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What Did You Do in the Currency Wars? (Part II)

Tony Addison

The present currency turmoil is both a product and a cause of profound changes now underway in the global economy. Part 1 of this two-part article, which appeared in the October Angle, focused on Latin America and Europe. Part 2 discusses the latest turbulence in the eurozone as well as China’s exchange rate dispute with the United Sates.

The biggest battlefield in the currency wars is the US bond market, the largest and most liquid in the world. When investors take fright—over the eurozone, lately—they retreat into US treasuries. Then the dollar rises against the euro. When their appetite for risk goes down, they typically buy treasuries; and sell higher yielding emerging market debt, as they did recently. BRIC currencies then fall, notably India’s rupee this month.

Bond veterans are usually on the look out for inflation. Many started 2011 positioned for a spike in inflation, implying a fall in the prices of treasuries, and a rise in bond yields. They sold treasuries. Now, most expect low bond yields to continue—an expectation encouraged by the US Fed, which wants borrowing costs to remain low. Some veterans were caught out, took their losses, reversed their firing line, and bought treasuries again. 

But some perished. MF Global moved out of the safety of US treasuries, borrowed US$300 million to leverage its investments, took a US$6 billion bet on eurozone sovereign debt, got murdered, and went bankrupt last month. For MF Global, this year’s turmoil was terminal.

MF Global was shot to pieces because it believed that the Europeans would staunch the bloodshed in the bond markets of Greece, Italy, and Spain. Instead, their bond prices fell, forcing MF Global to stump up more collateral for its creditors, until its solvency was questioned. It wasn’t the biggest bankruptcy in US history—a mere US$41 billion versus Lehman’s US$650 billion in 20083—but MF Global did manage to get itself into the top ten, coming in at number eight. Such is the power of leverage.

Will the dragon rescue Europe? Or will Angola?

Maybe MF Global was betting that China would ride to the rescue and buy eurozone debt. If so, they were sorely disappointed. While there is much chatter about this, China is not buying the debt of Mediterranean Europe, nor is it contributing to the European Financial Stability Facility (EFSF). Why should it place itself in a position of an almost certain loss?

Still, if China wants to eventually buy eurozone debt it need not worry about a drought in supply. Take Portugal, for example, where the bailout package provides support until 2013 when its debt will still be well above 100 per cent of GDP. Portugal’s massive financing needs continue, and with it the supply of bonds to sell.

In the meantime, ex-colony Angola is helping out, and is being encouraged to invest in Portugal’s forthcoming privatizations. Perhaps Angola will get some bargains, but its funds could yield higher returns at home—investing in sorely needed infrastructure and human capital, both of which remain in a lowly state nearly ten years after the end of the civil war. Still, Angola’s relationship with Portugal will now at least be on a more equal footing. Africa should take note.

China and the USA: another front in the currency wars

And as if the currency markets had not been exciting enough this year, China and America’s exchange rate wrangle has warmed up again. This front in the currency wars quieted down for a while. But then the US Senate decided to press penalties on China for undervaluing its exchange rate. The weapon of choice is countervailing tariffs on Chinese exports. This has not been ratified yet, but it marked a distinct hardening of the US view. President Obama added to the pressure at this month’s Asia-Pacific Economic Cooperation Forum in Honolulu. And the currency dispute has had the misfortune to become a campaigning issue in next year’s US presidential election.

The reminbi (or yuan, as its also known) has been steadily appreciating since 2010 when China introduced a managed peg; the currency is up 7 per cent against the dollar since then, though it dropped back over the summer. In contrast, Brazil’s currency is down 10 per cent against the greenback. China is bucking the overall trend for emerging market currencies to weaken.

The USA may have a point. Certainly the IMF thinks the reminbi is undervalued. But a faster reminbi appreciation won’t solve America’s problem of import competition from low-cost suppliers. As the reminbi moves up, and as China’s wages rise with economic growth, so more of the low-cost production will depart China for other bases (Africa take note). The aisles of Walmart may well then be stocked by the products of Ethiopia, Ghana, Mozambique—depending upon which countries are most successful in taking over the markets that China eventually leaves. Unless the USA attempts to bar all low-cost foreign suppliers it will still face import competition even if China takes a declining share. Protectionism might buy the USA some time, but it is not ultimately a way to restore the living standards of the average American.

China’s trade surplus with the USA is US$20 billion, up at least 10 per cent since 2010. US politicians are sure to focus on that number. But before they do so, they should look at another; China buys about US$100 billion worth of US products every year. As household consumption rises, it will buy even more. When China started to open its economy more 30 years ago, US companies grasped eagerly at the market potential. The size of that market can only grow, as China rebalances its economy, and internal demand steps up alongside exports as a driver of growth. Both China and the US have an interest in seeing that rebalance towards domestic consumption. Maintaining access to that market and its potential should be a US priority.

Yet the tensions are evident. The Honolulu meeting saw agreement on the foundations of a Trans-Pacific Partnership, an eventual free-trade zone for the Asia-Pacific region, that the USA is pressing hard. The Chinese say they haven’t been invited to join, and are pushing for a trade pact for the Association of Southeast Asian nations, as well as making noises about a possible free trade agreement with Japan and South Korea. This confusion around trade does not auger well for building an effective regional trade system based on mutual profit.

Congress needs to keep in sight the benefits of China’s growing market to US business. But US politics in election years is not known for calm rational debate—expect more thunder and noise on China as the US presidential race comes to the boil in 2012.

China’s response to global crisis

The Chinese inclination during times of global turmoil is to avoid big exchange rate moves. During the 1998 Asian financial crisis, China kept to its dollar peg. This helped to steer the economy through the havoc of the collapsing economies around it.

Over a decade on, export growth is running at about 16 per cent annually, but deceleration has set in. The Dragon sees Western skies darkening. Europe, not the USA, is China’s biggest trading partner. At the start of 2011, China’s export growth to Europe was a heady 25 per cent per annum. This is now down to 8 per cent and falling fast, as Europe slips into deeper recession. China can take no comfort in the austerity that Europe seems intent in imposing on Greece, Italy, and Spain. Their demand for Chinese goods will plummet, alongside their living standards.

This gloom is influencing China’s own internal debate. Some Chinese economists feel that the renminbi’s steady appreciation is a mistake, and that it should be slowed down. The more radical argue, mostly in private, that the renminbi should depreciate to offset the impact of the global economic slowdown on China’s exports and growth. Moreover, Chinese inflation is falling, and therefore the need for faster currency appreciation to dampen inflationary pressures is diminishing. But any shift of that kind in exchange rate policy would really mean China signing up for the currency wars. And that seems to be a step too far for China.

Tony Addison is the editor of WIDER Angle. He is Chief Economist/Deputy Director of UNU-WIDER.

WIDER Angle newsletter
November 2011
ISSN 1238-9544

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