Special Report: The Currency Wars – Part 2

Tom Tong25/Nov/2010Currency Updates

This is a continuation of the ‘Currency Wars’ special report, the first part of which was posted earlier here.

We believe there are three potential outcomes to the currency war – listed below in order of desirability:

1- Plaza II

This scenario would require concerted, agreed-upon gradual US dollar devaluation against developing currencies while the US dollar holds its range against most G10 currencies. We think that it would require a G20-level general currency agreement on par with the Plaza accord in the 1980s. This devaluation would correct the secular cheapness of emerging currencies relative to developed currencies, and would increase the general standard of living in emerging countries while providing much needed export stimulus to stagnant first world economies. An accord of this nature would probably require, at a minimum, China to speed up the revaluation of its currency against the dollar and for the Fed to start taking into account the effect on the dollar of its monetary policy. Obviously, neither development is likely to take place and we do not ascribe high probability to this scenario.

2 – Muddle through

In this scenario, the G20 does not agree on any Plaza-like accord to manage US dollar devaluation, but neither does it break down completely in acrimony and beggar-thy-neighbor competitive devaluation. The outcome would be a continuation of the trend of the last few years. China (and therefore other Pacific Rim countries) would continue to allow very limited and slow appreciation of its currency, though at a speed that is insufficient to provide significant short-term boosts to developed countries’ export sectors. Emerging economies with market-traded currencies are forced to resort increasingly to capital controls (such as the portfolio inflow taxes that Brazil has implemented recently) in order to slow currency appreciation. In this scenario, we would not expect there to be any massive shift towards protectionism in developed countries, as the constituencies that would benefit from such a shift (most workers and some manufacturers) lack the political clout to do so. However, we could see a number of localized currency and trade conflicts flaring up, suck as the tow already taking place between South Korea and Japan. We regard this as the most likely scenario

3 – Disorderly devaluation

We think that there is a small but far from insignificant chance of a much worse scenario than those described above. Prompted perhaps by a double dip recession, US authorities may lose patience with China and other countries running current account surpluses, and take a course of openly competitive devaluation against market-traded currencies and at least the threat of tariffs against countries with managed currencies. This would almost certainly cause a very fast devaluation of the greenback in forex markets, perhaps compounded by potential capital flight from the United States and/or US asset sales by countries with significant FX reserves. Such a scenario would likely imply another sharp reduction in worldwide trade flows, another round of financial crises, a general hit to consumer and business confidence, and very possibly, a global double-dip recession. We think that the chances of this coming to pass are quite low, but the consequences would be dire enough that even this low probability is worth watching out for.

After the latest events, we can almost rule out the first, most positive scenario of “Plaza II”. We have in mind, in particular, the surprisingly sharp rebuke that US monetary authorities have received from some of their counterparts. The Brazilian finance minister, Guido Mantega, who was the first to warn of a “currency war”, stated that “everybody wants the US economy to recover, but it does no good at all to just throw dollars from a helicopter.”

He added: “You have to combine that with fiscal policy. You have to stimulate consumption.” The German finance minister was even more aggressive, going as far as openly accusing the United States of breaking its promise made last June at the G20 summit in Toronto, to refrain from competitive devaluation.

More conciliatory talk just out of the Pacific Rim countries, in particular China and Thailand, makes us confident that the “muddle through” scenario is still the more likely one. However, it is clear that the events of the last week have increased the probability of the “disorderly devaluation” scenario, albeit to still low levels.


Written by Tom Tong

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