Since the global financial crisis, a currency cold war has been raging as Western central banks have sought to restore decades of lost competitiveness via dramatic monetary easing.
The primary culprit and he who fired the first shot was the United States Federal Reserve. First by crushing its interest rate to zero and then via successive rounds of quantitative easing, the Fed engineered a material fall in the US dollar from 2009 to 2012. The campaign was interrupted by a flight to safety in 2010 around the European crisis but was ultimately very successful, deflating the world’s reserve currency by some 17% over the period:
Until late 2012 the war was fought on only one side. But at the conclusion of that year, Mario Draghi was elected to the head of the European Central Bank and he launched Europe’s first counter-strike with his own versions of QE. The Fed was snookered and the US dollar rebounded.
To this point, the war was largely disguised by weak economies and the strictures of central bank code but it turned more overt late in 2013 with election of Shinzo Abe and his appointment of Haruhiko Kurodato to the Bank of Japan. Abenomics, as it is now called, openly sought currency debasement as a path to re-inflation via huge and un-ending QE. The results have been spectacular with the yen depreciating some 40% since:
So far, so good. The first phase of the war was exclusively monetary, and was somewhat under the radar though it became less so as time marched on. What did it do to Australia? It sent our currency to the moon, of course:
We found ourselves very popular with global capital flows and patted ourselves on the back, thinking it was all our own doing. But it wasn’t. Even accounting for the mining boom, our currency should never have been so high. Various currency valuation models will tell you different things but most agree we were 10-20% overvalued. Goldman Sachs’ model is an example:
Our terms of trade (and mining boom) peaked in late 2011, just as Draghi was loading up his cannon. In the past our currency would have followed the ToT down, it was falling very fast, but this time it didn’t and we spent a year and half being shot to pieces by the currency war. The capex boom busted much faster than expected as mining profitability collapsed. The budget blew up as nominal growth tumbled. And interest rates cuts did next to nothing to stimulate activity as the dollar kept hollowing out non-mining tradables.
It was not until mid 2013 that the RBA finally managed to lower interest rates enough to engender currency relief, and the results were nearly instant. Foreign capital flooded into housing, nominal growth recovered some lost ground and the budget experienced early stabilisation in revenues as mining and housing profits rebounded. Australia had finally joined the war and, for once, was winning!
But, as we have throughout this process, we again find ourselves tactically behind. Australia’s terms of trade have begun a second-round deterioration, led by iron ore and the two coals, which are all trading below or close to post-GFC lows. But the currency is again failing to respond.
The RBA’s Index of Commodity Prices is a decent proxy for the ToT. I’ve marked in red where the index is likely headed in the next six months as the spot price falls that have already happened filter through to delayed contract prices:
Yet our currency has returned to the painful state of ignoring this fundamental driver of the economy and the reason why is that in the past month the currency cold war has deepened and turned hot.
The first sign of this occurred in China. Since the GFC, the People’s Bank of China has maintained a consistent rise in the fixed-price Chinese yuan. It served China’s and the world’s interests for this to happen, helping rebalance the global economy by assisting in the repair of the competitiveness of the US and containing Chinese inflation at home. But, in the past two weeks this has abruptly ended. The Chinese yuan is now depreciating:
It’s the largest move in four years, even if small in the scheme of things. Over the weekend the PBOC permanently widened its fixing band to 2%, a move widely seen as preparation for full liberalisation of the currency. It also ensures that the carry trade that has helped fuel the yuan’s rise over years now faces the prospect of greater volatility, and will be deterred. The PBOC is seeking to keep its economy’s current slowdown from mushrooming into worse and, for the first time, it’s happy to use the currency as a weapon to do so.
Taken within the context of Japan’s dramatic moves to weaken the yen and the recent deterioration in relations between the two countries over sovereignty in the South China sea, one might read signs of increasingly fraught tension playing out in North Asian currencies. One wonders if the Chinese haven’t simply had enough of watching the yuan go nuts against the yen:
There is more obvious deterioration elsewhere. The US released its monthly Treasury flows data on Friday. From Society Generale:
“Foreign holdings of US government securities held at the Fed dropped by a whopping $104.5 billion in the week to Wednesday 12 March according to the data published overnight (see chart below). This marks the biggest single weekly fall on record and compares with just a $13.5bn drop the previous week and a 4-week average fall of $1.5bn. The previous largest fall came in mid-2013 (26 June, a week after the FOMC meeting) when holdings fell by $32.4bn. The selling over the last week coincides with the latest US employment statistics, a run of weak data from China and the escalation of the situation in Crimea and Ukraine … Russia has threatened to respond with sanctions of its own should economic measures be imposed by the EU and the US after the referendum in Crimea this weekend. Russia currently holds $138.6bn of USTs (based on December data) and the country has been a net seller for a combined $11.3bn of USTs over the last two months …”
Russians are pulling capital from Western nations for fear of confiscation as threats and counter-threats swirl around trade sanctions as a consequence of the annexation of the Crimea. The currency cold wars of the past few years are threatening to metastasise with strategic rivalries into hot trade wars.
Before you start thinking I’ve turned into a conspiracy nutter, let me make a simple point. I do not see history operating like some vast mechanism controlled by a few elite players pulling levers to turn this cog or that. For instance, the grand narrative of the Great Depression — that currency wars culminated in trade wars and ultimately actual conflict — did not come about as some linear cause and effect. It was a chaotic trend made up of countless small decisions that only in retrospect took on the shape of what we describe today as ordered and sequential “history”.
International relations is much more like the description offered by Australian guru Hedley Bull; a rough society of states rolling around a fundamentally anarchic billiard table, crashing this way and that.
So, when I describe an intensification of trade conflicts, I’m not referring to some master plan of Dr Evil or even to the gravity of historic inevitability. Rather, there has been a subtle tilt in the billiard table of states that is driving the balls into closer and more cacophonous proximity, and that is having an effect upon us via our own “gold-standard” currency.
The Australian dollar should already be at 80 cents but is being held aloft by our authorities’ blindness to, or refusal to face, the increasingly fraught and compromised international reality of forex markets. At least publicly, they maintain the view that they are either powerless in the face of “markets” or that they are ill-advised to intervene because “markets” are always right. But it’s not “markets” that are holding up the dollar, it’s the effect of realpolitik upon markets.
In this context, the RBA’s recent switch from an easing bias and currency jawboning to monetary neutrality can’t last. Macroprudential tools are the obvious answer. A temporary prudential lid on credit will allow more rate cuts and that will bring the currency down. It can’t happen soon enough.
*This article was originally published at MacroBusiness