Putting the currency wars in perspective

When Brazilian Finance Minister Guido Mantega first warned of “an international currency war” in September, accusing some governments forcing down the value of their currencies in order to remain competitive, he seems to have struck a nerve. The US soon turned on China, claiming it was not letting the yuan rise freely. China responded by accusing the US of depreciating by stealth, highlighting the second round of quantative easing. In the meantime, emerging Asian countries, worried by the flood of foreign investment into their economies, threatened capital controls to stem the flow.

Some are arguing that this currency war threatens to undermine the global recovery. The matter was deemed to be so serious that it came to dominate the G20 meeting in Seoul, which ended with a vague compromise on currency devaluation and trade imbalances. But did the summit put the issue to bed, and just how worried should private investors be by the global situation?

Guy Monson, chief investment officer and managing partner at Sarasin, believes that the arguments over currency came to a head because currencies were a way for countries to keep their own domestic economies relatively stable without really having to face up to the core adjustments that were needed in the long-term.

“I think since the height of the credit crisis and the consequent move to emergency monetary measures, we have lived in a slightly fairytale world which has been big on talk and not really required much hard adjustment. We have lived in a world of quantative easing, of printed money, of a tolerance of very substantial budget deficits in the name of Keynesian stability.”

He says that we now seem to be moving to the second phase of the recovery, which will see hard adjustments having to be made in each of the local economic regions.

“The US have near double digit unemployment and a core CPI that is running at 0.8 per cent, dangerously close to technical deflation and showing all the dynamics of a Japanese-style mild but semi-permanent deflation. The Chinese are beginning to have to recognise that the super-normal fiscal stimulus to save growth has brought with it some imbalances in terms of loan provisions and inherent inflationary pressures. The Europeans have a relatively robust core but a fiscal problem in the periphery which was always going to need cross-border fiscal transfers as long as the weaker members remained in the euro.”

These three big factors, while impossible to ignore, were identified as things that could be done “tomorrow” under the guise that the whole economy was too fragile to see these issues being dealt with in an immediate manner, believes Mr Monson.

“Suddenly, and perhaps triggered by George Osbourne in the UK, there seems to be a view that you could talk about these things for so long but actually you have to establish a meaningful mid-term trajectory that will deal with them in real terms.”

He believes that the UK’s announcement of £81bn (€96bn) in spending cuts then mushroomed out into China and the other Asian countries who started to take the inflation issue more seriously, and the US saying that without a weakening dollar they had to resort to quantative easing to keep inflation positive. Meanwhile the Europeans finally acknowledged the Irish problem could not be bottled up, and recognised that it is probably the precursor to a similar programmes in Portugal, and possibly even Spain.

“I think that currency as the punch bag of the global economy has more or less run its course,” says Mr Monson. “When you read the G20 statement, away from some of the political posturing, it’s pretty straightforward. It says everybody must watch their global imbalances, surplus and deficit countries alike, and if that is all done in a reasonably unified framework, then actually the world economy can continue to grow. I am a bit more positive than many commentators, but I think we are putting a bit of inflation back into the system, putting a little bit of growth back in, but most of the individual regional players, but hook or by crook, are pulling the right levers.”

Alain Bokobza, head of global asset allocation at Société Génerale Corporate & Investment Banking, is also confident that the global situation should not deteriorate into a global currency war.

“Bernanke (chairman of the US Federal Reserve) has been careful when launching QE2 not to do too much, otherwise the dollar would have collapsed, or too little, triggering a sell-off of risky assets.”

But it is a certainty that zero or close-to-zero yield on US and other G8 fixed incomes assets will trigger a huge inflow into emerging markets, he explains, and that currency appreciation in developing world will be a long-term trend. He suggests emerging market bonds as a good way for investors to benefit from this rise as it is not easy to directly buy these currencies against the dollar as many of them are not freely quoting, having controlled or semi-controlled exchange rate-mechanisms.

The arguments over currency are part of an ongoing structural change, and this should encourage investors who are not yet invested in emerging markets to increase their allocations, says Jerome Booth, head of research at Ashmore Investment Management. “I don’t like the term currency wars because it sounds like it is some kind of fad or story. It’s not. This is hugely important structural, slow moving change and what happens now will have huge implications for decades.

“It is inevitable that surplus currencies are going to go up against deficit currencies. So the first question is which are the surplus currencies, and the answer is emerging currencies. So it is a question of reducing your risk away from the risky currencies, which are those like sterling, the euro and particularly the dollar.”

The main reason for investing in emerging markets, particularly in fixed income and currencies, is to reduce risk, according to Mr Booth.

“The fact that things are getting a bit hot should make investors want to get on with it a bit quicker rather than sitting on their hands and hoping for the best as far as the US economy is concerned,” he says. “

This is all about risk reduction and people’s perception of risk becoming a little more realistic.”

He would not be surprised to see more currency controls brought in, as has already happened in Brazil and Thailand, but believes they may turn out to be quite temporary.

“Do they affect investors? Yes, of course they do, but they affect the ability of investors to change their mind quite so much,” says Mr Booth.

“At the end of the day it is not really going to change their main motive to get to emerging markets. Which is not ‘I want to go to emerging markets because I want to make a load of money’. It is ‘I want to go to emerging markets because I want to get out of the crash zone’. And if you are making 8 per cent rather than 10 per cent, well it isn’t really going to make that much difference to you. You are still going to make the investment.”

The global situation is also creating plenty of opportunities for investors looking to benefit from rising currencies, believes Andreas König, portfolio manager for the Total Return Currencies fund at Pioneer Investments.

“The situation really isn’t that bad or dangerous,” he says. “There is so much liquidity in the market at the moment which is looking for yield, and there is more yield in the emerging market economies, in Asia in particular, so the money is flowing there.” He says that it is perfectly normal that these flows are creating some concerns and that countries will try to slow the pace by taking measures, but that so far volatility is not extraordinary.

“It is an interesting market at the moment. It is working, it is very liquid, and there are loads of opportunities. I have been in the market for 16 years, and I have never seen the two big economies, the US and Europe, going in such different directions. The US is trying to spend its way out of the problem and is putting more liquidity into the market, while Europe is bringing in austerity measures. So this has to have effects on the currencies because they are doing the opposite.”

However Mr König believes that the risk-return in euro-dollar markets is not particularly attractive at the moment, and so is concentrating on Asia, and within that region particularly Korea, China and India.

“We have been long on China for around 1.5 years,” he says. “I don’t think they will do a one off appreciation of 15-20 per cent one day. It wouldn’t be in the interest of China, nor anybody else. Because no one can foresee what would happen afterwards. In my view they will continue with some kind of crawling appreciation over a range of 3 to 5 per cent per year.”

Mr König expects the Chinese government to take direct measures such as rate hikes and reserve hikes rather than turning the wheel on the currency side. “We all remember what happened when the Yen appreciated due to the Plaza accord in 1985 and China wants to avoid something similar to happening. And therefore I think they should be very careful, and they will be, and they have been doing very well so far. They shouldn’t listen too much to the pressure coming from outside.

“They were very responsible after the crisis, so I think the whole world should be pretty happy with what China is doing at the moment.”

Andreas König, Pioneer Investments