THE WORLD WAKES UP TO THREAT OF CURRENCY WARS / BARRON´S MAGAZINE ( HIGHLY RECOMMENDED READING )

Up and Down Wall Street

WEDNESDAY, SEPTEMBER 29, 2010

The World Wakes Up to Threat of Currency Wars

By RANDALL W. FORSYTH

CALL IT "CURRENCY WARS" or a "race to the bottom," the threat of competitive devaluations by governments to gain an advantage in a world of weak demand and high unemployment suddenly has come to the fore.


It is a threat I addressed here almost two weeks ago ("Central Banks Embrace Risky Currency Gambit," Sept. 17.) In a world where major central banks have slashed short-term interest rates—their traditional policy lever—to nearly nil, they are increasingly turning to their other, rarely used option, currency devaluation.


Now, the specter of international currency wars has been raised by Guido Mantega, Brazil's finance minister. "We're in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness," the Financial Times quoted him as saying. In that, the FT asserted Mantega was saying out loud what policy makers were saying in private (not to mention what was being written in this space.) No doubt this will be a major topic of discussion at next week's annual meeting of the International Monetary Fund and World Bank in Washington.


As noted here, these moves to keep a lid on currencies recall the "beggar thy neighbor" policies of the 1930s, which helped to spread and deepen the Great Depression internationally. Indeed, one especially perspicacious reader of this column suggests that this currency race to the bottom effectively constitutes "Smoot-Hawley Redux." Aren't governments now using currencies doing the same thing as the infamous tariff passed in 1929, which contributed greatly to the Great Depression?


The point is well taken. Mantega's government has been contending with relentless upward pressure on the Brazilian real as exports boom, especially to China. Meanwhile, global capital floods into the Brazilian capital market, which offers yields of 12% on government bonds denominated in an appreciating currency, the result of a tight monetary policy to restrain inflation.


Meanwhile, central banks and governments in the developed world are desperately fighting the economic stagnation and deflationary pressures resulting from the credit bubble and bust of the past decade. As noted, the key weapon has been to cut short-term interest rates to an irreducible minimum, along with emergency measures in the U.S., U.K. and Europe to prop up their financial systems. Then came outright buying of bonds by central banks, including $1.7 trillion by the Federal Reserve, to help push down longer-term rates.


The measures taken during the dark days of the crisis in late 2008 and early 2009 were remarkable for the coordination among policy makers across borders. Importantly, it was recognized that the crisis was international in nature, not the least because of the reckless purchase of securities backed by rotten American mortgages transcended borders. Toxic U.S. mortgages infected investments from Asia and Australia to Europe as well as their home market. The U.K., meanwhile, suffered a housing collapse that in many ways was a mirror image to the U.S., if not magnified.


That coordination has given way to competition. Two weeks ago, the Bank of Japan reportedly intervened to purchase the equivalent of ¥2 trillion ($23 billion), its first foray into the currency market since 2003. Importantly, the Japanese central bank left that ¥2 trillion in the domestic money market, instead of draining—or "sterilizing"--the liquidity injection from the forex operation.


What's noteworthy is that the BOJ intervention probably was rooted as much, if not more, in politics than economics. The operation followed the resolution of a fight for leadership in Japan's ruling party, a major point of contention was the soaring value of the yen, which is becoming a major factor in further depressing the nation's economy after what is dragging on to a second lost decade. While the challenge of the insurgents (who had wanted more forceful action to push down the yen) was defeated, the message wasn't lost on the incumbents. They quickly dispatched ¥2 trillion—which initially pushed dollar to 85 yen from 83 yen, but the effect has dissipated and the dollar is back under 84 yen. Which is to say, the BOJ has done squat.


Meanwhile, the euro has soared, from under $1.20 around mid-year and $1.27 as recently as Labor Day, all the way back to $1.35. That's about the last thing the eurozone economy needs. A salutary side-effect of the European sovereign debt crisis was a weakening of the euro, which goosed Germany's export-oriented economy to a nearly 9% annualized growth rate in the second quarter. With the euro's appreciation since then, growth has slowed markedly. And economies that produce little in the way of tradeable goods failed to see any benefit, such as tourism-dependent Greece. As spectacular as the sunsets are in Santorini, I'm not going there if there's a chance I'll be stuck in Athens airport by a strike against austerity—regardless of the exchange rate.


And, of course, the elephant in the room is China. As crucial U.S. midterm elections approach and the domestic economy continues to flag, the potential for retaliatory actions against the perceived undervaluation of the renminbi looms. While Chinese officials rightly point to the negative potential for the dollar from the rising U.S. government debt burden, U.S. officials contend China artificially suppress its currency's value. How? By financing the U.S. fiscal deficit by purchasing Treasuries, although China has pared its holdings of U.S. government obligations in recent months.


The downward pressure on the dollar is exacerbated by Fed's efforts, which it articulated last week as aiming to raise the inflation rate, which it said had fallen too low to meet its other goal of higher employment. Exports will be a major part of that effort, especially in view of President Obama's goal to double sales abroad.


All of which makes a strong currency undesirable to countries around the globe looking to do likewise. In a world where the pie isn't growing, everybody's looking for a bigger slice. But that's not possible for everybody and indeed becomes counterproductive as barriers are erected to trade.


That is why there are no winners in currency wars, only losers, which is the lesson of the 1930s. Most of the other lessons of that era have been learned well; policy makers have tried to counter the debt-deflation spiral that strangled economies then.


The question is whether they will heed the perils of competitive devaluations. So far, the signs aren't encouraging, which may help explain why gold surged to a record over $1300 an ounce.


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