Friday, 15 October 2010

The Empire strikes back - Currency Wars

This in an update in relation to the previous post relating to the current debasing game played by the US.

It is turning more and more nasty by the day, the beggar-thy-neighbor policy induced by the US is raging havoc around the world. It is savaging exports for Japan and exporting inflation to the Brics which force them to raise interest rates to slow hot money pouring in, as well as introducing capital control measures.

And yes, the game being played by the US is to put the blame on China and its yuan policy. The Chinese have learned from the Plaza Athena agreement of 1985 which sealed the fate of the Japanese economy 5 years later, as the Nikkei crumbled down to earth with its real estate market at the same time. The Nikkei stock index hit its all-time high on December 29, 1989 when it reached an intra-day high of 38,957.44 before closing at 38,915.87. On March 10, 2009 the Nikkei 225 stock index reached a 27-year low of 7054.98.

However Yao Jian, a Chinese Ministry of Commerce spokesman, rejected US complaints as unfair. “It's totally wrong to blame the yuan for the Sino-U.S. trade imbalance,” he said, “The Chinese yuan shouldn't be a scapegoat for the U.S.' domestic economic problems.”

I could not agree more with Chinese Ministry of Commerce. As I stated before, should all the countries with big trade balances surplus be targeted eve more by the US? Germany? Japan? Etc.

Where are we in this deflation crisis?

Staring at the Abyss:
We are at the stage of Competitive Devaluation. These currency wars are taking us closer to protectionism and tariffs. Given we have a major US election coming, the protectionism risk is alive and real. This what moved us in the 30s to the Great Depression. Have the lessons of history been learnt by our politicians? Let's all hope so.

In the same article from the Telegraph, Mr Yao has clearly learned from the Japan collapse following the Plaza Accord of 1985:

“Job losses would hurt the Chinese economy and domestic consumption. A relatively large yuan appreciation would definitely hurt Chinese exports, so a stable yuan exchange rate is needed for domestic consumption and the stability of the world economy," Mr Yao added.

"China has also said that legislation currently being formulated in the US to impose trade tariffs as a result of the yuan’s under-valuation would be in breach of World Trade Organisation regulations."

It could get very ugly and we need to watch very closely what can happen in term of trade tariffs. Last month the House of Representatives passed a law allowing firms to seek tariff protection against countries with undervalued currencies, with a huge bipartisan majority. The US fired the warning shots first. This could have unintended consequences should politicians decide to escalate with China into a full blown trade war.

South Korea is hosting the G20 summit next month:

For the US and Europe, it is clearly looking like the above cartoon. We don't need another 1985 Plaza Accord. The truth is, given the G7 is now wider to G20, it will be more difficult for some countries, like the US, to impose (bully?) their views on the rest of the world. Quantitative Easing 2 is the issue. You cannot ask China to increase more its currency while at the same time you are willing to debase the USD even more. A compromise has to be find for the sake of the world economy. Given the fragility of the current recovery, there is this time around too much at stake.

For those who would like to extend on a possible risk, I recommend reading this report from the IMF research website from Laurence J. Kotlikoff, Professor of Economics at Boston University.

"A minor trade dispute between the United States and China could make some people think that other people are going to sell U.S. treasury bonds. That belief, coupled with major concern about inflation, could lead to a sell-off of government bonds that causes the public to withdraw their bank deposits and buy durable goods (which will retain their value). The run on the banks could trigger a run on money market funds and insurance company reserves (as policy holders cash in the surrender value of their policies). In a short period of time, the Federal Reserve would have to print trillions of dollars to cover its explicit and implicit guarantees. All that new money could produce strong inflation, perhaps hyperinflation. Even though at the outset there might have been no serious inflation problem, the self-fulfilling aspects of multiple equilibria can take over and cause this outcome. Deposit insurance would be little help in preventing bank runs because it covers the nominal value of deposits and does not guarantee the purchasing power of those funds—which would be sharply eroded by heavy inflation.

There are other less apocalyptic, perhaps more plausible, but still quite unpleasant, scenarios that could result from multiple equilibria."

Avoiding protectionism:

Christian Henn, Economist and Brad McDonald, Deputy Division Chief in the IMF’s Strategy, Policy, and Review Department wrote a long article on the subject in March this year warning of the risk posed by protectionism.

The folly of protectionism

"Further restricting trade would be a poor policy response to the situation the world faces. Moreover, the difficulty in removing measures once they are imposed means protectionist actions taken now could retard economic growth for years. Fortunately, policymakers have recognized the potential for trade measures to interfere with the economic recovery. Too many restrictions may have been imposed, but their application has been relatively narrow. Still, protectionist pressures may intensify in 2010 because unemployment is likely to remain high and imports will bounce back."

A stark reminder of the Great Depression:

Experience of the 1930s

"Policymakers have done well to recall the experience of the Great Depression. In 1929, the U.S. Congress had begun work on a substantial tariff increase even before the stock market crash. The enactment of the Smoot-Hawley Tariff Act in June 1930—despite strong objections from many economists—provoked deep resentment and some retaliation globally. A League of Nations conference convened in 1930 to avert a cycle of protectionism broke down. In 1931 there was an accelerated deterioration in global trade and a “chaotic scramble to protect domestic markets and safeguard the balance of payments” (Eichengreen and Irwin, 2009). Major countries undertook substantial currency devaluations, imposed exchange restrictions, or sharply tightened import tariffs and introduced import quotas. Lacking an independent monetary policy, countries that kept their currencies fixed against gold were more likely to restrict trade, particularly once partner countries devalued their own currencies."

China and other members of the G20 understand what the US game being played is: by reducing the value of the Dollar, the US is trying to reduce the value of US debt owned by other countries. The big mistake the US is making is that the US is a net importer of oil, and depends highly on foreigners purchasing US Treasuries.

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