Be Careful What You Wish For: China Raises Interest Rates

For the last few weeks, Congress has been quite vocal about its demands that China allow the value of the yuan to appreciate versus the dollar. So yesterday The Bank of China announced a very small increase in internal interest rates, which presumably would have added at least some value to holding yuan versus the dollar.

So what happens?. Well, in the vein of pure Newtonian physics, for every action there is a reaction, and the markets reacted badly across the world. To name a few effects:

1. Stock markets get slammed across the world, with the U.S. market falling 1.5%;
2. Oil drops by 4%, or the largest decline in 8 months;
3. Gold falls by 2.6%;
4. Brazil announces its second tax on foreign investment in an effort to try to reduce the appreciation of its currency;
5. Japan and Canada, among other nations, express concerns about the currency markets. The Japanese central bank again publicly worries about the strength of the yen.

I could go on, but you get the idea. Markets are never as simple to manipulate as public leaders would like us to believe. Moreover, as nations across the world compete to see who can depreciate their currencies faster to help spur domestic economic growth, the eventual effects may not be what people want.

One of the most interesting points about yesterday's move in China was the fact that only recently Chinese officials had said that they did not see the need to change interest rate policy. In my opinion, the Chinese continue to want to send the message that they do not have to follow the lead of any other countries in determining domestic economic policies (especially the U.S.).

Here's an excerpt from today's Wall Street Journal:

Investors were split on the impact China's move will have on currency diplomacy. Tensions have been building as a result of the money flooding into emerging markets, driving up the currencies of countries such as Brazil and South Korea against the dollar.

Because China effectively pegs the yuan to the dollar, exporters in those countries have been losing competitiveness against China, their chief rival in the global markets. In response, many governments have been pushing back against the tide of money boosting their currencies.

Those issues were front and center Tuesday.

Brazil raised the tax on foreign investment in Brazilian bonds. And in Seoul, the South Korean finance minister said the government was considering reinstating a withholding tax on foreign investors' holdings in some Korean securities.

China Raises Interest Rates - WSJ.com

Randon Glenings on Other Sites

Susan Weiner (who I have corresponded with on Twitter but never yet met) pointed this piece out today. It comes from a site call Advisortweets.com

ww.advisortweets.com/blog/financial-advisors-tweet-currency-wars-dollar-qe2

Advisors Weigh In On Currency Wars, The Dollar, QE2

The strength of the U.S. dollar, currency wars and quantitative easing (QE and QE2) are topics that have broad appeal to advisors whose tweets appear on AdvisorTweets.com. A search for any of the terms will produce a rich list of content recommendations from several advisors.

Here’s a sampling of recent tweets that advisors have sent with links to content representing their own views:

1. 
   dhglen Random Glenings: Currency wars are necessary if all else fails – Te… http://t.co/VuRE41C 11 Oct 2010 from Tweet Button

— this quote was brought to you by quoteurl

1. 
   dhglen Random Glenings: More On Currency Wars http://t.co/ig7oWnf 13 Oct 2010 from Tweet Button

— this quote was brought to you by quoteurl

1. 
   WadeSlome Dealing Currency Drug to Export Addicts: Quest for devaluation nirvana is a waste. #IMF #QE2 #currency $WMT http://wp.me/pxctV-PL 08 Oct 2010 from WordPress.com

— this quote was brought to you by quoteurl

http://www.advisortweets.com/blog/financial-advisors-tweet-currency-wars-dollar-qe2

More On Currency Wars

More on the ongoing currency wars, this time from the FT's Martin Wolf.

Last week I posted a note that cited the German magazine Der Spiegel. Seen from the German point of view, the American demands for the Chinese to allow the markets to set the appropriate rate for the Chinese yuan seems hypocritical, given our benign neglect of the dollar as a way to boost our economy.

Here was the quote from the article posted on October 6:

There is, however, also a fair amount of hypocrisy behind the latest American initiative. Nobody has controlled the currency markets as much as the US has in the past. The US Federal Reserve still continues to print dollars to finance skyrocketing government debt. The fact that this erodes the value of the US currency is something that the Americans seem not to care about. Of course, this makes imports into the US more expensive, but it also makes American exports cheaper and enhances the competitiveness of US companies.

In yesterday's FT, Mr. Wolf notes that in a currency war the U.S. is sure to win, at least in the short term, since we control the world's reserve currency:

Above all, today’s low and falling inflation is potentially calamitous. At worst, the economy might succumb to debt-deflation. US yields and inflation are already following the path of Japan’s in the 1990s (see chart). The Fed wants to stop this trend. That is why another round of quantitative easing seems imminent.

To put it crudely, the US wants to inflate the rest of the world, while the latter is trying to deflate the US. The US must win, since it has infinite ammunition: there is no limit to the dollars the Federal Reserve can create. What needs to be discussed is the terms of the world’s surrender: the needed changes in nominal exchange rates and domestic policies around the world.

FT.com / Columnists / Martin Wolf - Why America is going to win the global currency battle

In my opinion, however, I am still not convinced that merely depreciating the dollar will solve all of our ills. On the other hand, there seems little doubt that trade wars waged by currencies can turn into mutually assured destruction.

Finally, I would note the following news item today, which underscores the urgent need that most of the world feels to do something about the huge trade imbalances (from today's New York Times):

SHANGHAI — China said Wednesday that its exports continued to surge in September and that the nation’s foreign exchange reserves ballooned last month, data that is likely to keep pressure on Beijing to appreciate its currency.

The government said its monthly trade surplus reached $16.9 billion in September, with exports up 25 percent and imports climbing 24 percent.

The surplus narrowed from August, when it had reached $20 billion, but it was still an enormous figure, analysts said.

Also Wednesday, Beijing said its foreign exchange reserves soared $194 billion in September to a record $2.65 trillion, far more than economists had forecast. China already had, by far, the world’s largest currency reserve holdings.

http://www.nytimes.com/2010/10/14/business/global/14yuan.html?_r=1&hpw

Currency wars are necessary if all else fails - Telegraph

One of my favorite columnists, Ambrose Evans-Pritchard of the London Telegraph had a interesting piece out yesterday.

Many people, including myself, view the on-going currency wars with some concern. "Beggar thy neighbor" strategies will resonate well initially with the local electorate, but eventually such policies will hurt all that are involved, in my opinion.

However, Mr. Evans-Pritchard points out that the U.S. policy may in fact be rational:

The countries actively intervening in exchange markets to suppress their currencies – China, Japan, Korea, Thailand, even Switzerland, to name a few – are all too often the same ones that have the biggest trade surpluses with the US.

They are taking active steps to prevent America extricating itself from the worst unemployment since the Great Depression, now 17.1pc on the latest U6 index and rising again.

Each country is doing so for understandable reasons: Japan to avoid a deflationary crisis, China to hold together a political order that is more fragile than it looks. In both these cases they are trapped because they clung too long to a mercantilist export strategy, failing to wean themselves off American demand when the going was good.

Yet this is an intolerable situation for the US. It should be no surprise that Washington has begun to retaliate in earnest, and not just by passing the Reform for Fair Trade Act in the House (not yet the Senate), clearing the way for punitive tariffs against currency manipulators.

Mr. Evans-Pritchard goes on to say that he feels the Fed is working with the Treasury to try to devalue the dollar in order to stimulate our economy. In this view, QE2 is not a possible effort to rescue the banking system, but rather a blatant warning to the Chinese that they should allow the yuan to appreciate, or face the reality that their dollar reserves will continue to lose their value.

Currency manipulation can be a dangerous business, in my opinion, since markets can move farther and faster than governments can control. Moreover, the dollar has been the reserve currency for the world since the end of World War II; if we deliberately devalue our currency, many countries may decide that they would like to try to create an alternative global reserve currency.

This could also be serious business. The U.S. has been able to borrow and spend without any real consequence since we are the only nation that can print currency to pay back our global creditors. Losing this status could force us to face the consequences of our huge fiscal debts much sooner than we expect, with concomitant economic consequences.

Currency wars are necessary if all else fails - Telegraph

The Specter of Protectionism: World Faces New Wave of Currency Wars - SPIEGEL ONLINE - News - International

I thought this was a very interesting piece from the German magazine Der Spiegel.

In the U.S. we have tended to view our huge trade deficits very benignly, with one exception: China.

According to Congress, and to many other public figures, the Chinese have unfairly benefited from an undervalued currency which has made U.S. goods in China less attractive.

When viewed from outside the U.S., however, the American position is hypocritical. Quoting from the article:

There is, however, also a fair amount of hypocrisy behind the latest American initiative. Nobody has controlled the currency markets as much as the US has in the past. The US Federal Reserve still continues to print dollars to finance skyrocketing government debt. The fact that this erodes the value of the US currency is something that the Americans seem not to care about. Of course, this makes imports into the US more expensive, but it also makes American exports cheaper and enhances the competitiveness of US companies.

The article also notes the problems that the Chinese face with regards to American demands that they allow the yuan to appreciate:

The Chinese want to avoid at all costs suffering the same fate as their neighbor Japan. After caving in to pressure from the US, in 1985 the former Asian superpower agreed to increase the exchange rate against the dollar. Within one year, the value of the yen had increased by some 60 percent. In order to balance out the negative consequences of the revaluation for the country's export industry, the Bank of Japan lowered interest rates to nearly zero, thereby triggering a huge speculative bubble on the stock exchange and the real estate market. Even today, Japan has still not recovered from the prolonged crisis that ensued.

The pressure on Japan also failed to bring the US much relief. American industries, particularly in the automotive sector, still couldn't effectively compete with manufacturers like Toyota and Honda.

The Specter of Protectionism: World Faces New Wave of Currency Wars - SPIEGEL ONLINE - News - International

While I continue to hope that cooler heads prevail in the U.S. Senate, and that a ruinous trade war can be avoided, recent political rhetoric seems to make this less likely. It is easier to bash the Chinese than to address the very hard fiscal questions that confront both federal and municipal governments.

The yield on the 10-year Treasury note has plummeted again this morning, and is now trading at 2.40%, the lowest level since January 2009. Yields are dropping on the expectations that the Federal Reserve is going to follow the example of the Bank of Japan yesterday, and aggressively intervene in the credit markets to try to push interest rates lower. While this may help our economy, it surely takes the currency wars up another notch, since lower yields reduce the attractiveness of the U.S. dollar.

Obama as Comeback Kid Just Needs Weaker Dollar: Simon Johnson - Bloomberg.com

There was a big story in this morning's Wall Street Journal talking about the apparent strategy of currency depreciation that is being followed by many countries, including the U.S. Here's an excerpt:

Tensions are growing in the global currency markets as political rhetoric heats up and countries battle to protect their exporters, raising concerns about potentially damaging trade wars.

At least half a dozen countries are actively trying to push down the value of their currencies, the most high-profile of which is Japan, which is attempting to halt the rise of the yen after a 14% rise since May. In the U.S., Congress is considering a law that targets China for keeping its currency artificially low....

http://online.wsj.com/article/SB10001424052748703882404575519372149380764.html?KEYWORDS=currency+wa

Simon Johnson, a professor at MIT and former IMF economist, is not surprised (BTW: I'm seeing Mr. Johnson next Monday at the Boston Security Analysts Society).

With U.S. domestic growth anemic, and no stimulus on the horizon, the only way to increase employment is to increase exports, which implies a weaker currency. Here's an excerpt from Johnson's piece on Bloomberg:

The main reason the U.S. isn’t bouncing back so fast is because of exports and the dollar. South Korea, Russia, and other emerging markets that go through severe crises usually undergo a sharp depreciation in the inflation-adjusted value of the currency, making them hypercompetitive, at least for a while. This makes it easier to replace imports with domestic goods and services and much more attractive to export.

In contrast, the global financial crisis actually strengthened the U.S. dollar as it was seen as a haven, although the dollar has fallen somewhat from its recent peak against major trading partners.

Interestingly, Johnson also argues that current government policies do not necessarily lead to inflation and higher interest rates:

The dollar is, therefore, likely to depreciate against all floating currencies. If this happens, the impact on U.S. interest rates will be minimal because the Fed will continue its easing. Inflation may rise slightly but high unemployment means the impact will be small, perhaps not even to the 2 percent annual rate that modern central banks quietly prefer.

The Obama administration is blamed for high unemployment -- the result of a financial mania that was emerged long before it came to power. It would be a nice irony if, also through no fault of the administration, jobs return faster than expected as we head into the 2012 presidential election.

Obama as Comeback Kid Just Needs Weaker Dollar: Simon Johnson - Bloomberg.com

I think that Johnson might be right over the next couple of years, but I worry about the longer term effect of competitive devaluations. The last time we saw countries fight trade battles using their currencies on a global scale was in the 1930's, when "beggar-thy-neighbor" policies were the norm, which of course ended badly.

Gold is the final refuge against universal currency debasement - Telegraph

I am not an advocate of gold as an investment, as I have written several times on this blog.

However, it is certainly worth considering what the price of gold may be telling us. Today's Ambrose Evans-Pritchard column in the London Telegraph presents sober reading. Here's an excerpt:

It is no mystery why so many states around the world are trying to steal a march on others by debasement, or to stop debasers stealing a march on them. The three pillars of global demand at the height of the credit bubble in 2007 were – by deficits – the US ($793bn), Spain ($126bn), UK ($87bn). These have shrunk to $431bn, $75bn, and $33bn respectively as we sinners tighten our belts in the aftermath of debt bubbles.. The Brazils and Indias of the world are replacing some of this half trillion lost juice, but not all...

..So we have an early 1930s world where surplus states are hoarding money, instead of recycling it. A solution of sorts in the Great Depression was for each deficit country to devalue, breaking out of the trap (then enforced by the Gold Standard). This turned the deflation tables on the surplus powers – France and the US from 1929-1931 – forcing them to reflate as well (the US in 1933) or collapse (France in 1936). Contrary to myth, beggar-thy-neighbour policy was the global cure.

A variant of this may now occur. If China continues to hold down its currency, the country will import excess US liquidity, overheat, and lose wage competitiveness. This is the default cure if all else fails, and I believe it is well under way.

Basically Mr. Evans-Pritchard is contending that all countries (with the possible exception of Germany) are attempting to juice their domestic economies by allowing their currency to lose value against their trading partners.

If this is the case, the rise in the price of gold is more a reflection of concerns over the intentional debasement of currencies rather than a foreshadowing of inflation.

I hope he's wrong - because historically the end of game of a currency "race to the bottom" has never ended well - but Evans-Pritchard is a pretty savvy observer.

Gold is the final refuge against universal currency debasement - Telegraph

Overview: Risk aversion lifts gold, yen, and US Treasurys

Global stock markets have been rallying this month.

At the same time, gold prices continue to hit record highs, and Treasury yields have sharply declined. These would indicate that there still is a large segment of the investing public that is deeply concerned about worldwide economic trends.

Then there is the yen, which hit 15 year highs versus the dollar yesterday. Although the strength of the yen has not received much press attention here in the United States, it is of deep concern to Japanese businesses, which are depending on export business.

And so this morning the Japanese government intervened in the currency markets for the first time in six years. The Nikkei turned in a strong performance as a result, rallying more than 2%.

It remains to be seen how much effect on a longer term basis the intervention will have. Most governments have stopped trying to intervene in the currency markets, after wasting considerable resources in the 1990's to try to influence currency levels with little or no effect.

I must confess that I have been puzzled as the yen continued to move higher versus the dollar throughout the year. I have been reading a number of reports on the currency markets, and as best as I can tell here is why the yen has been so strong:

1. With global interest rates so low, the "yen carry" trade (borrowing in yen at low rates to invest elsewhere) has largely disappeared;
2. Japanese exports have been much stronger than imports, thus creating a larger demand for yen;
3. China is diversifying away from only US investments to investments in Japan, mostly Japanese government bonds (JGB's).

This last point is important from at least a couple of respects. First, it demonstrates the larger role that China is playing in Asian markets. And, second, although so far China has been a largely passive investor in JGB's, there is always the possibility that it might start playing a bigger role in Japan, especially since China is now the largest trading partner of Japan.

Oh, by the way: guess who was selling dollars in favor of the yen this morning (i.e. directly counter to the trade the Japanese were implementing)?

That's right: the Chinese.

It is clear that with their increased economic strength that the Chinese are becoming more assertive in the global markets. Not only are they directly intervening against the Japanese currency effort, they have also quietly ignored the strong desire on the part of the US for the dollar to weaken versus the renminbi. Here's the way the FT put it today:

Japan’s intervention is likely to heighten tension around the already charged issue of China’s persistence in holding down the renminbi, which is set to be one of the most contentious issues at the forthcoming meeting of the G20 group of countries in Seoul.

The US is disappointed that China has allowed the currency to rise by less than 1 per cent against the dollar after its decision to unpeg the renminbi in June. This week, the US Congress will hold hearings to investigate options for penalising Chinese imports or having the currency intervention declared illegal by the World Trade Organisation.

Tetsufumi Yamakawa, head of research at Barclays Capital in Tokyo, said Japan’s intervention “at least, would give a good excuse to China for not moving by claiming that the Japanese authorities are manipulating their currency [as well].”

Stay tuned.

FT.com / FT's rolling global market overview - Overview: Risk aversion lifts gold and yen