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.

http://www.telegraph.co.uk/finance/currency/8065529/China-warns-US-against-making-yuan-dispute-a-scapegoat-for-a-flagging-economy.html

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.


http://www.imf.org/external/pubs/ft/fandd/2010/09/kotlikoff.htm

"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:

http://www.imf.org/external/pubs/ft/fandd/2010/03/henn.htm#author

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.

Analyze this

Allied Irish CDS Sub, you know the score from the previous post (Source CMA DataVision):



Anglo Irish CDS Sub on the 6th of October, can you spell default? (Source CMA DataVision):



and on the 7th of October, this is how it looks like for Anglo Irish Sub...2743.85 bps on the 5 year CDS...300 bps wider!



Debase this! Check out the evolution of the USD since 1971 against:

Japanese Yen:



Have a look at 1985 on the Graph and the huge rise in the Japanese yen following the 1985 Plaza Agreements which spelt economic disaster for Japan and the crash of the Japanese economy and the Nikkei index at the same time. 1985 to 1990, 240 to 120, bring it!

At around 82 JPY per USD I don't expect the BOJ to stay idle...

Swiss Franc:



and the evolution of the US dollar versus the Euro since 1999:



An interesting view of the evolution of Fed Funds Rate since 1950:



And the evolution of Oil prices since 1940:



Gold is continuing its steady rise:



At the same time we have Secretary of Treasury Timothy F. Geithner still gesticulating around China and the ongoing Debasing game taking place. Pathetic...

http://www.treasury.gov/press/releases/tg894.htm

"The Framework, called the "Framework for Strong, Sustainable and Balanced Growth," was designed to create stronger incentives for rebalancing growth, as the world recovered from the crisis, with higher savings in countries like the United States, complemented by reforms to strengthen domestic demand in surplus countries like China, other emerging economies, Germany, and Japan.

Alongside this "Framework" we agreed to give emerging economies a greater stake in the most important institutions for economic and financial cooperation, to increase the resources available to the international financial institutions, and to make the G-20 the centerpiece of cooperation, replacing the role traditionally played by the G-7."

Dear Tim, I don't think you have a choice in relation "to give emerging economies a greater stake in the most important institutions for economic and financial cooperation." Guess it is a done deal with China, India and Brasil...

"We have moved aggressively to do our part to help bring the world out of crisis. We are working very hard to repair our financial system, to fix what was broken, and to reduce the future risk of financial crises here at home. We have seen a very significant increase in private savings by households. Our external deficit has fallen sharply, and we are financing at home a much larger share of the fiscal deficits we inherited."

Wow!
Who in the first place put us ALL in this mess? Was letting Lehman Brothers going down a wise decision? I don't think so. In relation to reducing the future risk of financial crisis, I disagree, banks are still too big to fail. Fannie Mae and Freddie Mac are a joke and should be gradually winded down. The commercial real estate disaster is still an ongoing concern: 129 banks down this year so far and counting.

Hey Tim, where were you working before taking up the role of Secretary of the Treasury? Weren't you president of the New-York Fed from 2003? Were you not in charge of supervising and regulating financial institutions? Great work!
In May 2007, did you not work on reducing the capital needed to run a bank? Great timing! Was the "excellent" Lawrence Summers your mentor previously? It would explain a lot...

Nice one Tim, just like you tried to talk to the Chinese about how safe it was to invest in the US...
"On June 1, 2009, during a question-and-answer session following a speech at Peking University, Geithner was asked by a student whether Chinese investments in U.S. Treasury debt were safe. His reply that they were "very safe" drew laughter from the audience."



Tim, you can always send your CV to your buddy Hank Paulson, I am sure he can help you land a good job at Goldman Sachs...

Tim also added in the same speech:
"That brings me to the second policy challenge: we believe it is very important to see more progress by the major emerging economies to more flexible, more market-oriented exchange rate systems. This is particularly important for those countries whose currencies are significantly undervalued.

This is a problem because when large economies with undervalued exchange rates act to keep the currency from appreciating, that encourages other countries to do the same.

This sets off a damaging dynamic, described first by my former colleague Ted Truman, as "competitive non appreciation." Over time, more and more countries face stronger pressure to lean against the market forces pushing up the value of their currencies. The collective impact of this behavior risks either causing inflation and asset bubbles in emerging economies, or else depressing consumption growth and intensifying short-term distortions in favor of exports.

This is a multilateral problem. It is unfair to countries that were already running more flexible regimes and let their currencies appreciate. And it requires a cooperative approach to solve, because emerging economies individually will be less likely to move, unless they are confident other countries would move with them.

This problem exposes once again the need for an effective multilateral mechanism to encourage economies running current account surpluses to abandon export-oriented policies, let their currencies appreciate, and strengthen domestic demand."

The message is that the US is concerned that everyone is devaluating at the same time and they would like to be the only one playing this game to restore competitiveness. Tim would also love China to explode like Japan did after the 1985 Plaza Agreement. Unfortunately, dear Tim, Chinese are not stupid and are well aware of the risks. If the US hadn't based 70% of its GDP on Consumption and was actually producing more and exporting more, they would not be in such a difficult situation.