Competitive devaluation: A war of words or the next financial crisis?
For years, the White House has remained tight lipped on questions of currency.
You’ll be hard pressed to find a treasury secretary since the 1990s address such a query with anything besides vague praise for a ‘strong dollar.’ Until, that is, president Trump took office. The present incumbent of The Oval Office not only comments on domestic currency, he castigates other governments over the management of theirs.
Accusations of currency manipulation, levelled initially at China and Japan, and more recently at Germany, have sparked fears of a currency war; an under-the-table cold war that would see the victor triumph at the expense of the global economy. But how well founded are those fears and the assertions they are based on? Are we really facing the next financial crisis, or simply lending too much credence to Trumped up news?
The benefits of currency devaluation
Currency values are relative and measured against one another. As such, they are intrinsically linked to trade and the global economy. A rise in the USD against the EUR, for instance, will lower the price of European imports for the American consumer. At the same time, it will make domestic manufacturing more expensive, reducing the competitiveness of American products and increasing the demand for European imports.
Since currency values are relative, the balance of trade will eventually even out. When the demand for a nation’s products are high, so is the demand for that country’s currency. High demand creates low supply, which chases the price of the currency up. In the example above, an increase in European exports would eventually increase the value of the EUR against the dollar, making American products more competitive in the domestic market and decreasing demand for European imports in the US.
It’s a phenomenon called import inflation, and it is a key benefit of currency manipulation. When the domestic currency devalues, it simultaneously raises the price of imports and makes exports cheaper. By devaluing its own currency, a government gains trade advantages over other nations, increasing the demand for exports which, in turn, create more jobs.
Devaluing a currency
If a currency’s value is determined by supply and demand, then intentionally devaluing the currency requires manipulation to ensure an excess supply. Governments have a number of tools at their disposal to achieve this. Most will opt for less direct approaches — activities that can be dressed up to avoid any accusation of currency manipulation. These might include quantitative easing measures (i.e., printing more money) or buying foreign bonds to flood the forex market with excess domestic currency.
That’s not to say that currency devaluation is always covert. In March 2016, the Egyptian central bank announced it was devaluing its currency 14% to curb black market trade in USD. Sometimes, statements from top administration officials are all it takes to impact currency value.
Historically, currency wars have been few and far between. Most governments prefer to maintain high value currencies rather than engage in ‘beggar-thy-neighbour’ competitive devaluation. That said, we’ve seen a few grumblings of currency manipulation since the 2008 financial crisis, with governments devaluing their currencies in an attempt to jumpstart domestic industry. Chief among the alleged offenders were the USA, China and Japan.
Officially, the US government allows the dollar to float freely. Ostensibly, its value is determined solely by supply and demand in the forex market, but many analysts agree that quantitative easing measures employed by the central bank in 2009, exerted downwards pressure on the dollar. The RMB, on the other hand, is not free floating. In 2009, it was pegged to a basket of currencies — Beijing having ditched a fixed rate currency peg to the dollar in 2005. Yet, with a global recession raging, the Chinese government adjusted its peg to give greater weight to the dollar, effectively checking RMB appreciation.
In 2013, when the Japanese government announced a plan to buy bonds in foreign currency (thereby increasing Yen supply relative to demand), fears of a fresh round of currency wars ignited. These concerns were appeased somewhat, with a G20 summit of finance ministers concluding that the scheme was not designed to deliberately devalue the Yen, but rather was intended to combat deflation.
The 2017 currency wars: Fact or fiction?
Accusations of currency manipulation took center stage in the run up to the US presidential election, with Trump promising to declare China a ‘currency manipulator’ on his first day in office. It’s over a month now since he was sworn in, and such accusations have yet to be officially levelled.
The president might not harbor any doubts about the accuracy of his allegations, but there will be economists in the White House shaking their heads. Perhaps they are the reason his grumblings have stayed largely confined to Twitter. There have been allegations leveled at China about manipulating currency in the past, but recently Beijing has been strengthening RMB, not driving it down.
An analysis of RMB to the dollar index showed both currencies were positively correlated throughout 2016. Over the last year, RMB has matched movements in the dollar 79% of the time – it’s a hard won position, and Beijing has had to sell nearly US$1 trillion of its foreign exchange reserves to prop up RMB.
But China isn’t the only nation in the crosshairs of the Trump administration. In January, Peter Navarro –Head of the National Trade Council — leveled accusations that Berlin was ‘grossly undervaluing the Euro to gain advantage over trading partners.’ On the face of it, that particular denunciation may have some merit.
A recent analysis of EUR relative to USD saw the European currency move in the opposite direction to the greenback 96% of the time over the last twelve months. Of course, the EUR has weathered Brexit — and still faces huge political uncertainty, three major elections are pending in the trading bloc and nationalist parties are gaining traction. In contrast, the dollar jumped to 13 year highs in November following Trump’s shock election and hopes that his presidency would boost the US economy.
Given the current political backdrop, an uptrend in the dollar and a down trending Euro is hardly unexpected.
But a dollar riding at 13 year highs would spell trouble for US exports and manufacturing, and the then president elect had already promised booms in both. Days before his inauguration, in an interview labelling China and Japan currency manipulators, he expressed his opinion that the greenback was ‘too high.’ The result was a plummeting dollar index that lost 0.5% overnight.
Is a currency cold war raging? At this point, it seems unlikely. Trump’s alleged offenders – China, Japan, and Germany – are also (coincidentally) the nations holding the biggest negative trade balance with America. False allegations of currency manipulation could wipe millions from the US national debt. Despite the barrage of affirmations to the contrary, there may well be peddlers of fake news sitting closer to The Oval Office than the Briefing Room.
Hussein Sayed is chief market strategist at FXTM