By Kieran Osborne, CFA, Co-Portfolio Manager, Merk Mutual Funds
8 October 2010
The last thing the global economy needs right now is anything that would hamper or derail economic growth. Unfortunately, there appears a growing specter of this occurring. Brazil and Japan's recent decisions to intervene in the currency markets follow a disturbing trend. If policy makers are not careful, present dynamics may precipitate a worldwide economic slowdown, brought about by protectionist pressures and exacerbated by political motivations globally.
Competitive currency devaluation appears to be the name of the game for many Treasury departments and central banks alike. It may also be a key driver of the recent strength in gold; in such an environment, an asset that retains its intrinsic value is increasingly sought after. Vietnam instigated a devaluation of the dong earlier this year, Switzerland, a country renowned for stability and neutrality, attempted to devalue the Swiss franc relative to the euro, rhetoric out of Washington has intensified surrounding China's decision to continue to peg its currency closely to the U.S. dollar, and now Japan and Brazil have both decided to take unilateral action, intervening to weaken their respective currencies.
For many countries, the motivation to devalue the currency is to spur export growth. Devaluing a countries' currency is akin to providing a subsidy to the export sector, as it makes that country's exports relatively cheaper. The flip side, is that it intensifies inflationary pressures, as a devalued currency means that imported goods become relatively more expensive; for a high-growth developing economy, the combination of an undervalued currency and increased production and labor costs can cause substantial domestic inflationary pressures, as evidenced in China.
Moreover, devaluing a currency may lead to escalating international political strains, global criticism and intensification of protectionist pressures. Maybe the most prevalent example being the U.S. criticism leveled at China, culminating in the passing of legislation aimed at pushing up the value of the yuan. When one currency is artificially weak, other countries may be put at a disadvantage, as other countries' goods and services may be less competitive in the global market. Such a situation can and has encouraged retaliation, whether through competitive currency devaluations or outright trade wars, in the form of additional import taxes and duties levied, or sanctions placed, on specific exporting countries deemed to be manipulating their currencies. Trade wars are good for no one: they create inefficiencies and slow down global growth. In a period of lackluster global growth, this is the last thing we need. Recent references of a "race to the bottom" and worldwide "currency wars" should not be taken lightly - given that the global economic recovery remains on unsteady ground, the implications of another slowdown in growth could be disastrous.
We have discussed at length the very questionable currency policies pursued by the Swiss National Bank (SNB) - see our analysis here - and have been heartened to see that the SNB appears to have come to its senses and discontinued this approach.
We have long argued that China should allow its currency, the yuan or renminbi (CNY), to appreciate, as it may help alleviate much of China's domestic inflationary pressures. China has continued to rely on rather rudimentary banking regulation to curb lending and growth in monetary aggregates to rein in inflation, and recently announced a plan to allow the currency to trade within a wider trading band. It turns out that "wider band" is a relative term; the CNY has appreciated by a little over 2% since the announcement in June. The Chinese are unlikely to allow the currency to float freely overnight, as even small moves to the currency affect many businesses throughout the Chinese economy; the process is likely to play out over many years. This hasn't stopped U.S. politicians from taking a swipe.
While Treasury Secretary Geithner's recent testimony to congress fell short of labeling China a currency manipulator (and was much less aggressive than many politicians had hoped for), the message out of Washington is clear: the U.S. is increasingly unhappy with China's exchange rate policies. In our opinion, however, China is unlikely to allow the currency to appreciate simply because of threats from Washington; rather, they will act in the best interests of China. Moreover, the debate over China's currency policies is to some extent misguided: many politicians argue that a stronger CNY will generate jobs in the U.S. To a degree, this may be true: U.S. based companies may think twice before making the decision on additional hires should the CNY appreciate. But it is unlikely that much of the jobs that already left as part of the outsourcing bubble that occurred throughout the last decade will return to the U.S.; the U.S. simply cannot compete on cost; these jobs are likely to migrate to lower value producing countries, like the Philippines, Vietnam or Thailand.
These countries produce goods at the low-end of the value chain, have limited pricing power and are therefore forced to compete predominantly on price. As such, and in our opinion, these countries are more likely to instigate competitive devaluations of their currencies. With an ever-deteriorating consumer outlook in the U.S., the incentive for these countries to instigate competitive devaluations of their currencies grows significantly. Indeed, Vietnam has already intervened in the currency market, actively weakening the value of the dong (VND). With a continued weak consumer outlook in many western nations, it is quite likely that further competitive currency devaluations occur in the lower-value producing Asian nations.
Brazil's economic expansion, and the substantial appreciation of the Brazilian Real (BRL) share similarities to the Australian experience. Rich in commodities and natural resources, both countries have benefited from insatiable demand out of Asia, particularly from China. Both economies have rebounded strongly and in both nations, the unemployment rate has declined steadily, and remains well below the levels seen throughout much of the western world. Both central banks have led the world in interest rate increases, with the Reserve Bank of Australia raising the target rate by 1.5% since the latter half of 2009 and Brazil's central bank raising rates by 2%. Increased investment demand has flowed into both nations and as such, both nations' currencies have appreciated substantially: relative to the U.S. dollar, the Australian dollar (AUD) has appreciated 39.9% for the period March 31, 2009 to September 30, 2010; during the same period, the BRL appreciated 37.7%.
When it comes to exchange rate policies, the similarities stop there. Brazilian finance minister Guido Mantega has been particularly vocal about the government's concerns surrounding the strength of the BRL, describing the present situation as an "international currency war". Brazil previously imposed a 2% tax on foreign purchases of fixed income securities and stocks in October 2009, in an attempt to curb gains in the currency. Brazilian policy makers have now stepped up their offensive, increasing the tax on inflows to 4% and buying billions of dollars in the market in an attempt to stave off further currency appreciation. Speculation is rife that further steps will be taken, or that direct capital controls may be implemented. The government is certainly not taking this issue lightly, sending the ominous message that they are "not going to lose this game."
Conversely, Australia has been a leading proponent of the virtues of a free-floating currency, namely protection against inflationary pressures and boom-bust cycles. The Reserve Bank of Australia has lauded the flexible exchange rate as one of the great success stories of Australian economic policy making. In their opinion, Australia's free floating currency has helped mitigate exaggerated economic booms and busts and has protected against high, and volatile, inflation. Currency price movements helped the economy adjust more smoothly to the current boom in the resource sector, helped protect the economy in 2008 when global risk aversion was at its peak, and during the Asian financial crisis and the bursting of the U.S. tech bubble.
Brazilian policy makers may do well to heed their Australian counterparts: the appreciation of the BRL has undoubtedly helped alleviate inflationary pressures in Brazil, helping bring inflation back towards the target rate of 4.5% from over 6% previously, and could help bring the rate to a more price stable level. While Brazilian policy makers may or may not succeed in destroying the currency, one thing is for sure: they run the very real risk of alienating Brazil from global markets. In our opinion, Brazilian politicians' motivations are flawed: on the one hand they believe the strong appreciation of the BRL will stifle economic growth; on the other hand the talk of imposing rather draconian measures to stem demand for the currency will likely drive investment away. These are the same investment flows required to drive economic growth in Brazil.
Potentially more damaging globally is if these actions prompt other nations to follow a similar path. Already we have seen South African, Peru, and Mexican politicians (amongst others) uttering misgivings about the strength of their respective currencies. Should we enter a period of competitive currency devaluations globally, the risks of trade wars may increase substantially, which could come with serious consequences for global markets.
Countries that run current account deficits, including the U.S., may be at the greatest risk should a global trade war scenario play out, as these countries are reliant on foreign investors to finance their deficits. Should additional tariffs, capital controls or sanctions take effect (a very real threat given recent legislation surrounding currency manipulation), the U.S. may lose the trust of international investors, who may in turn pull funds out of its markets, putting pressure on the U.S. dollar.
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