Capital Research Institute Digest

Currency wars and global finance

The Fed and the ECB are continuing to pump trillions of dollars into the financial system to keep aggregate demand and therefore GDP from collapsing. The excess liquidity puts downward pressure on currency exchange rates, Guido Mantega, the Brazilian Finance Minister stated in 2010 that developed countries have started to engage in “currency wars”, also known as competitive devaluation. 

The first currency war started in the 1930s during the Great Depression when countries dropped the gold standard, which resulted in a loss of intrinsic value and therefore devaluation of the currencies as nothing backed the paper money in circulation. When one country devalues its currency it gains a short term advantage until the neighboring countries follow suit.

Once competing countries have devalued there is no more advantage and the price to pay is that international trade suffers, which in the end impacts all countries negatively. The major players were the United States, the UK, and France, of which the former two dropped the Gold standard in 1933 and 1930 respectively. 

The currency wars of the 1930s ended with the Tripartite Agreement in September 1936, countries agreed to sell gold to each other in the seller’s currencies at an agreed fixed price, which helped to stabilize exchange rates . During the years until 1971 under the Bretton Woods agreement, countries did not have the option to engage in currency wars; even after the gold standard was abolished countries had little incentive to engage in competitive devaluation since no synchronized effort among nations existed. 

During the 1997 Asian Financial crisis, countries lacked sufficient foreign currency reserves and therefore had to accept tough economic terms from the IMF. After the crisis, Asian countries started to intervene in the currency markets to keep their currencies low in order to increase exports as well as to have sufficient reserves to defend speculative currency attacks and protect from further crisis.

The recent financial meltdown of 2008 caused the re-emergence of currency wars as countries look for ways to improve their financial positions by reducing large current account deficits. Developed countries chose export strategies through competitive devaluation.

Central Banks have several options to participate in currency wars; they have the ability to intervene in the foreign exchange market by selling their own currencies. Another method which the Capital Research Institute (CRI) has covered in much detail is Quantitative Easing (QE), a practice of central banks to paper over a recession by increasing the money supply, which the Fed, ECB, and central banks of the UK, China, India and Japan engaged in. A QE strategy also includes a low interest rate strategy due to the increased money supply, which leaves room for arbitrage, also known as the carry trade, borrowing money in low interest nations to reinvest in high interest nations like Brazil.

Another method to impact a countries exchange rate is through the use of capital controls, which Brazil implemented in order to control capital in and out flows of the country. At the beginning of March 2012 Reuters reported that Brazilian President Dilma Rousseff, a career economist, slammed rich nations for “unleashing a tsunami of cheap money that was cannibalizing poorer countries such as her own, forcing them to act to protect struggling local industries”.

She said that these capital inflows are due to low interest rate polices in developed nations and that her country is flooded with easy money by investors trying to secure higher yields. Her statement came hours after Brazil announced an extension of taxes on foreign loans, a form of capital control.

Rousseff further stated that “We have a currency war that is based on an expansionary monetary policy that creates unequal conditions for competition” and concluded “we will continue to develop (our) country by defending its industry and ensuring that the strategy used by the developed countries to exit the crisis does not cannibalize emerging markets”. 

The US has been accusing China of currency manipulation by keeping its currency artificially low, even though the US is the real winner of the currency war as the US dollar has lost value relative to most other currencies since the financial crisis began.

The US is plagued with high unemployment; one way to increase employment is to increase exports, which are supported by a relatively low US dollar. China also needs to keep the Yuan-USD exchange rate low in order to keep exports stable, otherwise the country could face a significant downturn followed by high unemployment in the manufacturing sector, which would in turn affect the EU, especially the German economy that depends on growth in China to export its manufactured products such as cars and machinery.

An interest rate hike in the US could cause a domino effect that could send the world economy into a renewed recession due to the above mentioned contagion. 

While some countries engage in currency wars, others will pay the price due to decreasing exports. Recent news highlight the impact competitive devaluation has on major exporting nations as exports are slowing down. Reported in March 2012, Japan’s current account and trade deficit hit a record high in January, even though a weak Yen has been seen as “growth hormone” for the export driven economy, it is now backfiring due to Japan’s reliance on importing fuel for energy production since the Fukushima accident.

Even Australia, which has been doing very well due to continued exports of coal and iron to China, recorded its first trade deficit in eleven month in January and an 8% drop in exports, the largest drop in the past three years. The Australian dollar had appreciated 4% against the US dollar this year so far . Also Brazil reported a current account deficit of $7.1 billion in January 2012, the largest deficit on record and the real has appreciated 9.3% against the US dollar this year, more than any other currency .

China recorded the largest trade deficit during February since 1989, a shortfall of $31.5 billion. The deficit along with lower retail sales, industrial output and inflation estimates may lead the Chinese government to ease policies by reducing the rate of reserves banks have to hold, which would increase available funding to stimulate economic growth .

Exporting nations like China, Brazil, Australia, and Japan have historically enjoyed current account and trade surpluses, this shift in economic trade could further increase participation in currency wars in order to increase the competitiveness of each country’s exports. There is more to China’s deficit as we look closer; while exports to the EU collapsed, China’s imports increased 39.6% from last year. 

Even though the year to year figures have not dramatically changed, since June 2011 China has been selling US Treasuries from a high of $1.315 trillion in July 2011 to $1.152 trillion by the end of December 2011, a reduction of $163 billion. In past years, China did not have much of a choice than to continue to reinvest large trade surpluses into US Treasuries in order to keep inflation under control, but that trend seems to be changing, the question is which alternative China is taking to invest these surpluses.

Instead of continuing to purchase US Treasuries in order to invest large trade surpluses, China has increased imports of crude oil to record levels in January 2012. The trade surpluses must be reinvested in order to keep the excess liquidity out of the Chinese financial system, otherwise inflation would be very difficult to control.

Since it is questionable if China will ever see a single cent of their investments in US Treasuries, it is not surprising that China is looking for alternative ways to invest. With its huge appetite for crude oil, it makes for a good strategic alternative compared to further purchases of US treasuries.

Bloomberg reported this month that “China, the world’s second-largest crude consumer, finished filling the first phase of its emergency stockpile with 103.2 million barrels of oil in 2009. The second phase, comprising eight locations with a storage capacity of 168.6 million barrels, is scheduled to be completed by early 2013. The Lanzhou depot has a capacity of 18.9 million barrels”. The following graph shows China’s increase in crude imports during the last 10 years.

Now that we know what currency wars mean for developed and emerging nations, let’s consider the impact currency wars have on individuals. Since individuals purchase goods in the local currency the price impact of local exported goods is insignificant, since the price for those items at home does not change. The real impact is the loss of purchasing power for imported goods, since those now become more expensive due to the devalued currency that is used to import them.

The two imported items that individuals spend most of their disposable income on besides housing are gasoline and food; both become more expensive due to competitive devaluation. Currency wars cause the standard of living of individuals to decrease as prices of imported goods increase. 

The excess liquidity from loose monetary policies leads to commodity price inflation and a loss in purchasing power of all major currencies since the end of the gold standard in 1971. It is a race to the bottom and individuals that hold fiat currencies will ultimately pay the price.

First Published 10/03/2012