Download The impacts of currency markets in an increasingly

The impacts of
currency markets
in an increasingly
globalised world
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A rough time for Chinese stocks
Source: Bloomberg
August saw 2 year lows in Chinese shares, including a 12% drop on the 24th
Interesting times
The market moves of Monday, 24th August 2015
will last long in the memories of those of us who
watched it unfold in real-time. The Shanghai
Composite slumped 12% in just two days,
dragging markets across the world lower.
Trillions of dollars were lost. As markets tumbled,
I sat at my screens weighing up the prospects of a
‘new normal’ in global markets; a frightened and
fragile investment base, ‘beggar thy neighbour’
central bank policies, slumping global growth and
an eventual tip back into recession?
Are we back to the bad old days for Asian markets?
Some of the dust has settled since those Monday markets but the questions remain.
A cut in interest rates from the People’s Bank of China may have soothed market
nerves to a certain extent and granted us a little perspective.
That perspective is the gradual moving of the economic centre of gravity eastward,
back to Asia, having been temporarily loaned to the West. The impacts of this are
huge. Soft power – the ability to shape preferences without coercion – lags economic
power but that does come eventually, and similarly, the source for global and political
influence will gradually shift to the east over the next 50-100 years.
Policy formulation via forums such as the World Economic Forum at Davos, G20
meetings and other supranational bodies for the entire global economy – and global
governance more generally – will no longer be the domain of the last century’s rich
countries but instead will require more inclusive engagement of the East. Military
matters may calm and interventions become less partisan.
The questions that I am most asked by clients and journalists about Asia now are
“where do we go from here?” and “what markets should we be watching?” In this
whitepaper I will lay out my risks to the wider Asian economies and their policymakers
moving forward and the implications for people and businesses operating in the
region. The impact of Monday 24th was to focus the global financial community on
Asian risks once more. Dealing with these risks will refocus the same community on
the prospects and opportunities in the same region.
Yuan some more?
Risk No.1 - Could a ‘currency war’
break out and what risks does that pose?
Source: Bloomberg
The strengthening of the yuan vs the dollar looked like a one way bet
In my eyes, Asia has always been the spiritual home of the
currency war.
From the devaluations of the Asian Crisis of the late 90s through Japanese-led
quantitative easing to the constant positioning battles of the People’s Bank of China,
hostile currency policy has been a hallmark of Asian international markets.
Devaluation – nothing new?
Competitive devaluation has been around for years but it’s questionable whether this
practice has ever really worked effectively. Before the 19th century, huge amounts of
trade between countries were rare and therefore relative exchange rates were not much
of an issue. Devaluation did occur but mainly via reducing the amount of gold and silver
used within the actual tokens of money in the economy.
With the advent of global trade, exchange rates became more relevant and then came
the Great Depression. Countries devalued their currencies one after another in order to
try and gain an advantage. None really came for anyone. Following a collapse in global
trade, the world moved into the Bretton Woods system of semi-fixed rates until the
1970s exactly to prevent this kind of thing from happening again.
After the breakdown of Bretton Woods in 1971, most major currencies have once again
become free floating and therefore susceptible to a competitive devaluation. In a world
that is seeing widespread fears over deflation and low growth, is it really that surprising
to see central banks resort to these ‘beggar thy neighbour’ policies?
Land of the falling peg.
The Asian situation is complicated by the variety of currency arrangements countries
have in place to manage their respective economic situations. Hong Kong dollar held
a peg to the US dollar at a rate of 7.8 from 1983 until changes in the late 90s led to a
thin trading band (HK$7.75-7.85). Brunei has maintained a 1-1 relationship with the
Singaporean dollar for trade purposes and the Chinese yuan has been pegged at a fixed
rate, then crawled with, the US dollar. Recent moves have only served to open the CNY to
more volatility.
The decision of the People’s Bank of China to revalue the yuan was a perfectly reasonable
policy decision for a central bank plagued by a peg to an overvalued currency.
Beggar thy neighbour
Until the yuan is a fully free floating currency, then the People’s Bank of China will be
playing with its currency – as it is perfectly entitled to do.
China is attempting to transition from a manufacturing and industrial driven economy to
one supported by consumption, all while attempting to grow at 7% GDP per annum. This
is like trying to change the tyres of a car while it is doing 70mph the wrong way down a
motorway. Using the currency as a tool to control inflows and outflows of the currency is
a fundamental right of a country to make sure the wheels don’t come flying off.
The movements have not gone amiss in Vietnam, where the dong has been devalued
three times this year already. Or in Malaysia where the ringgit continues to drive to lows
not seen since 1997. I am not of the opinion that we are in the midst of a re-run of
1997 however.
Central banks in Asia have learnt from the Asian crisis and they sit in vastly superior and
protected positions. All have higher FX reserves to intervene in markets for extended
periods, stronger current accounts to limit the amount of financing that needs to be
brought in from abroad, and any debts that are held are mostly denominated in local
and not reserve currency elsewhere.
Commodities have not enjoyed 2015?
Source: Bloomberg
Nearly every traded commodity is down heavily on the year
Demand
Simple demand dynamics and a shrinking of the aggregate demand frontier is easily
seen in the recent moves in oil and other industrial commodities. Falling export
demand has affected all of Asia in recent quarters as the headwinds from the
European economy and the slow recovery in other developed markets has caused
consumers to look inward. Lower prices could have helped the situation if the falling
demand was price driven and not as a result of a slowing of global growth. Prices fell,
factories closed, growth declined and prices fell again. A dead demand spiral comes in
many forms.
Supply
We have an oversupply of commodities in global markets at the moment. From oil
to iron ore, tin to coal, we have too much of the stuff. This oversupply comes from
deposits that have already been refined and made ready for consumption, only to find
that buyers are nowhere to be found.
The reasons are numerous. Firstly, expansion of supply operations in places like Canada,
South Africa and Australia when prices were higher was too much. Capital expenditure
by the industry’s largest miners, surveyors, drillers and refiners has plummeted in
recent years as the curtailment of demand has closed numerous operations.
Risk No.2 - Commodities – the dark side
of cheaper oil for Asia
Commodities are as key to some currencies as interest rates. Terms of trade is the
balance of export prices versus import prices, and high commodity prices go together
with strong emerging market currencies like sunshine and laughter, and did so through
the uplift of the commodities super cycle.
Now however, both the supply and demand dynamics of commodity markets are in
jeopardy and explain why prices have fallen to a 16 year low at the time of writing.
Deflation
In such an environment, and given the high level of weighting that energy makes
up of both developed and emerging market inflation baskets, deflation is the major
concern for policymakers. Of course, outright deflation in core assets such as food
and energy leaves consumers with more money at the end of the month allowing
spending on discretionary assets – cars, TVs, air conditioning units – to increase. For
western economies that are built on consumption this is a boon, for emerging market
economies that still rely heavily on manufacturing the effect is less pronounced.
The outlook
If there is a recovery in commodity markets it is likely to come from the demand side of
the equation; demand in turn driving inflation that will see industry and manufacturing
expand. In the short-term, however, the supply side dynamics look set to bring about
further falls in commodity prices, particularly oil.
Oil markets are oversupplied following OPEC decisions to maintain supply in the face
of falling prices. This was a well-executed play to disrupt the shale operators in the US
that were stealing market share, albeit at a much higher marginal cost. Storage, both
onshore and offshore, is filling up as refiners bank supply and wait on higher price levels
to sell into the market. So even when prices come higher, bleeding in of this supply will
keep prices depressed. Fold in the 500,000 barrels a day that an unsanctioned Iran is
looking to produce, and oil supply is going to remain a headache in commodity circles
moving forward..
The world of interest rates
Source: Bloomberg
Central banks are diverging with some expected to hike rates (green) and some to cut (red)
State of the Union
First is the US labour market. Since the advent of ‘forward guidance’ the jobs market
has been the barometer of strength of the US economy. Each payrolls report is viewed
as the next hurdle for markets. Payrolls numbers above 200,000 with a decent wage
increase are just the kind of gradual and sustainable improvements that the Federal
Reserve is looking for.
The second and most pertinent condition is inflation. Inflation in the US remains
at stubbornly low levels with the year on year increase a rather miserly 0.2%. Core
inflation is stronger at 1.8% but still below the 2% that policymakers view as a happy
medium. Although the labour market improvement has continued, the increase in
employment has not tightened the wage construct enough to create inflation…yet.
There is an obvious deflation risk from the Chinese yuan devaluation but the lag
between the People’s Bank of China’s actions and the impact on inflation in the US is
around nine months. At the time of writing we are still waiting on the Federal Reserve
to comment on the wider effects of the sell-off on Monday, August 24th. At the start
of that day, we were strong advocates of a hike in September but the uncertainty
and the lack of support in FOMC members comments persuaded us to postpone until
December. I still think they should hike in September but now accept that they won’t.
Risk No.3 - The Federal Reserve – the most important
and, possibly, the most dangerous
Despite the movements of the People’s Bank of China in the past month, the Federal
Reserve remains the most important central bank in global commerce and it is the
movements of the Fed that will govern markets into 2016. Normalising monetary
policy in the United States is only the latest starting pistol to be fired across asset
markets this year, but is a bigger risk to the world economy than Greece, the
revaluation of the yuan and the collapse in oil markets.
The conditions need to be right however.
Comments are key
The most recent set of minutes also noted that many members “continued to see
some downside risks arising from economic and financial developments abroad”
though the risks to the domestic outlook were “nearly balanced”. I have been working
in markets for 13 years now and I am struggling to think of a time where there
weren’t risks from abroad. If the Chinese devaluation of the yuan is enough to put off
the Federal Reserve from starting a policy of normalisation then we were never ready
in the first place.
What should you do?
The risks outlined here could all drive volatility higher but, unfortunately for
those of us trying to plot the best course through these waters, it is unlikely
to be just that simple. For example, should global market falls prove less
of an impediment to the Fed’s policy of normalising interest rates than
currently thought, then there will be additional risks to bear in mind. Capital
controls have yet to be imposed but are a risk if a country’s currency comes
under speculative attack. Pressures on the corporate sector may increase
as foreign currency denominated debt payments come due. Liquidity
could easily dry out in less available currencies. Holders of Asian and other
emerging market currencies are likely to have their feet held to the fire in
the coming months.
With these risks ahead of us it makes sense to talk to a currency expert.
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The comments in this guide are our views, and the views of our contributors. You should act using your own information and judgment.
Although information has been obtained from, and is based upon, multiple sources the author believes to be reliable, we do not guarantee its
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