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A currency war begins
Currencies are unusual ‘assets’. They don’t have a value on their own, only a rate at which one can be exchanged for another. This means that a currency can only really fall in value relative to another currency. They can’t both fall at the same time.
So what happens when two major economies, such as the US and China, each want their currency to be lower than the other?
Only one can win, so we see the beginnings of a ‘currency war’.
Why is weaker better?
Since the onset of the Global Financial Crisis (GFC), both the US and China have accused each other of deliberately devaluing their currencies to boost their own economic growth at the expense of other economies.
A strong currency is usually viewed as a sign of economic strength. It means more buying power, which helps avoid inflation being imported from overseas, and generally results in increased investor confidence.
But when a country needs exports to boost economic growth, a weaker currency helps competitiveness.
What are they doing?
Generally speaking, exchange rates can either be determined by the markets, or set by governments.
If a currency is freely traded in the markets without day-to-day intervention, it’s referred to as a free float.
When a currency is matched to another country’s currency, or to a basket of currencies, it’s referred to as pegged exchange rate.
The US dollar is a free floating currency, although critics, including some Chinese authorities, believe that the most recent round of quantitative easing (QE2) is deliberately targeting a devaluation of the US dollar.
In recent times, Chinese authorities pegged the Yuan to the US dollar, and progressively adjusted the level of this peg.
This strategy has been an important aspect of China’s transition from an insular, rural economy to the world’s second largest economy.
Initially, the US benefitted from purchasing cheap imports from China and its current account deficit (CAD) rapidly grew.
Right up until around 2007, policy makers didn’t see the rapidly growing CAD as a major concern, but the fallout from the GFC changed all this.
The build up of both private and public debt means that the US now faces twin deficits – a CAD that’s around 3 per cent of GDP and a government budget deficit that’s around 93 per cent of GDP.
In other words, the US is feeling the pressure to earn more than it spends.
In contrast to previous US recoveries, consumption and housing can’t lead the way forward. Consumer demand is low because unemployment remains stubbornly high at 9.6 per cent and households are paying down historically high debt levels. The housing market is also still falling.
This time, US exports and investment are the key components driving economic recovery, as shown by figure 1 below.
Figure 1: Exports and investment driving US economic recovery
Source: AllianceBernstein
A weaker US dollar can help make US exports more competitive in the global market.
China on the other hand, has built large surpluses, but still wants to remain competitive in global export markets, as it can’t yet support a large scale shift to domestic consumption.
While Chinese authorities officially de-pegged the Yuan from the US dollar in June, they resisted pressure to allow a one-off large-scale appreciation of the Yuan by maintaining a narrow 0.5 per cent trading range.
The US Federal Reserve has denied that QE2 was targeted to lower the value of the US dollar, which hasn’t eventuated (yet).
One possible reason for the US dollar not depreciating is that banks are still hoarding record amounts of cash with the US Federal Reserve, as shown by figure 2.
Figure 2: Excess cash at the Federal Reserve
Source: AllianceBernstein, US Federal Reserve Board. Data through to 31 July 2010
What this means for investors
The US’s latest round of quantitative easing runs the risk of putting too much heat in developing economies, as investors seek out yields that are higher than those in the US, which are historically low.
The increased flow of capital to emerging market countries is placing upward pressure on their currencies, and has prompted some nations, such as Brazil to implement controls to limit the amount of capital inflows.
These factors have also been placing an upward pressure on the Australian dollar.A higher Australian dollar is positive for Australian based investors purchasing overseas equities, but detracts from returns on already held unhedged portfolios.
It may come as a surprise for some investors to learn that countries, such as the US, which have feced concerns about the possibility of a double dip recession, have posted among the best sharemarket returns.
Over the past 12 months, the US sharemarket has risen by 7.8 per cent, while China’s sharemarket is down by 11.7 per cent, and the Australian sharemarket is down by only 2.5 per cent.
This is largely because the US corporate sector is in very good shape, with strong balance sheets and profits rebounding quickly. This again shows that it is important to consider the implications of these developments on individual companies, not just countries.
2 December 2010
