As we are now more than halfway into the third quarter of 2015, substantial divergence still prevails around the world in terms of monetary policy and economic conditions, with certain regions experiencing accelerated growth and several others still struggling. Inflation has reached several decade lows despite monetary policy being extremely loose in most of the developed economies and tight in emerging economies and credit spreads are trading below default rates, while yields still remain near historic lows. Such low inflation rates around the world, and disinflation caused by sliding oil and other commodity prices, have been triggering a number of central bank responses such as negative interest rates, asset purchases and FX interventions, in summary declaring Currency Wars.
Manufacturing activity in China has reached a six-year low
Currency war is a tactic used in international affairs with potentially destructive outcomes. Countries enter a race to the bottom in an effort to boost their ailing domestic economies and growth figures by competing against each other in weakening their currency to achieve a relatively low Exchange rate. This policy effectively causes countries to “steal exports” and therefore growth from their trading partners. The result can be a potential decline in international trade, eventually harming all countries. In recent years, countries that have been participating in a competitive devaluation race since 2010, have used a combination of policy tools, including quantitative easing, direct government intervention and imposition of capital controls.
From Easy Monetary Policy to Outright Competitive Devaluation
Monetary easing measures by BOJ and the ECB, bailouts in Greece and Ireland, Chinese currency manipulation, the unexpected move of SNB to remove the 1.20 peg on the EUR/CHF pair and Sweden dropping the Swedish krona interest rate below zero, have all been indicators of the intensification of the currency wars in recent times. In extreme cases, countries have even resorted to the ultimate measure of imposing capital controls in order to prevent currency outflows, as seen in Greece after the Euro-zone bailout negotiations fell apart last June. The recent burst of the Chinese stock market bubble has proved to be a major catalyst in global market developments, as it has been adding severe pressure on the Chinese economy, threatening to drag it further down to the slowest pace since 1990. In an effort to put a brake on the stock market decline and deteriorating economic growth, China unexpectedly moved last week towards devaluating its currency, a move that has intensified the continuing currency wars. Furthermore, as the latest figures issued this morning indicate that manufacturing activity in China has reached a six-year low, the possibility of further currency devaluations in the near future is high. As already discussed in our previous article titled ”Is This the End of the Chinese Stock Market Meltdown or Just the Beginning?”, the bubble was created as share prices had been disconnected from underlying economic fundamentals causing a stock market rise of 150 percent over the past year, which was not justified by dividend yields, return on equity or other financial characteristics of companies. Even though the Chinese government has persistently been trying to prevent further stock market losses by drawing the line around the 3,500 level for the Shanghai Stock Exchange Composite Index (SHCOMP), it is questionable whether it will continue to provide support in order to sustain this market level indefinitely, as it is proving to be a very expensive exercise. The Hong Kong Stock Exchange Hang Seng China Enterprises Index (HSCEI), on the other hand, entered a death cross pattern earlier this week, a momentum technical indicator triggered when the 50-day moving average crossed below the 200-day moving average, signifying further market weakness and contagion in the region, with potential implications on currency moves.
Escalating Risks to Global Growth
In order to draw the whole picture, there are four major risk factors that are responsible for currency devaluation moves in the developing economies: (1) as already mentioned above, the slowing growth in China resulting in devaluation of the yuan, (2) the collapse of oil prices (3) the possibility of US interest rate hikes (4) the continuing severe recession in Russia. All of these factors are interrelated and affect the economies of various developing countries in a combined manner. Kazakhstan’s move to abandon its currency-band exchange rate mechanism and adopt a free-floating exchange rate, is the latest sign that emerging countries will not defend their currencies any longer after China shocked the global markets. This central Asian nation, whose major trading partners are Russia and China (as well as the US to a limited extent), has switched to a free float which triggered a 23 percent decline in the tenge to a record low of 257.21 against the US dollar, after its central bank had already spent a staggering amount of 28 billion US dollars to defend the currency during 2014 and 2015. This news hit the markets just one day after Vietnam's latest devaluation of the dong, the third adjustment so far for this year, in the country’s effort to catch up with regional peers already participating in the currency wars. The State Bank of Vietnam devalued the dong by one percent against the US dollar last Wednesday, while it simultaneously widened the trading band for the second time in six days from two to three percent.
Global Markets Rout
Furthermore, last week’s devaluation of the yuan triggered a storm of declines in the range of 5% in most emerging market currencies which had already been at multi-year lows, from Russia to Turkey and Malaysia. There are several other countries exporting goods to China that are at risk as a consequence of the yuan’s devaluation, including Brazil, Peru, Thailand, Taiwan, South Korea and South Africa. The South African rand slumped beyond 13 against the US dollar for the first time since 2001 while the Brazilian real has been the greatest loser of the developing nation currencies this year, the Turkish lira fell to a historic record low and the Malaysian ringgit traded at a seventeen-year low. Nigeria and Egypt are two countries heavily exposed to oil, which have so far resisted entering the currency revaluation arena, mainly for political reasons. If their currencies are allowed to float, their cost of living will skyrocket as they heavily rely on imports even for essentials, such as wheat for making bread. It may become inevitable at some point, however, and these countries may also have to enter the currency race to the bottom sooner or later. By applying competitive devaluation, all of these emerging countries have an opportunity to “import” growth from developed economies. However, the result of all this competitive currency devaluation game gaining momentum around the globe is becoming the new catalyst for the direction of the markets; it could gradually lead to reduced demand for US products in all of these developing countries, subsequently hurting US producers, with growth/high momentum stocks being the first ones to suffer. This fear of potential growth slowdown being eventually spilled over back to the US is already beginning to cause serious jitters as the stock markets are heading towards the close of their worst week in 2015, which will likely amplify as the currency wars continue to intensify. Great challenges will therefore continue to persist until the end of this year and beyond, in the effort to restore balance in the global economy. Based on the experience of past currency wars, while one or the other country may be ahead of the race to the bottom in the short-term, most likely no one will end up being a real winner in the end.
