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What are Currency Wars and Are We In One Now?

Investing

What is a currency war, and are we looking at one now?

It was probably inevitable: Japan, the UK, the Eurozone and now the United States find themselves mired in quicksand pit of debt.  The UK has racked up debts equivalent to over 82 percent of its gross domestic product, according to data from the International Monetary Fund. The European Union as a whole has borrowed the equivalent of 90 percent of its GDP.  The United States’ debt recently crossed the 100 percent threshold. That is, it would take the entire economic output of every man, woman and child in the United States for one year to pay off everything we borrowed.  Meanwhile, the total public debt of the government of Japan amounts to a staggering 230 percent.

Widespread Debt in the West

The hope of net borrowers, generally, is that the borrowing will finance economic growth, and that the growth will outpace the interest on borrowed money.  But even though interest rates are extremely low throughout the developed West, growth has been hard to come by – a fact underscored by the United States’ disappointing negative growth announcement for the 4th quarter of 2013.

The western powers are having a hard time paying down the debt by raising taxes. The French tried with a confiscatory tax of 75 percent on the wealthy – which caused capital to go rushing for the exits. Gerard Depardieu famously moved away – but he was joined by thousands of other wealthy French.

So public debt problems are resistant to tax hikes as a solution.  Conservatives, of course, argue that tax hikes are part of the problem.

So if you can’t grow your way out of debt, and if you can’t tax your way out of debt, what’s left?

Competitive Devaluation At Work

Competitive devaluation occurs when each country works to flood the market with its own currency to make it cheaper relative to other currencies. That way, you can borrow big dollars then pay it back with cheap ones.

All things being equal, net debtor countries want their currencies cheap because it makes their debt servicing more affordable. This is, indeed, how Germany paid off its post WWII war debts: It inflated the deutschemark to an absurd extent and repaid the face value of the debt.  Creditor countries, on the other hand, want their borrowers’ currencies to remain strong.

The countries with the most to gain from competitive devaluation are the ones that have the highest debt levels per unit of GDP.

We’re lookin’ at you, Japan.  The graph featured here by a DailyFX strategist clearly shows a surge in short interest in the yen over the last couple of months. That means speculators are betting on the yen falling still more – an event that can become a self-fulfilling prophecy. Especially if the Bank of Japan wills it. The Bank of Japan, however, has been debasing the currency for years, holding interest rates at barely above nothing for a generation of investors.

As of this writing, the Japanese yen is approaching 12 consecutive weekly declines against the dollar, the longest such run in over 40 years. The other Asian economies are beginning to take note – and slash their own currencies to protect themselves.  Korea, not wanting to lose a vital manufacturing business to Japan, is reaching for the dump lever. If it does, China is likely to follow suit in a massive economic exercise illustrating the prisoners’ dilemma.

A USA v. China Currency War?

Meanwhile, China had been objecting to the United States’ Federal Reserve policy of quantitative easing. That is, propping up the U.S. economy by buying massive amounts, not just in treasuries, but also troubled mortgage pools and other kinds of structured debt.

Much of this debt was held by the net saver Asian emerging markets. Historically, Asian households don’t consume much compared to westerners. Instead, they generally put their surplus earnings in Asian banks – which, in turn, lend them to their largest and most ready market: the West.

The Chinese foreign minister, Zhu Guangyao, warned in 2010 that the then-current round of quantitative easing would result in some $10 billion in ‘hot money’ coursing through the Asian emerging markets economies like a snort of cocaine – potentially disrupting smaller economies throughout the region.

Furthermore, a sustained cheapening of the U.S. dollar would cost Chinese jobs. Why? Because exports have lately made up between 31 and 35 percent of the Chinese economy. They’re making the iPhones Americans are lining up to buy. A falling dollar would increase the cost of Chinese exports to American buyers – and cause American goods to become cheaper in China. This is good for American manufacturers.

All other things being equal, the flow of jobs goes to the weakening currency, not the strengthening one.

And that’s the crux of the argument. When governments allow their currencies to weaken or strengthen, it’s really a fight over table scraps. A weak currency is ultimately about preserving manufacturing jobs. Who pushes for cheap currencies? Manufacturers, union members and net  borrowers. A weak currency policy is actually a pro-jobs, pro-labor policy.

China retaliated for the U.S. Central Bank’s potentially inflationary monetary policy by unpegging its own currency from the dollar – and letting it fall. The U.S. threatened to formally name China a ‘currency manipulator (though the Obama Administration stopped short of that measure, instead just calling the Renminbi ‘significantly undervalued’).

If there are enough Asian countries devaluing their currencies to reach critical mass, there is a danger that the whole ASEAN bloc could fall into a beggar-thy-neighbor spiral – a currency war could erupt, with each state involved working to stick a shiv in the ribs of every other player by devaluing its own currency.

How to Protect Yourself From a Currency War

There are two tricks to protecting yourself against the possibility of a currency war. The first is to stick to hard assets that cannot be devalued. For example, real estate, precious metals, commodities and the securities that are linked to them. No matter how far they debase the currency, real assets like these will retain their value. Their value will only be subdivided more finely thanks to smaller and smaller currency units.

For debt instruments, there are some things you can do: Buy bonds in countries that are not likely to get dragged into a currency war. That is, keep your assets denominated in strong currencies in nations that are boosting their currencies, rather than diluting them. You can also go ahead and invest in that inflation protection rider if you are a buyer of annuities. That will help cushion the blow if the currency war leads to inflation.