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Asia Business Development – Asia Business Consulting » The Global Currency Wars
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SpirE-Journal 2010 Q4

The Global Currency Wars

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The Global Currency Wars

Since the Brazilian Finance Minister Guido Mantega used the term “currency war”, the world has been spooked by the prospect of a vicious cycle of competitive devaluations among the countries of the Group of 20 (G20)1. Of particular concern is the tension between the United States and China. How will companies in Asia’s emerging economies be affected by this latest episode of global currency volatility?

If ever there was a need, the recent G20 Summit in South Korea illustrated the impasse in the global economy over currencies and trade imbalances. The conference became gridlocked between the opposition of emerging economies to America‟s quantitative easing, which threatened to depreciate the US dollar against most emerging market currencies, and the perception of the US that China was artificially holding down the value of its currency. The final communiqué reflected the failure of the conference to broker a consensus among the world‟s leading economic actors.

This article examines the genesis of the current crisis in global currencies and the implications for business.

The background to the current crisis

Since 2001, US dominance in global economic matters has been in decline at the same time as the role of China and other emerging economies has increased. However the US continues to be a major global importer and generally runs a sizeable trade deficit with the big emerging economies of the world.

At the same time, the US dollar is highly internationalized. Vast quantities of US dollars are held abroad by governments as foreign exchange reserves. The dollar is also used to fund international transactions, with the US dollar having been historically viewed as the world‟s most stable currency for this purpose.

The backdrop to the crisis has been the accumulation of a huge burden of fiscal debt by the US government, with a large share held by foreign governments such as those of China, Japan and the Gulf states, mostly in the form of US Treasury Bonds. This debt burden has created a major incentive on the part of foreign governments to support the stability of the US dollar so as to maintain the value of their investment. This burden of debt increased radically in the wake of the US$ 787 billion stimulus package passed by the US government in 2009. The result? Pressure on those creditor economies to maintain the value of their currencies against the dollar.

At the same time, the Chinese government has been accumulating enormous amounts of foreign exchange reserves due to its capital controls on the RMB combined with its incredible success in exporting manufactured goods to the world. This development has attracted great scrutiny of the way China manages its capital controls. The Chinese government manages the value of the RMB such that it is fairly stable against the US dollar (in the range of between 6.5 and 6.8 since 2005). Even though the value of the RMB against the dollar was strengthened by China in 2005 (it used to trade at roughly 7.3 to the dollar), many voices in the US have claimed that the RMB is still very much undervalued against the dollar, perpetuating the huge trade deficit and, some say, the loss of US jobs to China.

What is at stake amidst all this international wrangling about currencies?

A weaker dollar makes it harder for emerging economies to export – and exports are a great way for them to create jobs at home.
The sharp decline in the dollar also leads global institutional investors to shift assets out of US dollars and into emerging market currencies (as well as other OECD countries such as Canadian and Australian dollars). This can fuel confidence-sapping inflation and risky asset price bubbles in emerging economies.
One of the few pieces of good news for the US economy in 2010 has been its strong export performance, driven in part by the weakening dollar. By refusing to strengthen the RMB further against the US dollar, China is seen to be limiting the ability of the US economy to recover. The US government has been accusing China, in increasingly strident language, of deliberately under-valuing the RMB.


America’s Monetary easing

In a controversial move to aid the US economy, Federal Reserve Chairman Ben Bernanke announced in November a USD$600 billion buyback of its Treasury securities, to make loans cheaper and encourage consumer spending. This announcement evoked criticism from emerging economy governments. 5 The Finance Minister of Brazil declared it to be the equivalent of “throwing dollars out of a helicopter.”

This second round of Quantitative Easing (dubbed QE2) followed the precedent set by the first such move in early 2009. It is expected to increase liquidity in the markets in terms of loans and consumer spending, which might in turn spur employment and economic growth in the US. However it will undoubtedly place downward pressure on the dollar.

Interestingly, a growing body of opinion holds that this liquidity injection is a gamble and may not necessarily achieve its goals. Businesses could potentially suffer due to more expensive commodities, which could exacerbate inflation when the US economy eventually improves. This could lead to a scramble to lock in prices, which would drive up futures contracts. It could also lead to retaliation from emerging economy governments.

China – in the hot seat over the RMB

China has consistently been blamed for undervaluing its currency, in spite of its efforts to let it rise gradually. China has undoubtedly controlled the rise of the RMB by limiting it to less than 7% per annum. It has risen 2.84% this year alone10. If the Chinese government gave in to US demands and allowed the RMB to float freely, the sharp appreciation in the RMB would cause China‟s exporters to suffer immensely, as most Chinese export businesses operate on thin margins and profit mainly on volumes of goods sold11. This would lead to business closures, job losses and social instability, particularly in Southern and Eastern China. A stronger RMB could also cause an outflow of Foreign Direct Investment (FDI) to countries such as Vietnam and India, where labor is cheaper.

The thinking of Chinese policy-makers is opposed to any sharp appreciation. Rather, they favour a gradual pace of change to amend trade imbalances with the richer economies.

Curbing the flood of 'Hot Money'

In the current climate, global institutional investors are anxious to shift a larger share of their portfolios to appreciating currencies. It is difficult for them to purchase Chinese RMB-denominated investment products for this purpose. The result? A flood of foreign investment into the stock markets, bond markets and property markets of emerging economies, which often fuels rampant inflation. And, as is well-known, sustained inflation can kill business confidence in an economy.

This prospect has already forced other nations into what they see as defensive economic strategies to keep their economies from overheating. In October, both Thailand and Brazil raised taxes on foreigner‟s bond holdings and Taiwan imposed a limit on foreign holdings of long-term government bonds.

The more export-dependent economies in Asia, such as Malaysia, Vietnam, Taiwan, Thailand and Singapore, will probably experience the largest impact from such inflows. The Taiwanese central bank said that it would intervene if the Taiwan dollar appreciates sharply.

India is also monitoring the rise of the rupee. The country has seen record capital inflows of over 22 billion dollars into Indian equities in 2010. The Reserve Bank of India feels it will be necessary to intervene to curb exchange rate volatility. South Korea, too, adopted an “accommodative stance” initially, but then moved to increase its base interest rate by 2.5 percentage points to deter rapid gains in its currency and reign in accelerating inflation.

Although the excessive capital inflow to emerging economies is expected to be temporary, sustained currency appreciations in more developed economies like Taiwan and Singapore could potentially force businesses to shift elsewhere to reduce the cost of overheads and labor.

Business implications

The current weakening of the US dollar will encourage US export competitiveness. Cash rich investors from emerging markets may see the weakening dollar as a good opportunity to invest in the US. However, a weakening dollar would also hurt emerging market exports to the US in many cases, as it reduces the buying power of US importers.And the US market generally accounts for roughly 20 percent of the global export market for many mainstream, mass-market products and services (in a few cases considerably more).

Business will also be affected by the economic cooling measures that emerging market governments will introduce to limit the effect of “hot money” inflows and the inflation they create. Measures such as interest rate hikes and curbs on property buying, other than curbing inflation, may sap consumer and business confidence and reduce sales in emerging market economies.

The uncertainty created by currency tensions will also require businesses to modify their strategies to cope with heightened volatility. This may lead to more investment in financial products such as hedging contracts, a renewed scramble to lock –in supplier contracts and the need to keep business practices as vigilant and flexible as possible.

[title text=”Conclusion – between a rock and a hard place”

The current global tension over currencies reflects a deep-seated reality about our current situation – the world‟s inability to resolve the huge global imbalances between the US and leading emerging market economies.

In the longer-term, economic actors must hope for a rebalancing arising from changed behavior – US consumers saving more, Asian ones saving less and exchange rate regimes becoming more aligned world-wide. If this happens, and if the global economy recovers somewhat, the enormous pressures on currencies would gradually melt away.

However it is clear that this will not happen in the short-term or even medium-term, at best. Consumers in emerging markets still save considerably, due to a lack of well-developed social safety nets. As for US consumers, while household savings were climbing after the 2008 crisis due to deleveraging, the latest indications are that the trend has reversed. And there is likely to be no substantial movement by the China government on RMB appreciation against the US dollar, at least until after the 2012 Communist Party Congress.

Uncertainty is never a good thing for business. But as far as global currencies are concerned, it looks like uncertainty will persist in a big way for a long time to come.

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