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Doubling down
on QE3, the Federal Reserve (Fed) Chairman Bernanke tells China and Brazil:
allow your currencies to appreciate. One does not need to be a rocket
scientist to conclude that Bernanke wants the U.S. dollar to fall. Is it
merely a war of words, or an actual war? Who is winning the war?
 
The cheapest
Fed policy is one where a Fed official utters a few words and the markets
move. Rate cuts are more expensive; even more so are emergency rate cuts and
the printing of billions, then trillions of dollars. As such, the Fed's
communication strategy may be considered part of a war of words. Indeed, the
commitment to keep interest rates low through mid 2015
may be part of that category. But quantitative easing goes beyond words: QE3,
as it was announced last month, is the Fed's third round of quantitative
easing, a program in which the Fed is engaging in an open-ended program to
purchase Mortgage Backed Securities (MBS). To pay for such purchases, money
is created through the strokes of a keyboard: the Fed credits banks with
"cash" in payment for MBS, replacing MBS on bank balance sheets
with Fed checking accounts. Through the rules of fractional reserve banking,
this cash can be multiplied on to create new loans and expand the broader
money supply. The money used for the QE purchases is created out of thin air,
not literally printed, although even Bernanke has referred to this process as
printing money to illustrate the mechanics.
Read past Merk Insights
Why call it a
war? It was Brazil's finance minister Guido Mantega
that first coined the term, accusing Bernanke of starting a currency war.
Here's the issue: like any other asset, currencies are valued based on supply
and demand. When money is printed, all else equal, supply increases, causing
a currency to decline in value. In real life, the only constant is change,
allowing policy makers to come up with complex explanations as to why
printing money does not equate to debasing a currency. But even if intentions
may have a different primary focus, our assessment is that a central bank
that engages in quantitative easing wants to weaken its currency. It becomes
a war because someone's weak currency is someone else's strong currency, with
the "winner" being the country with the weaker currency. The logic
being a weaker currency promotes net exports and GDP growth. If the dollar is
debased through expansionary monetary policy, there is upward pressure on
other currencies. Those other countries like to export to the U.S. and feel
squeezed by U.S. monetary policy. Given that politicians the world over never
like to blame themselves for any shortcomings, the focus of international
policy makers quickly becomes the Fed's monetary largesse.
Bernanke
speaking at an IMF sponsored seminar in Tokyo pointed to the other side
of the coin: if China, Brazil and others don't like his policies because they
create inflation back home, they should allow their currencies to appreciate.
But these countries are reluctant as stronger currencies lead to a tougher
export environment.
Now keep in
mind that it is always easier to debase a currency than to strengthen it.
Switzerland, the previously perceived safe haven by many investors, has taken
the lead. Using a central bank's balance sheet as a proxy for the amount of
money that has been printed, the Swiss National Bank's printing press has
surpassed that of the Federal Reserve considering relative growth since
August 2008. Again note that no real money has been directly printed in these
programs; also note that some activities, such as the sterilization of bond
purchases by the European Central Bank, cause a central bank balance sheet to
grow, even if sterilization reflects a "mopping up" of liquidity:
Japan has
warned about intervening in the markets on multiple occasions, but the size
of the Japanese economy as well as the lack of political will make an
intentional debasement more difficult. Indeed, the Japanese did their money
printing in the 1990s, but forgot we had a financial crisis in recent years.
Bernanke does
acknowledge the concerns of emerging markets, but argues they are blown out
of proportion. He elaborates that undervaluation and unwanted capital inflows
are linked: allow your currencies to appreciate (versus the dollar) and you
won't have to be afraid of excessive capital inflows, inflation and asset
bubbles. Ultimately, and importantly, Bernanke says the Fed will continue its
course, suggesting that it will strengthen the U.S. economic recovery; and by
extension, strengthen the global economy.
Let's look at
the issue from the viewpoint of emerging markets: policy makers like to
promote economic growth, among other methods, through a cheap exchange rate,
up to a certain point. They don't want too much inflation or too many side
effects. Historically, they manage these side effects with administrative
tools. However, taking China as an example, taming price pressure through,
say, price controls, has not been very effective. We believe that's a good
thing, as China would otherwise experience product shortages akin to what the
Soviet Union experienced. Conversely, however, China must employ a broader
policy brush to contain inflationary pressures. We believe - and Bernanke
appears to agree - currency appreciation is one of the more effective tools.
So how will
this currency war unfold? The ultimate winner may well be gold. But as the
chart above shows, it's not simply a race to the bottom. If one considers
what type of economy can stomach a stronger currency, our analysis shows an
economy competing on value rather than price has more pricing power and
therefore the greater ability to handle it. Vietnam mostly competes on price;
as such, the country has, more than once, engaged in competitive devaluation.
At the other end of the spectrum in emerging markets may be China: having
allowed its low-end industries to move to lower cost countries, China
increasingly competes on value. Within Asia, we believe the more advanced
economies have the best potential to allow their currencies to appreciate.
It's not surprising to us that China's Renminbi
just recently reached a 19-year high versus the dollar.
What we have
little sympathy for is an advanced economy, e.g. the U.S., competing on
price. We very much doubt the day will come when we export sneakers to
Vietnam. As such, a weak dollar only provides the illusion of strength with
exports temporarily boosted. Yet the potential side effects, from inflation
to the sale of assets to foreign investors with strong currencies, may not be
worth the risk.
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