Download Only One Clear Winner (October 2010)

The South African Index Investor Newsletter
www.indexinvestor.co.za
October 2010
The Currency Wars: Only One Clear Winner
By Daniel R Wessels
In the IMF’s latest World Economic Outlook (October 2010), Olivier Blanchard, the IMF economic
counsellor, summarised the current state of the global economy as follows: Achieving a strong,
balanced and sustained world recovery was never going to be easy. It requires much more than just
going back to business as usual. It requires two fundamental and difficult economic rebalancing acts.
First, internal rebalancing: When private demand collapsed, fiscal stimulus helped alleviate the fall in
output. But fiscal stimulus has to eventually give way to fiscal consolidation, and private demand must
be strong enough to take the lead and sustain growth. Second, external rebalancing: Many advanced
economies, most notably the United States, which relied excessively on domestic demand, must now
rely more on net exports. Many emerging market economies, most notably China, which relied
excessively on net exports, must now rely more on domestic demand.
1
The aggressive monetary policy followed by the U.S. policymakers is central in both processes. The
necessary adjustments are difficult to accomplish, especially if accompanied by immediate losses for the
countries concerned. Export-orientated economies whose currencies have appreciated against the
dollar are feeling the squeeze as they are losing their competitiveness in export markets. Basically, as
Martin Wolf, chief economics commentator for the Financial Times, put it: The U.S. wants to inflate the
rest of the world, while the latter is trying to deflate the U.S., but the U.S. must win, since it has infinite
ammunition – there is no limit to the amount of dollars the Federal Reserve can create.
2
Thus far it is clear that U.S. policymakers will do anything in their powers to avert deflation in their
economy. For example, the new quantitative easing programme (QE2) that was recently announced
stated that the Federal Reserve is planning to buy $600 billion of U.S. government debt in the next eight
months, thereby creating additional liquidity in the markets. This extra money will invariably flow to
countries with less expansionary monetary policies and higher returns, like emerging markets.
The recipient countries face some uncomfortable choices on the other hand: Let the exchange rate
appreciate, and thereby impairing their global competitiveness, intervene in currency markets by
acquiring low-yielding and depreciating U.S. dollars or curb capital inflow by controls and taxes. None of
the options seems plausible at the end and therefore it is not surprising these countries are extremely
unhappy with the Fed’s unconventional monetary policies.
Even within the U.S. the announcement of the Fed’s QE2 programme have been met with sharp
criticism, for example, comments like “injecting high-grade monetary heroin” that will kick-start a global
currency war, weakening the dollar, spark inflation and creating asset bubbles around the world have
2
been made. Yet, despite all the internal and external criticism the Fed is willing to risk it all to prevent
another Japan-like deflationary outcome for the U.S. in the future.
Peter Tasker, a Tokyo-based analyst with Arcus Research, sketched in a recent Financial Times article
the circumstances which led to Japan’s economic woes in recent decades, but more importantly
possible lessons that Chinese authorities and other high-flying emerging markets may learn from this
episode:
In the Plaza Accord of 1985 the G7 attempted to address global imbalances at the time [by today’s
standards very small imbalances, indeed] by encouraging significant changes in currency parities. They
got what they wanted. The yen took off and never looked back. Japanese policymakers accepted the
loss of competitiveness not because they were submissive, but because they were brimming with selfconfidence. They believed their economy would survive any downturn with little damage, and they were
right: the recession of 1986 was short and shallow.
Furthermore they saw a strong yen as a useful weapon in a world in which Japan’s trading partners
were imposing quotas on its most successful companies. Again they were right. The all-powerful yen
allowed Japanese auto makers to build up manufacturing capacity inside key Western markets.
They also believed it was high time to shift the Japanese economy from exports to consumption, and
that a stronger yen would raise the purchasing power of households. Here, though, they were wrong.
What got in the way was one of history’s worst doses of bubble trouble. For a crucial thirty months after
the mild recession was over, the authorities allowed credit growth to rip and real estate and stock prices
to soar.
Why would they do such a thing? Because of those fatal words that lie behind every bubble: “this time
it’s different.” They genuinely believed what pundits, academics and opinion-leaders everywhere were
saying – that Japanese industrial might was unstoppable, that Japan was destined to become the
world’s largest economy.
3
So in a sense Japan did commit financial suicide – not by allowing the extraordinary rise in the yen, but
by allowing an even more extraordinary rise in asset prices. By the end of 1989 Tokyo accounted for
more than half of the world’s stock market capitalisation and the grounds of the Imperial Palace alone
were reportedly worth more than the entire state of California.
The inevitable bust took down the banking system and set off a deflationary dynamic from which Japan
has yet to recover. 3
Thus, it was not really the appreciation of the yen which sunk Japan, but erroneous policy response.
Likewise, the meteoric rise of China will be halted by the formation and blowing up of gigantic asset
bubbles. For example, by not appreciating the renminbi significantly or keeping interest rates at low
levels will force savers out of cash and into the residential housing market, and if credit grows much
more than the gross domestic product it will be the perfect recipe for the making of asset bubbles.
Similarly, the euphoria surrounding other emerging economies is worrying. In most instances stock
markets are priced far above their historical valuation levels. Basically, these markets are discounting
near-perfect scenarios going forward. Bubble trouble in China, however, would set off a second round of
deflation and undoubtedly end the emerging markets boom.
It seems, however, that Chinese policymakers are well aware of possible inflation and bubble risks in
their economy and recently announced – somewhat unexpectedly – further tightening measures to curb
these possible risks. Two factors weigh in on inflation expectations: One, wages are increasing rapidly
and while it is good for rebalancing the economy with higher consumption levels, it does have
inflationary effects. Two, credit growth is likely to surpass the official target. With the abundance of
liquidity and negative real deposit rates investors are forced to the stock market, housing market and
commodity markets. Despite tightening measures aimed especially towards the housing market, excess
liquidity and inflow of “hot money” remain a serious concern for policy makers. 4
Clearly, the current U.S. monetary policies are going to have a profound impact on the rest of the world,
especially emerging markets. Yet, it does not need to have a bad ending. With a bit of luck and smart
monetary policy management an asset bubble implosion can be avoided in China. If not, for all practical
purposes the emerging market boom and party will be over. Oliver Blanchard correctly summed it up in
his foreword: Achieving a strong, balanced and sustained world recovery was never going to be easy…
4
1
IMF, World Economic Outlook, October 2010.
Martin Wolf, 2010. “Why America is going to win the global currency battle”, Financial Times, October
12.
2
3
Peter Tasker, 2010. “Emerging markets at risk from a gigantic bubble”, Financial Times, October 18.
4
Yiping Huang, 2010. “What does PBOC’s latest rate hike tell us?” VOX, October 20.
5