Focus on currencies – Currency wars needed to erase global imbalances, Ashmore warns
The current liberal monetary policy of heavily indebted developed countries (HIDCs) gives an idea of what could happen when currency realignment becomes the main tool to erase global imbalances.
According to Jan Dehn, head of strategy at Ashmore Investment Management, a liquidity crisis is threatening treasuries, as over the last years emerging economies have accumulated huge foreign reserves, contributing to the global imbalances by investing in government securities from the biggest borrowers.
Given the recent stasis in currency markets, currency realignment has become the main vehicle against global imbalances created by the excessive debts in developed countries against excessive foreign exchange reserves in emerging markets.
When economic fundamentals such as interest rates, growth rates and inflation begin to move, Dehn warns, a real currency war kicks off.
The expression ‘currency wars’ was coined by Brazilian Finance Minister Guido Mantega to describe the damage inflicted on emerging markets by over-easy monetary policies in developed countries, just a month after the Federal Reserve launched its second round of quantitative easing (QE2) in 2010.
“Quantitative easing, he argued, weakens HIDC currencies, undermines emerging market exports, saps their growth and in the final analysis transfers the cost of adjustment from developed countries to emerging markets through currency weakness,” Dehn recalls.
According to the strategist, Mantega’s currency war has not gone away. It is merely on hold, in much the same way that phoney wars presage the outbreak of real hostilities.
“Temporary economic conditions and policy choices keep currencies locked in relatively stable ranges, but these conditions are not immutable. Deleveraging will unfreeze credit markets, resulting in higher spending, stronger growth, and eventually rising inflation risks. The US Federal Reserve will be forced to raise rates and to reverse its unorthodox easing measures,” he says.
Ashmore Investment Management hopes that the process of unwinding the global imbalances will happen slowly, as the alternative could be a mighty dollar crash.
“It is unsustainable for public debt levels in HIDCs and foreign exchange reserves in emerging markets to continue to increase indefinitely. Rising debt service costs stifle private sector growth and eventually lead to crises, such as the one we see in Europe. Similarly, continuing reserve accumulation has ever growing opportunity costs in terms of forgone investment and consumption opportunities in the domestic economy,” the strategist adds.
Over the coming years, emerging market central banks are likely to continue to diversify away from developed countries, stop building reserves and eventually reducing reserves at some point.
On the debtor side, indebted countries can increase exports by becoming more productive, lowering costs, or by weakening their currencies.
Indeed, currency depreciation is the most likely tool to improve HIDC external balances.
“Debt overhangs, high levels of risk aversion and financial repression have put currencies into a temporary stasis, but deleveraging will gradually resurrect the fundamental drivers of currencies and more rapid adjustment is of course always possible through additional quantitative easing,” Dehn warns.
As pointed out by Mantega at the time, currency weakness transfers the cost of adjustment onto foreign central banks. “Generally, however, the asset side of emerging market central banks, mainly foreign exchange reserves, has been neglected for a long time and remains in serious need of reform, especially diversification,” the strategist says.