According to Goldman Sachs (which if nothing else, is good at characterizing financial trends. Remember “BRIC?”), there is a “Wall of Money” that is already flooding emerging markets and will continue to do so for the foreseeable future.
“The move into emerging markets has been led by stock investors, who will pour an estimated $186 billion into these countries this year, — fully three times the annual average of $62 billion generated between 2005 and 2009.” Emerging Market Bond funds, meanwhile, now routinely receive more than $1 Billion per week. Sovereign wealth funds are also starting to shift some of their assets into emerging market assets/currencies as part of their respective diversification strategies. As you can see from the chart below (courtesy of The Economist), Asia is by far the largest recipient of investment, followed by Latin America.
The continued shift of capital from the industrialized world into emerging markets as being driven both by economic fundamentals and the desire to earn a greater return on investment. “The IMF forecast this month that developing nations will expand 6.4 percent next year, outstripping growth of 2.2 percent among advanced economies.” Meanwhile, the ratio of foreign debt to GDP among developing nations has been cut to 26 percent, compared to 41 percent in 1999. And yet, even as analysts predict that emerging markets will account for 85% of global growth going forward, “emerging markets account for $3 trillion, or only 15 percent of market capitalisation of the benchmark MSCI world index.”
While it’s understandable, then, that investors would want to rectify this imbalance as quickly as possible, they need to realize that developing countries’ capital markets simply aren’t deep enough to absorb all of the incoming capital. In other words, an limited pool of capital is chasing a limited stock of accessible investments, and the result is that asset prices and exchange rates are climbing inexorably higher.
Analysts argue, “Some appreciation is due: a rise against rich-world currencies is both a natural consequence of the faster growth of emerging economies and a way to correct global imbalances.” But a 50% rise over five years (notched by a handful of currencies) does not represent some appreciation, but rather an explosion. This is precisely the sentiment echoed by many of the emerging markets, themselves, which have taken to using guerilla tactics to hold down their currencies. Since the latest phase of the “currency war” was ignited by Japan in September, every week has led to increasingly far-flung countries – Peru, Chile, Czech Republic, Poland, South Africa – reputedly contemplating intervention.
According to an interesting economic analysis, which scaled intervention to the size of the given country’s monetary base, South Korea and Taiwan have been among the most active participants in forex markets, while Thailand and Malaysia have been among the most restrained. This is born out by the sizable appreciation of both the Thai Baht and Malaysian Ringit over the last few years. However, I wonder if some economists will take issue with their assessment that Brazil and China have been relatively modest interveners.
Of course, this doesn’t make it any easier to forecast, since how a country behaved in the past isn’t necessarily indicative of how it will behave in the future. For example, Thailand just announced that it will not intervene, but Brazil will double its forex tax from 2% to 4%. Case in Point!
Currency War: Who are the Winners and Losers?
On September 27, Brazilian Finance Minister, Guido Montega, used the term “currency war” to describe the series of recent Central Bank interventions in forex markets. While he may not have intended it, the term stuck, and financial journalists everywhere have run wild with it.
In the current cycle (dating back a couple years), more than a dozen Central Banks have entered the forex markets with the intention of holding down their respective currencies, both against each other and also against the US Dollar. What makes it a war is that the Central Banks are fighting to outspend and outdo each other. It is a War of Attrition, in that Central Banks will fight until they’ve exhausted all of their wherewithal, conceding defeat for their currencies. On the other hand, unlike in a conventional war, there aren’t any alliances, nor is there much in the way of little strategy. Central Banks simply buy large blocks of counter currencies and hope their own currencies will then depreciate on the spot market. In addition, since the counter currencies are almost always Dollars and/or Euros, the participants in this war are not even competing directly against each other, but rather against an enemy that isn’t doing much to fight back. [Chart belowcourtesy of Der Spiegel].
The Swiss National Bank (SNB) was the first to intervene, and staged a one-year campaign over the course of 2009 to hold the Swiss Franc at 1.50 against the Euro. Ultimately, it failed when the sovereign debt crisis caused an exodus of Euro selling. The Bank of Brazil was next, although its interventions havebeen more modest; it seems to have accepted the ultimate futility of its efforts, and will seek to slow the Real’s appreciation rather than halt it. Last month, the Bank of Japan spent $20 Billion in one session in order to show the markets how serious it is about fighting the Yen’s rise. In fact, it was this intervention that sparked Montega’s comments about currency war. (The BOJ hasn’t intervened since). All along, the People’s Bank of China has continued to add to its war chest of reserves – currently $2.5 Trillion – as part of the ongoing Yuan-Dollar peg. And of course, there have been a handful of smaller interventions (South Korea, Singapore, Taiwan) and no shortage of rhetorical (Canada, South Africa) interventions, as well as indirect (US, UK) intervention.
That’s right- don’t forget that the Fed and the Bank of England, through their respective quantitative easing programs, have injected Trillions into the financial markets and caused their currencies to weaken. In a sense, all of the subsequent interventions have been effected in order to restore the equilibrium in the currency markets that was lost when these two Central Banks deflated there currencies through wholesale money printing. Since much of this cash has found its way into emerging markets (See chart below), you can’t blame their Central Banks from trying to soften some of the upward pressure on their currencies.
It’s still too early too early to say how far the currency war will go. The G7/G20 has announced that it will address the issue at its next summit, though it probably won’t lead to much in the way of action. Ultimately, politicians can’t do much more than shake their fingers at countries that try to hold down their currencies. In the case of the Yuan-Dollar peg, American politicians have tried to take this one step further by threatening to slap China with punitive trade sanctions, but this probably won’t come to pass and may disappear as an issue altogether after the November elections. As I reported on Friday, Brazil has taken matters into its own hands by taxing all foreign capital inflows, but this hasn’t had much effect on the Real.
That brings me to my final point, which is that all currency intervention is futile in the long term, because most Central Banks have limited capacity to intervene. If they print too much money to hold down their currencies, they risk stoking inflation. Of course China is the exception to this rule, but this is less because of the size of its war chest and more because of the mechanics of its exchange rate regime. For Central Banks to successfully manipulate their currencies on the spot market, they must fight against the Trillions of Dollars in daily forex turnover. Eventually, every Central Bank must reckon with this truism.
In terms of identifying the winners and losers of the currency war (as I promised to do in the title of this post, the Euro will probably lose (read: appreciate) because the ECB is not willing to participate. The same goes for the Swiss Franc, since the SNB has basically forsaken currency intervention for the time being. The Bank of Japan has deep pockets, and if the markets push the Yen back up above 85 Yen/Dollar, I wouldn’t be surprised to see it intervene again. With the Fed mulling an expansion of its quantitative easing program, meanwhile, the Dollar will probably continue to sink. And as for the countries that are doing the actual intervening, they might succeed in temporarily holding down the valuer of their respective currencies. As capital shifts to emerging markets over the long-term, however, their currencies will soon resume rising.
In the current cycle (dating back a couple years), more than a dozen Central Banks have entered the forex markets with the intention of holding down their respective currencies, both against each other and also against the US Dollar. What makes it a war is that the Central Banks are fighting to outspend and outdo each other. It is a War of Attrition, in that Central Banks will fight until they’ve exhausted all of their wherewithal, conceding defeat for their currencies. On the other hand, unlike in a conventional war, there aren’t any alliances, nor is there much in the way of little strategy. Central Banks simply buy large blocks of counter currencies and hope their own currencies will then depreciate on the spot market. In addition, since the counter currencies are almost always Dollars and/or Euros, the participants in this war are not even competing directly against each other, but rather against an enemy that isn’t doing much to fight back. [Chart belowcourtesy of Der Spiegel].
That’s right- don’t forget that the Fed and the Bank of England, through their respective quantitative easing programs, have injected Trillions into the financial markets and caused their currencies to weaken. In a sense, all of the subsequent interventions have been effected in order to restore the equilibrium in the currency markets that was lost when these two Central Banks deflated there currencies through wholesale money printing. Since much of this cash has found its way into emerging markets (See chart below), you can’t blame their Central Banks from trying to soften some of the upward pressure on their currencies.
It’s still too early too early to say how far the currency war will go. The G7/G20 has announced that it will address the issue at its next summit, though it probably won’t lead to much in the way of action. Ultimately, politicians can’t do much more than shake their fingers at countries that try to hold down their currencies. In the case of the Yuan-Dollar peg, American politicians have tried to take this one step further by threatening to slap China with punitive trade sanctions, but this probably won’t come to pass and may disappear as an issue altogether after the November elections. As I reported on Friday, Brazil has taken matters into its own hands by taxing all foreign capital inflows, but this hasn’t had much effect on the Real.
In terms of identifying the winners and losers of the currency war (as I promised to do in the title of this post, the Euro will probably lose (read: appreciate) because the ECB is not willing to participate. The same goes for the Swiss Franc, since the SNB has basically forsaken currency intervention for the time being. The Bank of Japan has deep pockets, and if the markets push the Yen back up above 85 Yen/Dollar, I wouldn’t be surprised to see it intervene again. With the Fed mulling an expansion of its quantitative easing program, meanwhile, the Dollar will probably continue to sink. And as for the countries that are doing the actual intervening, they might succeed in temporarily holding down the valuer of their respective currencies. As capital shifts to emerging markets over the long-term, however, their currencies will soon resume rising.
Brazilian Real at 2-Year High Despite “Currency War”
Brazil is beating the drumbeat of war. The forex variety, that is. According to the Finance Minister, “We’re in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness.” By its own admission, Brazil will not be sitting on the sidelines of this war. Rather, it will do battle on behalf of its currency, the Real.Brazil’s concerns are perhaps justified, since the Brazilian Real has surged to a 2-year high, and is amazingly not worth more than prior to the collapse of the Lehman Brothers and the ignition of the global financial crisis. (If anything, this shows just how far we’ve come in returning to stability). According to Goldman Sachs, the Real is now the most overvalued major currency in the world. This is confirmed by The Economist’s Big Mac Index, which shows that in Purchasing Power Parity (PPP) terms, Brazil is now the third most expensive country in the world, behind only Norway and Switzerland.
As I said at the beginning of this post, the Bank of Brazil has several tools up its sleeve. It has already resumed “surprise daily auctions to buy excess dollars in the spot market” (suspended in 2006), in which investors can trade Dollars for Brazilian government debt. It is also proposing reverse currency swaps, which would serve a similar purpose. ” ‘The order is to buy, buy and buy,’ ” said a government source. It has purchased nearly $1 Billion in foreign currency in the month of September alone, and has pledged to deploy its $10 Billion Sovereign investment fund if necessary. Finally, there is talk of raising the tax rate (currently 2%) on all foreign capital inflows, though there is no real timetable for such a move.
Alas, while the government of Brazil is certainly sincere in its intentions to hold down the Real, it lacks the wherewithal. Its $1 Billion intervention in September was dwarfed by the $20+ Billion spent by the Bank of Japan in one day to hold down the Yen. Even controlling for the difference in the size of their respective economies, Brazil has still been thoroughly outspent. Its $10 Billion investment fund pales in comparison to the ~$1 Trillion forex reserves of Japan. In short, Brazil would be wise to avoid full-fledged engagement in currency war.
Besides, the Real strength can better be seen in terms of weakness in the US Dollar and other G4 currencies. In this regard, Brazil’s measly purchases of US Dollars on the spot market probably won’t do much to counter the gradual exodus of cash from safe-havens back into growth currencies. Perhaps, it can take solace in the fact that the Real is so overvalued that it would seem to have no place to go but down.
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