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Tuesday October 5, 2010 - 17:16:43 GMT
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Currency War it is Not, but Currency Conflict Perhaps

Vietnam ran for over a decade and at a huge cost in lives and money though pale in comparison to say WW2.  And Vietnam was never declared a war by the US Congress.  It would appear that the world is moving closer to a currency conflict than a currency war…but who cares at the start of it…there is death and mayhem anyway.


Anyone of the following stories could read as the Gulf of Tonkin incident (lead to the Vietnam conflict).  (Connect the dots below is from a dear friend and market pro.)


  • Japan:  The BOJ cut rates to a 0-0.1% range (from 0.1%) ….and launched a fund to buy, among other assets, ETFs and J-REITS!
  • Australia:  The RBA left rates UNCHANGED at 4.50%.  Most had been expecting a hike.  The AUD dropped immediately
  • Brazil:  After the close last night, Brazil increased the IOF tax on fixed income investment from 2% to 4%.  FinMin Mantega told the press that the measure is aimed to help stem the appreciation of the BRL.
  • Korea will make more attempts to disallow free FX trade, saying that it plans inspection of FX derivative positions at banks from October 19th.
  • Europe badgering China on the yuan:  ECB’s Trichet said the yuan’s move against the EUR “is not what we would have hoped.”   EU’s Juncker said that China’s FX rate remains undervalued
  • NZ FinMin English said “…the strength of the NZD is one of the headwinds for our recover….We would prefer our dollar to be a bit more competitive….”
  • Reserve Bank of India Deputy Governor Gokarn said the central bank is considering measures to deal with an influx of foreign fund flows.  "It is becoming a larger global problem because of the imbalance, that there is so much of liquidity and the returns are skewed towards emerging markets.   So it is emerging as a potential threat and we are clearly thinking of ways in which we can deal with it…As long as the capital flows are in excess of the current account deficit the pressure to appreciate will continue and it could potentially disrupt."
  • The Institute of International Finance [representing 420 of the world’s leading banks and finance houses] is reported by the FT as warning that the world’s leading countries should agree to a new currency pact to help rebalance the global economy, and that a lack of such coordinated rebalancing could lead to more protectionism.    The upcoming G20 meeting in Korea in Nov is getting more and more interesting.


Brazil’s Finance Minister Mantega last week warned of a brewing currency war.  Brazil seems to have decided to pick up arms as it has stepped up intervention and raised taxes to dissuade capital inflows into local bonds (where much of the global capital flows end up as opposed to stocks).   Moreover Canada’s Finance Minister Flaherty who chairs G7/G20 this year has said he plans to have currency part of Fri-Sat discussions.  Every other report on CNBC has currency war in the teaser. 


Barclays Bank reportedly argued today that central banks now engaged in QE or contemplating it are pushing on a string…liquidity trap…won’t work.  How they and others draw that conclusion is beyond me.  Fed in theory could buy enough 30-year government debt to take the yield to 1.00%...and the 30-year fixed mortgage rate to say 1.25%.  I am not saying it will but it could and this would surely have an impact on housing prices, inflation and the value of the dollar…remember the Fed wants inflation to move up not down as it has been doing in the last 2 years.  Moreover the Fed could buy more MBS and influence mortgage rates more directly (it probably won’t as it does not want to add to its existing risky position here) and it could buy any asset like stocks or muni debt.  So anyone who says the Fed is out of bullets on policy accommodation needs to visualize Helicopter Ben. 


The Fed is surely on the brink of deploying more QE…this is a given and the November meeting (02-03) is when it will start.  Given the weak domestic US economy (private consumption), fading fiscal stimulus (maybe tightening in 2011 from tax hikes) and Fed QE2 in the cards, it is natural for the dollar to weaken (US has a large external imbalance – trade deficit).  There is nothing sinister or war like about the dollar declining now. 


But not all QE is created equal.  Japan is now embracing QE as of today’s policy decision to move to a zero bound rate and target JY5trln in asset purchases (and promising to keep zero bound until prices stabilize) yet the yen weakened only briefly which surely disappointed Japanese officials who wanted the yen to weaken on the QE news.  The problem is that Japan is running a large external surplus and because of this (and low domestic rates, near two decade flat stock market), the natural flow is into yen by Japan exporters.  QE2 in the US will do to the USD what QE1 in Japan can not achieve…not at a JPY5trln scale.  Japan remains in an intervention only box if it hopes to prevent more yen appreciation. 


It is not a coincidence that the main call to arms in this currency conflict is from the developing markets…they are exporters often (run surpluses) and are the target of lots of global savings because they offer higher rates of return (real and nominal) and because the developed world central banks are pursuing policies that promote riskier assets…not just as an investment destination but as a source of funding to invest there.  QE2 will free up more reserves for all investments including emerging market debt and equity.  Brazil is saying no thank you.  And surely China is eager to see less QE from the US not more as it imports Fed policy from its fixed exchange rate regime (crawling peg) at a time when it is dealing with overheating risks. 


What is a developing nation to do when the cost of money in the developed world is close to zero (for banks) and the flow of funds is to the developing world (could add developed mercantilist nations like Japan to this group)?  Currency intervention.


But there are limits to currency intervention.  As stated above any effort to manage an exchange rate to the USD implies that central bank or set of monetary authorities are importing Fed policy which is increasingly totally inappropriate for the likes of emerging Asia and Latam where policy tightening not additional (radical) easing is needed.  Reserve accumulation is also problematic as it implies a need to drain currency reserves from the local market (sterilizing) in capital markets that are often undeveloped and not particularly easy to sterilize especially when the scale of intervention is as enormous as is the case today. 


Moreover, the huge build up in FX reserves leads to questionable asset allocations – risk free over risk….virtuous or vicious cycle (former becomes latter over time)…more intervention yields more developed world bond accumulation and lower developed world rates and cheaper funding costs for capital to finance more developing world investments.  Indeed currency reserve accumulation in the last decade could well end up being the next super bubble that bursts…massive flow of world savings into developed world bonds and developing world currencies (and assets).   Indeed I suspect, with all due respect, that Barclays and others are confusing the limits of QE with the limits of currency intervention (unsterilized currency intervention is QE in case of Japan now but not at a large enough scale – despite record single day intervention – to make a difference in a $3trln a day market). 


Enter Speedy Sarkozy…his answer is a new global economic order where currency volatility is managed by agreement among nations and perhaps executed by the IMF…a world Exchange Rate Mechanism.  Sarkozy is probably more interested in his legacy than reality when it comes to a new world order for currencies and capital.  This is more out there than turning the IMF’s SDR into the new world reserve currency (for all I l know perhaps the SDR as USD replacement is part of his grand scheme?). 


This approach is dead in the water.  Floating exchange rates as a mechanism for adjustment and free flow of capital are pillars of modern global capitalism.  While we have seen time machines dragged out to transport banking back in time, there is not a big enough machine to do it to currencies (dollar) and flow of capital.


I am sympathetic to world leaders who feel victimized by currency volatility.  However, the response should be not more currency management but less…more floating less managing.  And this road leads to Beijing (all roads lead to China).  China’s determination to leave the yuan hugely undervalued creates distortions in other floating currencies against the USD…EUR, CAD and even AUD must shoulder a greater share of the adjustment burden for the USD than would otherwise be the case if the yuan were allowed to float.  No one is arguing for an overnight float of CNY, but large and steady progress to this point…say over 5 years.  So China is the key to preventing a currency problem from becoming a currency conflict.  Unfortunately as EU leaders learned this week, China is not interested in anyone else’s notion of the pace for Chinese reform.


Some currency intervention is helpful as well…introduce two-way risk to markets where due to a host of reasons markets have a propensity to overshoot and undershoot.  But making currency intervention a be all and end all is unsustainable and what is raising the stakes for the next global economic and financial disaster.


David Gilmore


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