The financial news media has a way of shifting people’s focus on certain key issues that are supposed to occupy an investor’s mind for certain periods. Sadly, the bold headlines encourage the spread of fear and often do more damage than good.
In this day and age, who has the time to read details and go beyond the headlines? This causes investors to pay too much attention to the bold statements and to make investment decisions based on fear. The fear is caused by headlines such as: Currency Manipulators, Currency Crisis and even Currency War. The amount of fear is evident in the continued rise of Bond prices, Stock prices above fair value and most obvious in the price of Gold which hit $1,364 this week.
At this week-end’s G20 meeting, the finance ministers will then engage in some diplomatic battles and there will be some finger pointing towards an easy target: China - as if all economic woes could suddenly be resolved if and only if China would revalue its currency.
But China is not the only and certainly not the first country to peg its currency with the US Dollar; for instance, most countries in the Middle East have done so for decades. It is also not the first time in history that nations have had major arguments about the “correct” rate of exchange. Ever since the major currencies abandoned the Bretton Woods agreement and were allowed to freely float, there have been periods of much debate about correct values of exchange rates. Starting with the Plaza accord in 1985 when it was agreed to depreciate the US Dollar against the Japanese Yen and the Deutsche Mark, the perceived currency culprits then, there have been rambles in the markets and political opinions as to what might be a correct exchange rate. Misgivings about a chosen currency framework, be it fixed or floating, have come to the public on a number of occasions. Take Britain’s exit from the Exchange Rate Mechanism (ERM - a forerunner of the Euro). Or consider the 1997 Asian financial crisis which resulted in massive debasements of some Asian currencies.
For better or worse, China has chosen to peg its currency closely to the US Dollar at allegedly artificially low rates. The general assumption is that by artificially debasing its currency, China was able to export its way to prosperity and become the world’s largest exporter. On first glance, it is indeed remarkable how closely China’s initial economic growth correlates to the debasing of its currency starting in the Mid-80’s with the major push in 1994 when the Yuan was debased by over 30% in one big adjustment.
Since then however, China has allowed to let its currency regain some value and Beijing has expressed a willingness to continue a gradual appreciation versus the US Dollar.
Currency War might be an overstatement but there is indeed a growing discontent of some nations with the way their currencies are currently valued most notably against the US$. Branding China as a currency “manipulator” though is somewhat misplaced. China has chosen to implement their multi-decade economic plan via a currency that is not freely convertible and is essentially fixed against the US Dollar. That policy has also come at a cost, most evident by the rampant domestic inflation in China. The Yuan rate versus the US Dollar therefore is not manipulated but is rather actively managed.
To give some credit to China, we must also consider that it is sitting on a foreign exchange reserve of some $2.5 trillion, most of which are in US denominated assets such as US Treasuries. The values of these assets have to be taken into account when considering a correct rate of exchange for the Yuan. If China were to revalue its currency by say 10% only, the value of their substantial US$ holdings would decrease by 10% as well. It is therefore unlikely that China will do any sudden changes in their current policy.
The real manipulation however, is happening elsewhere. From the perspective of countries like Brazil or Australia, whose currencies have been soaring against the US Dollar, the exchange rate versus the Chinese Yuan is perhaps an even bigger issue. The US$ has continued to loose value in recent months and commodity-rich countries like Brazil and Australia are finding it increasingly hard to price their exports to China competitively. China piggy-backing its rate on the US Dollar however did not manipulate things from their perspective. It is rather more likely that the easy money policy since the beginning of the last decade with currently near zero interest rates led to a depreciation of the US Dollar in real terms.
Financial markets respond to incentives first and foremost. For the time being there are very few incentives to invest in US$ denominated financial assets; near zero interest rates are one big factor, the growing US deficit maybe the next one in a long chain of arguments that give rise to a capital flight out of the US.
The huge US debt burden however is an incentive to debase the US Dollar in real purchasing power terms, perhaps the only real way to ever get out of the miserable debt spiral (the Weimar Republic argument). Countries like China and Japan who continue to feed into this debt (refinancing) know that the deficit spending cannot continue forever and they must be concerned about the true value of their holdings. Japan, which is sitting on close to $1 trillion in US assets, has already shown their level of concern by intervening in the currency markets and embarking on further easy money policy in the hope to reverse the rise of the Yen against the Dollar. Others have expressed similar concerns which is why there has been so much talk about a debasement of all fiat currencies resulting in a race to the bottom.
The US however, must look to its own backyard in terms of finding solutions for economic and fiscal policies that stimulate sustainable long-term economic growth rather than finding the fault with the economic policies of other countries. Branding China a currency manipulator does nothing to renew economic growth in the US, nor will it really lead to significant job growth in the US. It is not in China’s interest to have their largest customer go broke. They have too much at stake and too much of a vested interest.
If we really want to give China an incentive to continue their currency revaluation process, US officials should start by finding ways to balance their budget and make a sincere effort towards eliminating the US debt burden. Once that is in place and the US Dollar is no longer “manipulated” into loosing its real value, we might find that it is also in China’s interest to make currency adjustments, possibly to let their currency freely float.