Currency Warfare

For about a decade now China has kept a fixed exchange rate with the US. This has worked well for China which has achieved spectacular growth over the period. It also provided much needed stability during the 1997/8 Asian crisis and in recent years, despite complaints from the US, has been a key component in stimulating US economic growth, and more widely the whole world economy. So broadly speaking this policy has remained mutually beneficial. However, this is now beginning to change. 

While we had a stable system currencies were not the driving factor for world markets, they were a given. However, as the self-interest of the major countries begin to diverge, major currency adjustments become much more likely. The lynchpin of world economic growth in recent years has been the fixed exchange rate between China and the US. Any change in this link will influence far more than just the currency markets and the pressure for change is beginning to build.

The circle of manipulation

First of all we need to understand a little about how the current system has been working. Politicians and policy makers naturally always prefer growth to painful readjustments, particularly when they are confronted with elections. That’s natural enough, and we have had elections in the US. Both China and the US found a system that seemed to work well, and everyone else was happy to go along.

First the Fed kept interest rates low, which led to an asset price and consumer boom, which led to a widening current account deficit, mostly with Asia. Asian central banks wanted to keep their export economies strong, so they supported the dollar and created excess liquidity in their own economies. Excess Asian liquidity led to too much capital spending, which led to over capacity and deflationary pressures from Asia into the US (and elsewhere). Deflationary pressures led to the US keeping interest rates low and so we go round the circle again.

This system benefited the US in the short term as it generated some much needed short term growth, but it has also created a great deal of long term damage. While China was provided with wealth creation and capital to financial its remarkable transformation, the US raided all its reserves of policy measures, and has now been left running on fumes. Real interest rates are still negative and fiscal policy is still expansionary which provides some ongoing support, but the drivers of self-sustaining growth are absent. I realize this is a controversial view as most market participants believe that growth in the US economy is much more durable. So it is necessary to explain why this may not be the case.

What the consensus doesn’t see

Normally a massive credit boom with excessive consumption spending would fuel runaway inflation. But ferocious international competition diverted it to foreign competition. What lulled Mr Greenspan, investors and the public into complacency was the persistence of low inflation rates. Remarkably it seems to have occurred to no one that soaring imports and asset prices are alternative outlets of credit inflation. This has been the view taken by central banks in the UK, Australia and New Zealand, and all these countries have raised interest rates significantly. The Federal Reserve has been far more accommodative, and it is important to realize the extent to which it has diverged from other central banks.

Hailing low inflation as striking testimony to economic success has blinded policymakers and economists from the enormous damage that the protracted credit excess has done and continues to do to the US economy’s whole structure. Above all the monstrous trade deficit inflicts enormous damage to capital formation. Consumer’s spending power floods overseas, depriving domestic producers of profits and capital. In turn this limits their ability to provide domestic jobs and income growth. Rising asset prices convince everyone that saving is not important as apparent wealth is abundant. This chronic shortage of savings further deprives domestic producers of investment capital. Meanwhile, exploding budget deficits absorb more and more of what limited capital is still remaining for investment.

As Dr. Kurt Richebacker puts it “The sombre reality is that this credit excess has devastated the manufacturing sector. It has devastated the trade balance, and it has devastated domestic savings. In our view, the three add up to virtually prohibitive conditions for a self-sustaining recovery. America’s key structural problem is a protracted shift away from investment and toward consumption. Restoration of self-sustaining growth requires the economy’s return to a better balance between these two components. Just the opposite has happened.”

What now?

As the election policy stimulus subsides, the US economy will now be left to run on fewer supports. The Fed is still providing negative real interest rates, but most other forms of stimulus are used up or already very extended. Certainly fiscal policy provides minimal scope after the extraordinary deterioration in the budget deficit over the last few years. This leaves the US dollar as the main source of relief.

This conclusion stems not unreasonably from the weakness of the dollar during the first Bush administration as well as some recent and remarkably blunt statements from three Federal Reserve governors. Although the Federal Reserve usually tries to avoid commenting on exchange rate policy, leaving this as the domain of the Treasury, it broke with tradition in recent months (Texas governor Mcteer has since left) with statements to the effect that it was inevitable that in the long term the dollar would decline.

This leads us back to the fixed exchange rate with the Yuan, the Chinese currency. It seems likely that before long the growth disparity between these two economies will make a fixed exchange rate untenable. We are not there yet but so far China’s economy has shown only a minor setback to extraordinary growth levels while the US has begun to falter (as have Europe and Japan). China’s leaders have clearly stated that they want some moderation in economic growth, but so far they have been careful in applying restrictive measures, and recently made only a small upward adjustment in interest rates. 

 

The Chinese leadership do not appear to be in any great hurry to change the exchange rate. They have set out the conditions needed for them to revalue and are required to move to a floating exchange rate within 4 years under the WTO agreement. However, there is little hurry from their standpoint to rush to any change ahead of further financial sector reforms.

This has become a bone of contention with the US which claims, with some justification, that this is damaging growth in the US. Unfortunately, this has given rise to some protectionist measures in the US. Most people will agree that this is the worst solution to the problem, but it is also the only recourse available to the US. China controls the exchange rate. It seems likely that this dispute will become more intense as it is probable that the growth disparity between China and the US will continue to widen.

Without a resolution, however, as the dollar declines it takes the Chinese currency down with it. This means that Europe takes a big hit. The head of the European Central Bank, Jean Claude Trichet, described the recent appreciation of the Euro as “brutal”. Not only does Europe lose competitiveness against the US dollar but, with its fixed exchange rate, also with China and by extension Asia. Other Asian countries remain unwilling to appreciate against the Yuan.

While the current exchange rate system continues to suit China, it is becoming a problem both for the US and Europe. Not only does Europe take a double hit from the dollar devaluation, but the US may not be able to achieve the devaluation it wants while fixed to the Chinese Yuan.

Without a self-sustaining recovery in the US this pressure is likely to build. If fiscal policy becomes less expansionary and interest rates are “normalized” to say 3% to 4% it is very hard to how the US will derive much growth. Ultimately, even China will realize that without growth in Europe and the US its own prospects become much less positive.

Much will depend on how strong the Chinese economy remains and how weak the US economy becomes. The best outcome would result from China choosing to revalue because its economy remains strong and a currency revaluation is needed to help stem inflation. This would result in a boost to both the US and European economies as well as a rebalancing of economic growth. Without this development, however, it is hard to see how we get out of this box. An upside surprise in either the US or Europe is always possible but it is hard to justify this as a high probability.

If economic growth in China continues to subside and China does not need to tighten policy through the exchange rate, then the chances are that economic pressure could become intense both in Europe and the US.  While there is some room for stimulus in both these economies there is only so much and China and Asia need healthy economies for their exports.

In short the world economy has now become increasingly dependent on growth in China. Growth and/or inflation may result from China’s incredible economic growth, but if there is not sufficient follow through, global growth will soon subside once again.

Another crucial point in this regard is that a world in which most countries seek to avoid an appreciation of their currency, or seek a devaluation is primarily a world where inflation and/or growth is faltering. If China does not see the need soon to revalue, then the world will soon once again be looking for more stimulus to avoid a recession.

Conclusion

China’s fixed exchange rate with the dollar in recent years has been, in broad terms, mutually beneficial. But most of the long term benefit has accrued to China, while the US economy has become increasingly unbalanced and over dependent on consumer spending rather than productive investment, and on debt and foreign capital rather than domestically generated savings.

As the election policy measures subside, the US economy is left with enormous limitations to self-sustaining growth and will almost certainly need a weaker currency over time, both for economic relief as well as a means of correcting its imbalances. Without a revaluation of the Yuan this puts enormous pressure on Europe, and again without a revaluation of the Yuan it is hard for the US to achieve the devaluation it may well need.

Much now depends crucially on the strength of the Chinese economy and the policy measures they choose. It looks like a very delicate balance. For the time being China seems unwilling to revalue, but this may soon become an untenable position.

For some years now a number of countries have either experienced deflation or have come close to experiencing it. While we remain in a world in which most countries seek to avoid an appreciation of their currency, or seek a  devaluation the risk remains that inflation and/or growth is faltering and deflation risks still linger.

Investors now need to pay close attention to the issue of the fixed exchange rate between China and the US, as it is key for all markets as well as the world economy. Buying foreign government bonds, without a currency hedge may well continue to reward investors.

 

 

 

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