By Satyajit Das a risk consultant and the author of the Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives
During the European debt crisis, in a matter of days, the dollar strengthened by around 10%. The weakness of the Euro and resultant appreciation of the Renminbi by over 14% reduced Chinese exporter’s earnings and competitiveness. Some of the moves reversed equally quickly when markets stabilised. Volatility of currency exchange rates has increased markedly in recent months.
To paraphrase Oscar Wilde, the US dollar has no enemies, but is intensely disliked by its friends, especially key investors like the Chinese. The Euro is now the “Drachmark” (a derisory combination of the former Greek Drachma and German Deutschemark). Investors assumed that the Euro would be a new Deutschemark, supported by German commitment to fiscal and monetary rectitude avoiding Gallic and Mediterranean extravagance. Instead, investors have been left holding a currency underpinned by unexpected German extravagance and Gallic and Mediterranean rectitude.
Despite sclerotic growth, public debt approaching 200% of GDP and a budget where borrowing is greater than tax revenues, the Japanese Yen has risen to its highest level against the dollar in 15 years. China is even switching some of its currency reserves into Japanese government bonds with returns only apparent under powerful electron microscopes.
Fears about the value of any currency have seen a resurgent interest in gold. Traders are now reading their John Milton: “Time will run back and fetch the age of gold.”
Amongst currencies, it is simply a race to the bottom. On 27 September 2010, the Brazilian Finance Minister Guido Mantega stated the obvious speaking of an “international currency war” as governments around the globe compete to lower their exchange rates to boost competitiveness. In the words of English philosopher Thomas Hobbes it is “war of every man against every man”.
Arcane currency shenanigans point to deeper, unresolved economic issues that policymakers are unwilling or unable to confront but whose resolution is crucial to a sustainable recovery and growth. The odd thing is that the problem is not new, having been there all along.
Since the end of the de facto gold standard and Bretton Woods, currencies increasingly have become weapons of choice in trade and economic wars. In the German and Japanese model of economic development, an undervalued currency is a key mechanism for maintaining competitive costs and high levels of exports to drive growth. Successive generations of emergent countries, most notably China, copied the model.
Despite tensions, the model worked well in a world of strong economic growth and increasing trade. It was a question of dividing growing wealth. The model is more problematic in a world of low growth.
Currently, the world may be entering a period of lower growth. Consumer spending, funded in developed countries by debt, has slowed. Given significant over capacity in many industries, business investment is weak. Under increased pressure from money market vigilantes, governments are cutting spending and raising taxes, embracing the “new austerity”.
As growth slows, maintenance of competitiveness requires businesses to manage costs brutally. Cheaper currency values assist in remaining competitive, avoiding the need to overtly cut costs by reducing wages or cutting benefits, explicitly lowering living standards. During the global financial crisis, the repeated manouevering of China, Japan and Germany to maintain the low value of the Renminbi, Yen and Euro against the dollar was designed to maintain export volumes to cushion the worst effects of the recession.
To a large extent, it reflects the underlying structure of economies heavily geared to exports. Angela Merkel has repeatedly stated that she sees no change to the export driven German economic model in the near term. For Japan, falling living standards combined with an aging, falling population means increasing dependence on exports. For China, increasing wages pressures and domestic inflation means that rising production costs must be offset by other means, including an undervalued currency.
The problem of shifting models is great. In 1985, the Plaza Accord forced Japan to effectively revalue the Yen, setting off a rise from Yen 230 per dollar to Yen 85 per dollar. The rise in the Yen reduced Japanese export competitiveness and led to a recession. To stimulate the economy, the Bank of Japan and Government pumped large amounts of money into the economy. Rather than assisting recovery, the money set off a commercial real estate and stock market boom that collapsed spectacularly at the end of 1989 plunging Japan into the “ushinawareta junen” – the Lost Decade.
Aware of the Japanese experience and at risk of repeating the experience, China has fervently resisted revaluing its currency, despite pressure from the US. Recently, Chinese leaders have spoken about the economic and social catastrophe that would result from a major reminbi revaluation.
Chinese Premier Wen Jiabao told an European business conference that: “If we increase the yuan by 20 percent-40 percent as some people are calling for, many of our factories will shut down and society will be in turmoil. If China’s economy goes down, it’s not good for the world economy.” In order to forestall, European calls, led by French President Sarkozy, for a revaluation of the Renminbi, Wen cunningly voiced support for Chinese purchases of Greek debt. Wen urged Europe not to “join the choir to press China to allow more yuan appreciation.”
The unstable currency order creates distortions, frequently preventing action to deal with economic problems. It leads to countries pursuing odd and sometimes contradictory policies.
For example, financial triage, cutting the unsustainable and unlikely to survive countries out of the Euro, would restore their competitiveness through devaluation. But Germany is unlikely to allow weaker countries to leave the common currency precisely to avoid a sharp increase in the value of the Euro, making its exports less competitive. Contrary to popular view, the Germany has much to lose from changes in or abandonment of the Euro.
Recent German economic performance has benefited from the effects of a stronger Yen relative to the Euro making its exports more competitive. German corporate profitability has recovered strongly to pre-crisis levels. More recently, Japan has intervened in currency markets to prevent the Yen testings its 1995 high of Yen 79.75 against the dollar.
Interest rate policies pursued, in part, to manage currencies also perpetuate economic dislocations. Paralleling the events after the Asian monetary crisis in 1997/1998, the flight to dollars during periods of European instability pushes down interest rates on U.S. government debt.
The possible reintroduction of quantitative easing (it used to be called “printing money” in a less politically correct world) reflects, in part, attempts by policymakers to influence currency values. Paradoxically, lower interest rates reduce pressure for required deleveraging and deficit reduction by lowering the cost of servicing debt.
Major reserve currencies, like the dollar, Euro and Yen, provide some ability to offset changes in value by invoicing trade in their own currencies. Unfortunately, for minor currencies, the fact that trade continues to be denominated in the major currencies creates difficulties where a one day move in foreign exchange markets can wipe out the entire profit margin. The higher volatility means that the cost of hedging the risk of such currency moves is large, reducing profitability.
The currency crisis highlights the “beggar thy neighbour” policies pursued by many economies. China, Japan and Germany have consistently pursued policies that emphasise high domestic savings, low domestic consumption and an undervalued currency to drive its export driven economies. These global imbalances contributed significantly to the current financial problems.
A global economic order where a few countries save and lend to finance their exports while other countries act as consumers of last resort is unsustainable. A system where each country seeks to maximise its own competitive position and financial security at the expense of trading partners is not viable.
An emerging toxic combination of inflexible global currency arrangements, a destructive cycle of currency devaluations, trade restrictions and the need of governments to rein in spending to balance budgets is reminiscent of the 1930s. They threaten a period of prolonged global economic stagnation.
The globalization of complex financial relationships, much lauded before the crisis, is now proving a liability in resolving the crisis. Optimists must rely on Israeli politician Abba Eban’s observation that “History teaches us that men and nations behave wisely once they have exhausted all other alternatives.”