Satyajit Das: Weapons of Choice in Trade Wars

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.”

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  1. attempter

    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.

    And even more so with Peak Oil and the end of “growth”. (Not that there truly has been growth in most Western countries, as opposed to sham finance games, in many years.)

    Since we need to smash the finance tyranny, and since we’re seeing the end of globalization and the progressing relocalization of trade relationships, it’s time to relinquish this perspective on currencies as weapons against one another.

    If there are two perspectives on a currency: Relative to the domestic economy from which it arises, and relative to other currencies (e.g., that’s the difference between saying “yuan” and “renminbi”, isn’t it?); then it’s only the former which any longer has any significance for the path America must travel more or less soon. Meanwhile the former is not only obsolete but pernicious since it plays into the hands of the criminal banksters, who want to retain the paradigm of currencies as just different colors of play money to speculate off against one another.

    (European countries will remain closely linked trade partners, which is why it’s self-destructive for many of these countries to remain mired in a “common currency” which was really conceived and put into practice as a German economic weapon, for its own absolute advantage. As a natural fact, American history has seen the same dynamic as parasitic Eastern money preyed upon the farmer economy. It’s ironic that geographical heartland “freshwater” economics is now considered more predatory than “saltwater”, when it’s really just the more extreme, purified version of it. From the point of view of the food producers, neither is water at all but poison.)

  2. kevin de bruxelles

    Thanks for this. I always appreciate your posts and am very happy to see that you take a global view on the currency wars.

    But if I didn’t have a few quibbles why would I bother commenting?

    I preface that my remarks are made from the point of view of Europe and the potential of a two front currency war that I fear will soon engulf us. From the West we have spectre of the US threatening to release the massive QE2 flood waters of dollar liquidity. From the East we have the descendants of Genghis Kahn (often literally) just over the horizon ready to swarm in from the steppes to wreck havoc on an already shaky European employment situation by raiding and looting vulnerable European jobs.

    In discussing currencies and manipulation we should really be talking about the Eurozone as a whole. In this case the Eurozone has more or less balanced trade with the rest of the world. By concentrating on Germany in isolation, it gives the false impression that they are the cause of global imbalances. There are certainly imbalances within the Eurozone to which Germany contributes and these are indeed an issue, but I think it needs to be emphasized that from a global currency-block point of view, the Eurozone is generally in balance with the rest of the world.

    I also question the idea that Germany is has historically manipulated its currency down. From the ashes of the Second World War, Germany rose strongly from 1960 into the 1990’s the D-Mark appreciated strongly against the British Pound. This winning streak ended in the aftermath of Germany Reunification (and after Britain finally recovered from the spanking Soros gave them) but started again around 2002 with the increase of the Euro all the way up until 2008. Whilst some trade unions might have objected, most Germans accepted the strong Euro, it was, and quite justifiably, the peripheral countries who objected to the strong Euro. My German contacts tell me that historically Germany has always been ready to accept a wide external value range for its currency due to the fact that Germany must import so many raw materials. The price disadvantages of exporting with strong currency were always offset by the price advantages of importing raw materials to build those products with that same strong currency. And it was obviously vice versa with a weak currency, the price benefits were offset by rising raw material costs. The Bundesbank is certainly not known historically for overseeing a weak currency.

    But those D-Mark days are past and Europe has responded to the pressure of the growing power of larger global economic units by attempting to create its own global economic power node.

    Europe’s historic strength (since 1500 at least) in relationship to Asia has been its fragmented political structure. This may seem counterintuitive but in many ways this model of multiple power nodes can indeed over time lead to better results than one major autocratic power node. For example, in Europe, where due to geography and culture, no one power could dominate, innovation and competition led to advances that could not be crushed by a institutionalized autocratic power looking after its own best interests. For example the triad of post medieval European power, firearms, long distance naval fleets, and the printing press, were all first developed in China. But the development of these technologies there was thwarted by centralized autocratic power and it was only in the Darwinian laboratory of intercultural European strife that these inventions blossomed into their fullest potential.

    But as global power blocks grow in size, Europe had to grow in turn or face the prospect of being picked off in detail. Just as the Romans mastered the art of divide and rule against the Germanic tribes, the Americans and the Chinese would surely prefer to face a fractured Europe. One can imagine on the military level that an enemy of Europe would prefer not to face a united European army but would prefer to pick off each country one at a time while exploiting inter-European jealousies by bribing neighbouring countries to assist. But there are certainly dangers in centralization. Powerful central elites can often become ossified and weak and eventually be co-opted by neighbouring competitors, as the historic example of China shows over and over again. So to continue the military example, it is less likely but it be actually be easier for this enemy of Europe to defeat an incompetent, or bribe a corrupt centralized elite instead of having to destroy each nation one at a time. So as Europe moves towards a model of global power blocks it must always seek the benefits of centralization while hedging its risks with fragmentation.

    As for potential solutions to the global currency wars, it is clear that natural resources are not distributed equally across the globe and so a redistribution of natural resources via globalization makes sense. But there is no corresponding logic to a consumer product globalisation; televisions for example, can be made anywhere. The addition of consumer goods into the mix throws an already potentially unstable globalization balance into complete disequilibrium. My only solution from a European perspective to the dilemma faced by currency pressures is that Europe must move away from the current model of consumer globalization and instead adopt a more limited resource globalization. This would in effect create walls that would protect EUrope from the floods waters of American liquidity plus also act as a barrier against Chinese job raiding. The downside is the possibility that local manufacturers could maintain a near monopoly and sell low quality products to a captured market. But if the economic blocks are large enough, and I think Europe is, and they maintain internal competition; technological developments from a neighbouring economic blocks should be able to find there way into the all the other blocks just as firearms, long distance naval fleet, and the printing press found there way into Europe 500 years ago. The key for each block is to fine tune its centralization vs. fragmentation levels so that these advances can be exploited and not crushed.

  3. Jim the Skeptic

    The proponents of Global Free Trade (GFT) are as idealistic as the proponents of Communism. Neither practice can survive in the real world.

    The currency moves we are seeing today are a direct result of GFT. If countries were free to raise or lower tariffs then currency manipulation would fade into the background.

    Countries will act in their own best interests, one way or another. It would be better to deal with the issues directly rather than by subterfuge.

    The question is, will it take another 50 years before we except the inevitable?

    1. Externality

      Yes. The European, NY and DC elites are wedded to a model of “global governance” where Western and Westernized elites run the planet, NY and London banks run the global economy, Western values are “global values,” nation-states become obsolete, and little Brown and Yellow people work to produce goods for the world. (The White populations of Western countries are seen as backwards, too expensive, too quarrelsome, and in the case of the US, useful only as cannon fodder for wars to expand the global empire. Note how the most of the technology jobs reserved for US residents are defense related.)

      China, conversely, wants to use trade and finance to fund its rise to power against an aging superpower, much as the US used manufacturing and finance to fund its rise to power in the late 19th and early 20th centuries. China does not want to be just another cog in the machine of Westernized global empire. Nor does it want to destroy its environment, economy, and ancient culture to provide manufactured goods, only to be discarded the way that the Rust Belt and its workers were discarded when the costs of pensions and environmental remediation drove up costs there.

      It will be interesting to see whether China, with its increasingly Confucianist culture and strong manufacturing base will be able to displace the Western elites running the planet for themselves and international bankers.

      1. Jim the Skeptic

        Too much like propaganda to suit me. Actions speak louder than words.

        Interesting that in the face of terrible rural poverty, China has decided to modernize their army and navy. Perhaps China believes that using “trade and finance to fund its rise to power” may be inadequate to the task when dealing with their neighbors?

        China has made absolutely spectacular domestic progress since 1948. Maybe it is time for it to become a little less paranoid in it’s dealings with the outside world? China can not expect to benefit forever from the western powers’ desire for some idyllic trade system. Reality was bound to intervene sooner or later. China can compete on the global scale in any case, it will just have to reorganize itself for a little more domestic consumption. Perhaps by raising the standard of living for it’s rural population.

        And China’s “increasingly Confucianist culture” will always be delimited by it’s Communist government. To that extent, China is self limiting.

        Have a good day.

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