Exchange rate management:

Two contrasting articles to show you how exchange rate management has to evolve to fit in with circumstances, plus an article from 2006 explaining why countries pegged themselves to the $. The first was written back in 2010; the second is from December 2014. Compare & contrast:

ARTICLE 1

China is letting the yuan “off the leash”, says Ian King in The Times. Since July 2008, the government has pegged its currency to the dollar in order to shield its crucial export sector from the impact of the global downturn.

This has caused a spat with US lawmakers. They point to China’s hefty current-account surplus (and the US deficit) as evidence that it is gaining an unfair trade advantage by not allowing its currency to appreciate against the dollar. Now China has moved back to a ‘crawling peg’ system introduced in 2005. The currency is allowed to rise (or fall), but it can only move in a band of 0.5% around a point set by the central bank every day.

Risk assets bounced so sharply you’d have thought the news signalled “a cure for male pattern baldness”, says FT.com. Analysts cited plenty of reasons to be impressed. The move will forestall US protectionism. It suggests that China has gained confidence in the strength of the global recovery. A dearer currency boosts Chinese companies’ and households’ purchasing power, which should underpin exports elsewhere. Meanwhile, cheaper imports should temper inflation, helping China achieve a soft landing. This marks the beginning of a shift away from China’s dependence on exporting, helping to rebalance the world economy.

Yet the move is hardly a “game changer”, as Capital Economics puts it. This isn’t a shift to a freely floating regime as the daily trading band is staying. And China won’t countenance a major rise in the yuan-dollar rate, given the yuan’s appreciation against the euro, says Rom Badilla on Bondsquawk. It can’t spur consumption overnight, given the “culture built on savers and under-investment”.
In any case, there’s more to global imbalances than currencies, as Economist.com points out. From 2005 to 2008, for instance, the yuan rose by 20% against the dollar, yet the Chinese current-account surplus, and the US deficit, kept rising.

As for protectionism, China’s announcement has defused tension before the G20 meeting this weekend. But with elections looming, China remains a “convenient economic scapegoat” for misguided legislators, says James Pethokoukis on Breakingviews. “The risk,”
says Capital Economics, is that China is “criticised for moving too slowly and that trade tensions escalate again.”

ARTICLE 2

At the start of this year, “investors thought there was next to no chance” that the Swiss central bank would stop artificially weakening the Swiss franc against the euro, says The Daily Telegraph’s

Peter Spence. “They do not want to be burned a second time.” So after last week’s Swiss shocker, everyone is wondering – which country might be next to abandon a long-held currency peg?

Denmark’s currency peg is under pressure

The spotlight has fallen first on Denmark, which is now the last major economy to peg its currency to the euro. Denmark’s Nationalbank (DNB) targets a value of 7.46 Danish krone to the euro. The currency is allowed to fluctuate in a band of 2.25% around this target.

The authorities are in a similar position to the Swiss. Concerned investors have moved money from euros to krone, which has forced the DNB to buy foreign currencies to prevent the krone from rising too far. When the European Central Bank (ECB) launched quantitative easing (QE) this week, the DNB had to slash interest rates twice and buy more foreign currency to keep the krone weak.

Markets expect the DNB to be far more committed to the euro peg, which is over 30 years old – the Swiss National Bank had only been holding the Swiss franc back for three. Moreover, the DNB’s balance sheet has only swollen to 20% of GDP following its foreign-exchange purchases, compared to 70% in Switzerland. So there should be some way to go before fears over a bloated money supply or major future losses on currency holdings begin to rattle the Danes.

Even so, given the money flowing out of Europe, the DNB may have to be more radical, says Capital Economics. It has already imitated unconventional ECB measures, such as generous three-year bank loans, but the Danes may yet have to turn to QE of their own.

Hong Kong’s will endure…

Like Switzerland, Hong Kong has also amassed a huge pile of foreign-exchange reserves. Its aim is to hold the Hong Kong dollar (HKD) steady at 7.80 to the US dollar. But this is one peg that looks likely to last for some time. It has been in place for the past 32 years, and unlike the Swiss one, enjoys widespread credibility and popularity. It is recognised as “the cornerstone of Hong Kong’s… stability”, say John Tsang and John Greenwood in the South China Morning Post.

The main advantage is predictability and stability for businesses’ costs and pricing: Hong Kong’s economy is completely dependent on exports, so there would be huge uncertainty if the currency were to float freely. The link to the dollar, the world’s reserve currency, has also shored up the financial sector during bouts of emerging-market panic, when capital tends to flee to the developed world.

These factors are widely deemed to outweigh any disadvantages, such as having to import US monetary policy. This problem is mitigated by Hong Kong’s extremely flexible labour market, which has tempered both inflationary booms and slumps in demand.

…but will China’s?

Another potential “fault line on the global currency map” is the Chinese yuan, says Craig Stephen on Marketwatch.com. Its “crawling peg” – the yuan is allowed to move within a band that is gradually shifted upwards – is becoming “increasingly painful to maintain”. China’s economy is slowing and deflation spreading, with producer prices having fallen for three years. Falling prices make the real value of the country’s huge debt load, around 250% of GDP, even heavier.

A stronger currency fuels these trends. To make matters worse, major trading partners are printing money to make their exports more competitive. Japan’s aggressive QE has been a particular headache, says Société Générale’s Albert Edwards – and Europe’s won’t help either. Devaluation of the yuan is “an inevitability”. Capital flows out of China suggest investors may agree.

ARTICLE 3

Try and imagine you live in a country where you can borrow at 6-7% per annum for a return of about 15% – obviously not guaranteed but pretty good odds. Would you do it? Of course you would.  Now, imagine that country is China.  Hold your horses, you may argue. The cost of borrowing is higher than 6-7% in China. More like 10-12% for the average entrepreneur. Well, don’t bet on it. As the world increasingly becomes one big open market place, and the Chinese authorities stubbornly maintain their view that the best recipe for China is a Yuan which closely follows the US dollar – albeit with a couple of percentage points of annual revaluation thrown in for good measure – borrowing in US dollars to invest in China carries little or no perceived currency risk.

In a recent article in the FT fm2, some interesting observations were made in terms of the implications of large emerging economies such as China deciding to shadow the US dollar. In fact, the dynamics are not terribly different from those of the EU, where several countries have enjoyed an unprecedented boom in recent years as a result of the “one size fits all” monetary policy forced upon us after the introduction of the euro.

Had countries such as Denmark, Ireland and Spain been able to determine their own independent monetary policy, interest rates would most likely be higher in those countries today. However, these countries, and more, have benefited from the fact that ECB’s policy has largely been dictated by the sicklings of Europe, i.e. Germany, France and Italy.

When credit is cheap relative to expected returns, it encourages increased borrowing. It is as simple as that. There are obviously other measures available, should your government be keen to slow down the economy, but with monetary policy outsourced to the eggheads in Frankfurt, membership of the euro club has effectively stripped its members of the most effective tool available.

Now, let’s go back to the Chinese example.  Access to cheap capital has a number of implications – positive as well as negative. One of the most obvious ones is asset inflation, in recent years manifesting itself through higher property prices and buoyant equity markets all over the world. It should also be noted that China is not the only country linking its currency to the US dollar, although some tie ups are more formally established than others. The currency peg approach has been fashionable in Asia for years and is now spreading to other parts of the world.

The dollar peg: effect on current account deficits

This also helps to explain why so few emerging economies are running current account deficits –contrary to economic theory which suggests otherwise. Normally, when a country runs a large surplus, currency appreciation will, over time, reduce the level of competitiveness and thereby reduce the surplus. However, when the currency is artificially held down, as is the case with China and certain other countries, no such mechanism is in place to address the imbalance.  Another, and potentially positive, side effect from the Dollar Club phenomenon is the effect an American slowdown may have on the other members of the club. It is an almost universally accepted view today that a meaningful US slowdown will have negative implications for growth in other parts of the world, as many emerging economies are export driven.

However, this argument fails to address the rebalance of economic growth which may happen as a result of lower US dollar borrowing costs.  Let’s assume for a second that the US economy were to go into recession at some point in 2007 (for the record, we do not expect this to happen).  The Fed would almost certainly lower the Fed funds rate in order to stimulate domestic demand. Meanwhile, as a result of even cheaper credit amongst the other Dollar Club members, growth in these countries could in fact accelerate.  So far so good.

Why currencies should be allowed to float freely

More worryingly, the long term implications for inflation are not encouraging.  Eventually, excessive levels of liquidity will not only feed into asset inflation but will also put upward pressure on consumer price inflation.  How long it will take before this problem becomes apparent is difficult to say. What we can say, though, is that when the problem is there for everyone to see, it will be a difficult one to handle for the local monetary authorities, as they will find that they have lost the ability to effectively control monetary policy, just as it has been the case in Europe.

How markets will react to that situation is anyone’s guess. One thing is sure, though. The only lasting solution is to allow all currencies to float freely. Only then will the imbalances we are currently experiencing be addressed once and forever. However, as long as the Chinese (and others) show a complete disrespect for fair play, the chances of that happening are probably quite remote.

By Niels C. Jensen, chief executive partner at Absolute Return Partners LLP. To contact Niels, email: njensen@arpllp.com