Currencies | Oct 25 2010
By Greg Peel
As has been well documented, the world's major economic powers are currently engaged in a Currency War involving a “race to the bottom” on currency devaluation. No one shot an Arch Duke, sunk a passenger liner or invaded Poland. It just sort of happened.
It happened because the developed world has been struggling economically since the GFC and the key to dragging an economy out of recession and to reduce government debt is to increase exports. Developing economies may be the great hope for ultimate export growth but in the meantime, a finite pool of export demand means the country with the lowest value currency has the advantage on pricing and thus sales.
At the centre of the Currency War are China and the US – the former due to its artificially undervalued currency which Beijing refuses to revalue with any expedience and the latter due to existing and further planned quantitative easing (also known as money printing) in a deliberate and seemingly arrogant attempt to devalue the reserve currency at everyone else's expense.
US devaluation has forced a struggling Japan to intervene in its currency while the UK is also tossing up further QE measures. Brazil is among others forced to intervene across the globe to cap runaway currencies and Australia is looking on anxiously. The problem is that every currency initiative impacts on every other currency within a “closed shop” which means a Currency War could rage on ad infinitum with no winners.
Appreciating this point, finance members from the G20 nations met in South Korea on the weekend with a prime objective being to put an end to this folly. But as is the case with most G20 or similar meetings (take climate change meetings as an example) there was much talk about vague agreements not to be naughty and to rouse on anyone who is but nothing in the way of agreed upon limits.
No one was much expecting a result anyway and so it could be assumed the Currency War will indeed rage on. But there was one rather surprising development.
The International Monetary Fund was created by the US and its allies after WWII as an adjunct to the Bretton Woods agreement which pegged all currency values to the US dollar and the US dollar to gold. The Gold Standard was abandoned in the seventies (call that the true root of the ultimate GFC) but the IMF has lived on with a brief to be global currency monitor and rescue team for collapsed economies.
Not unsurprisingly, IMF influence is dominated by the US. The US is keeper of the reserve currency and by far the biggest economy on the planet. But since the War, former enemies have been added to IMF membership along with a lot of friends. There are now 186 members with varying voting power and that voting power largely runs on economic size lines. Hence the US has the biggest proportional clout at 16%, with a big gap to Japan and Germany on around 6% each, the UK and France on 5%, and so on down the list we go (Australia 1.5%).
Voting rights are not, however, automatically adjusted at the end of each year based on GDP. Changes to voting proportions are made only sporadically and they can only be achieved by a vote. Thus it is not so surprising that while China's economy is now bigger than Germany's and Japan's, China only has 3.7% of the vote. Russia has 2.7%, India 1.9% and Brazil 1.4%. Yet the entire world is now dependent on the economic success of the BRICs.
While China, in particular, is never going to just meekly accede to Western demands, China's disproportionate IMF representation has been an additional driver of recalcitrance. For the Currency War to end, China must begin to realistically revalue its currency (and the US, in turn, thus has to stop printing more currency). So far, global pleas and in particular US antagonism has not worked.
Winston Churchill once said, “Americans can always be counted on to do the right thing…after they have exhausted all other options”. Perhaps the beginning of the end of the Currency War actually did occur in Korea – not because of vague G20 promises on trade balances but because an agreement was reached to give a greater IMF representation to the underrepresented emerging economic powers.
The assumption is that if China felt it was being treated fairly by the global community with respect to the IMF, it would be more responsive to renminbi revaluation pleas. If the renminbi is revalued then everyone else's currency will devalue in return, without having to print money.
Apparently it is the European nations, now in the grip of austerity measures, who will have to give ground to accommodate the BRICs in the IMF. That argument is yet to occur.
The point is, nevertheless, that the Currency War was only likely to lead to a second front once everyone realised that a devaluation merry-go-round could not work. That second front would be trade sanctions, and protectionism has oft been touted as a major reason the 1929 stock market crash led, three years later, to the Great Depression. Maybe, with a more equitable IMF distribution, the second front can be prevented and the first front dealt with.
And maybe, as little birds are suggesting, the People's Bank of China has come to an agreement with the Fed to revalue the renminbi faster if the Fed backs off to a smaller QE2 package.
While this is good news all round for the global economy, it will mean a decent correction in stock markets cannot be ruled out due to over-hyped QE2 expectations in the US.
