Currency War

By David Underwood, October 9, 2010

Image courtesy Philip Brewer Flickr

Image courtesy Philip Brewer Flickr

Countries using their currencies as a policy tool are putting global recovery at risk. "Beggar thy neighbor", "competitive devaluation", "race to the bottom" are the polite terms but the fact remains, it is a “currency war”. This is not just an argument between China and the USA; anyone can be dragged into the ring at a moment’s notice and be left scrambling for cash.

There is a currency war going on, admittedly it is only in the initial stages, “a latent war” as the Brazilian Finance Minister described it. There are random skirmishes and the occasional cross border raid but the markets are waiting for the high-level bombing to begin – unless of course the warring parties can be brought to the table and made to cooperate. Not everyone is getting overexcited though, the less inflammatory commentators are talking about a mere “misalignment of currencies”.

The weakening dollar is devaluing the Chinese currency along with it, as the Chinese have pegged their renminbi to the US dollar. As the renmimbi devalues nobody can compete on the export markets with the Chinese who are undercutting everyone on price. Chinese goods for export become more and more desirable by the day as the dollar weakens. And why is the dollar weakening? Because the Fed is about to start another round of quantitative easing to re-stimulate the US economy to avoid a double dip recession.

The dollar may be devaluing but everyone wants it to happen in an orderly fashion. There are precedents for global collaboration on managed currency devaluations such as the Plaza Accord in 1985 and the Louvre Accord in 1987. Something similar may be needed if the dollar is going to continue to devalue and if the Chinese currency is going to remain pegged to the dollar.

Collateral Damage
This is not just a war between China and the USA by any means, Take Japan, they were caught in the crossfire when China recently bought a massive pile of yen by buying Japanese bonds. The Japanese fought back by massively buying dollars to drive the yen back down again. This currency “diversification” by the Chinese was an attempt to keep the renminbi down but this had the undesired effect of pushing up the value of the yen, a disaster for the Japanese given the dire straits of their economy, so the Japanese intervened massively and started to buy their way out of the situation. The Japanese were not the only ones to suffer, the South Koreans, Brazilians, Australians and Russians were all caught off guard.

Was this an act of simple economic diversification by the Chinese or a cruel blow to an already precarious economy? It created a temporary imbalance in the currency markets but it also reinforced the message that nobody is safe. Treasuries worldwide were left scrambling for spare cash to throw at the problem so their currencies did not get caught up in the fracas.

All the other currencies watching the debacle on the sidelines are desperately trying not to get sucked into the maelstrom. The Brazilians have also been complaining that their currency the “real” has been pushed up in value by the “race to the bottom” by the currency superpowers. They too are threatening to intervene to keep their currency low so they too can remain competitive.

Political leverage
China is being coy about allowing its currency to float free (something the US administration has been calling for insistently) and find its true level, sometimes mentioning a gradual 10% rise every year until the currency markets stabilize but the Chinese are no doubt enjoying the political leverage that their new status affords. For example, when China’s Premier Wen recently met with EU officials he was pushing for the EU embargo on arms sales to be lifted on China. This is not just a game of currencies. China may want to milk this situation politically before it lifts the dollar peg on the Renminbi, after which her trading partners will be much less attentive to her needs.

This crisis takes on the semblance of a war as the Chinese want to inflict a deflationary spiral on the US economy and the US wants to unleash inflation on China, neither are willing victims. There are worries that that the end result will be a return to the protectionism of the 1930s as countries close the hatches and opt for survival and self defence but as Dominique Strauss-Kahn, the Managing Director of the IMF said when commenting on this crisis said that “This is a real threat and everyone has to keep in mind this mantra that there is no domestic solution to a global crisis”.

Beggar thy Neighbor
These currency wars start out as a game, a game called “Beggar thy Neighbor” – it is a game everyone is being forced to play as everyone is suffering from the fallout from the economic recession and just about everyone wants to fight their way out of the economic doldrums by exporting their own goods. Finance Ministries everywhere are pinning their hopes on their own export led growth and for that they need a weak currency to ensure that their goods are attractive relative to those of the competition. But the problem is everybody is playing the same game and everyone is trying to undercut the currency of everyone else.

So everyone wants to export their way to economic stability but mathematically that cannot happen, somebody has to buy and somebody has to sell, it all has to net out in the end. But if everyone is pinning their hopes on their neighbor being the buyer, it quite simply will not work. Frustratingly simple.

There are too many countries trying to devalue their currencies at the same time. But why this insistence on currencies, are there no other levers of power available? Apparently not, the main policy lever is tinkering with interest rates but they are almost all hitting zero so the lever is next to useless. So Treasuries moved on to the next best policy lever, “quantitative easing” , the buying of assets by central banks, a way of stabilizing and stimulating the economy but also of devaluing your currency, sort of the next best thing to actually printing money. This is causing the trouble.

The US is desperate to get the Chinese to allow their currency the Renminbi to float freely and find its true value on the currency markets. China is keen for that not to happen as its export led economy depends on a weak currency to make Chinese goods irresistible but the dollar equally wants to compete but cannot so long as the Chinese are undercutting them. If Chinese goods were not so incredibly cheap, buyers might look elsewhere, Vietnam?

Chinese political suicide?
But what could possibly induce the Chinese to revalue their currency, lose competitiveness, damage their economy and create social strife throughout the country as a result? Can they be convinced to shoot themselves in the foot? It is an odd situation with the Chinese giving the United States a master class lesson in unbridled capitalism and the US is squealing, “That’s not fair”. And since when was capitalism ever fair?

See it from the Chinese point of view. They are the most competitive country on the planet but with an expensive currency they would export significantly less, their economy would stall and tens of millions of unemployed migrant workers in the country would start to look for ways to take out their frustrations, a political disaster would ensue, it is Beijing’s worst nightmare. Couple that with the tens of millions of disgruntled minorities in China just waiting for an opportunity or a sign of weakness to impose themselves.

China begs to differ. It say that their goods are cheap as labour costs are so low and anyway their profit margins they say are very thin so there is little room for manoever. But that argument falls on deaf ears as the reply is always, well if unpegging the renminbi from the dollar is not the issue why are you avoiding it so assiduously?

The International Monetary Fund
The IMF after many years in the wilderness being spurned by previously desperate economies that no longer respected their economic wisdom nor needed their money has returned centre stage and is now hoping to broker some sort of a currency cooperation deal between the main economic powers. Above all, the IMF does not want to see currencies and quantitative easing being used as policy weapons, the situation is bad enough already and this belligerence would merely undermine a fragile economic recovery. But does the IMF have the clout to get the Chinese to do their bidding? Absolutely not, but perhaps in exchange for a more significant role in the IMF and the World Bank?

Europe too has now entered the fray after a recent meeting between EU officials and their Chinese counterparts but the meeting was inconclusive but perhaps cleverly the Chinese decided to “help” the Greeks by buying some of their government bonds. Was it an act of generosity and fraternity or just another way of bumping up the Euro and keeping the Renminbi artificially low? The Chinese are happy with a robust Euro, the stronger the Euro the cheaper are Chinese goods for the Eurozone – easy! It can be a dirty game, especially when the Chinese government has so much cash to play with. There is no obvious solution.

The hell-fire rhetoric against China in the US Congress is a good vote catcher but any Congressman with any sense knows that the Chinese will not bleed themselves to death just to give the US economy a helping hand. Would the US do such a favour to the Chinese? So the language is being toned down and the talk is now of now is cooperation, coordination and stability. The tempatation to brand China with the official stigma of currency manipulator would be pointless, given that the US economy is living off borrowed time and money, both thanks to the Chinese who keep soaking up US Treasury Bonds in their FX stockpile against a rainy day. The Chinese too want these dollars they have in the bank to remain at a stable value and the US would just hate it if the Chinese slowed their rate of buying dollars significantly. The situation has been called the Balance of Terror, not for nothing. China is the USA’s credit card and the monthly bills are looking pretty terrifying. Everybody wants stability and the Chinese can provide it.

The burden of responsibility
China has painted itself into a corner. Having dedicated decades to low-key and behind-the-scenes foreign policy manoevers, flying under the radar on the global stage, its newfound economic power is obliging it to be a protagonist in full view. The understudy is now the diva and we are all watching to see if she can sing in key. China now has unwanted global responsibilities, unwanted as China has quite enough domestic problems of its own without taking on the mantle of global savior as well. China needs global stability and that means currency stability so that it can continue to enjoy the fruits of its robust growth so it may have to extend a magnanimous or at least compromising hand to struggling trade partners.
There is clearly no justice. Everybody wants to be just like China and everybody also wants to stop China from being China!

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