets in a world where there is no inflation is not about having a strong or weak currency but about the best way in which the economic engine can chum along in a world where most emerging economies are pawns in a great power game over which they have little control. It seems that the more intelligent strategists within the emerging markets space have understood that an economy with a responsible wage growth policy, when coupled with a realistic currency regime that cannot remain alien to the happenings of the world, will be key to their future success. A country cannot after all import its way to prosperity.

By Sameer Sharma

The author is a chartered alternative investment analyst and a certified financial risk manager. This article reflects solely the personal views of the author.

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