Currency war

We’ve heard of trade wars before. Now the talk is about the outbreak of a currency war.

The dimensions of this currency war are not fully defined. The goals are not clear. The standards by which we are to distinguish winners and losers are not agreed upon.

For the most part, currencies are traded freely. Their exchange value is determined by market forces — at least in principle. Although central banks everywhere discreetly nudge the currency exchange markets one way or the other, most of the world’s major currencies are traded freely in the currency market.

There are a few currencies that are not fully traded in the global financial system. Russia’s currency, for instance, is not yet fully interchangeable despite the increasingly large role this economy plays in the global economy. The Chinese yuan is pegged, although it is fully interchangeable and tradable.

For the longest time, the US has made such a large fuss over the yuan being intentionally undervalued in order to boost Chinese exports and act as an effective barrier against imports. Washington has bluntly told China it should allow its currency to revalue. Beijing takes offense at the apparent bullying by the Americans, maintaining that the exchange value of the yuan is market-determined.

The fuss Washington makes about the yuan is intended largely for domestic consumption.

There is this strange belief among Americans that unemployment in their economy is high because China stole jobs from the US economy. Cheap Chinese imports into the US market killed off light industry and forced many factories to shut down.

Many Americans think that if the yuan is allowed to appreciate, jobs will return to the American economy. That is largely a piece of economic superstition. The more likely outcome of the yuan appreciating is that factories in China will move down to Vietnam or even Laos. Those factories will not travel all the way back to the US.

But with midterm elections coming up in the US, it is profitable for American politicians to raise the yuan bogey — mainly for domestic voter consumption.

Beijing is not likely to accede to the American demand it revalue its currency. This has nothing to do with Chinese exports to the US. That volume of exports will remain robust even if the exchange value of the yuan is allowed to reasonably rise.

The main reason for Beijing’s reluctance is financial. China maintains a trillion-dollar foreign currency reserve. The rising Asian dragon has humungous amounts of dollars invested in US equities and bonds. If Beijing allows its currency exchange value to appreciate, it will (in yuan terms) allow billions of dollars in investments to evaporate.

All Beijing has to do, to cause the dollar to crash, is to cash in on its offshore investment in US bonds and equities. By taking that decision, Beijing will unleash a flood of dollar-denominated paper on the market, effectively pushing down the US dollar’s value. However, a drastic fall in the dollar’s value will translate into a de facto appreciation of the yuan.

Beijing, ironically, has a financial interest in keeping the dollar strong.

But the dollar is falling anyway, against a basket of global currencies including, quite notably, the Philippine peso. Over the past few trading days, the peso has appreciated against the dollar. So have the Japanese yen, the euro and nearly every other currency for the matter. The Canadian dollar has found parity with its American counterpart. The Thai baht is now moving close to its pre-1997 exchange value against the dollar.

All the other currencies are not strengthening. It is the dollar alone that is weakening.

The phenomenon is not due to any aggressive design by the other economies. It is due to the appalling deficit the US is accumulating and the decision by American monetary authorities to keep interest rates at very low levels as a tool for stoking economic expansion in the US.

 In a word, the dollar is falling because of American fiscal imprudence.

When the cost of money is cheap, as it is in the case of the US dollar, the value of the currency will tend to erode as well. With interest rates kept aggressively low in the US, few would want to keep their investments in dollar-denominated instruments. They will likely sell down those instruments and flee to stronger currency instruments such as Euro bonds and emerging market equities.

 The US does not have to badger China, therefore, to allow its currency to appreciate. The same effect is achieved by allowing the dollar to collapse.

Nobody wants to see a weaker dollar. That is the irony of what is happening this days. Every other nation fears that a weak US dollar could unhinge the global financial system and open the door to currency chaos where every other country will try and undermine the value of their respective currencies. If they do not, the US market for their exports will effectively shrink and their capacity for growth undermined.

 Because of its fiscal imprudence, the US is opening a door to high domestic inflation. That eventuality will soon force US monetary authorities to raise interest rates, which in turn will prop up the dollar. But such an outcome will foreclose a stronger American economic recovery.

We have little means to influence the current realignment of the major currencies even if we have a major stake in what is happening. The strengthening peso might help curtail inflation in our domestic economy. But it will also shrink the peso value of OCW remittances and, at some point, undermine the cost advantage of our exports.

In addition to having little means to determine the fate of the peso, our government does not seem to have a clear policy on monetary management. We seem doomed to be washed whichever way by the shifting tides in the world’s currency exchanges.