Currency jigsaw puzzle

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As authorities in Western economies grapple with slow economic growth and exhausted policy tools, an old policy favourite, ‘currency devaluation’, could become an appealing option. It may be challenging to devalue one’s currency when many other nations are in the same economic predicament, particularly when those nations are holding one’s debt. However, solving the currency jigsaw puzzle presented could be very rewarding.

In 2008, the UK was able to ‘get away with’ a 26% devaluation of its currency against the US dollar, and devaluations of 23% and a staggering 40% against the euro and the yen respectively. The UK economy is now in a better position as a result of the lower value of the pound; had it not cheapened the relative value of its debt, it is possible that the UK could have faced some serious funding issues.

The German economy, its exporters reaping the benefit of a weakening euro, has benefited from the troubles in the eurozone periphery. Those troubles have caused the euro to fall by 20% against the yen and by around 11% against the US dollar this year.

Could it now be the turn of the US dollar to endure a phase of currency weakness? If so, against what, and how, might it fall in value? There are significant difficulties associated with the devaluation of a global reserve currency, exemplified by the tensions inherent in the symbiotic relationship between the US and China.

The Chinese authorities would probably welcome the beneficial effect that an appreciating renminbi (versus the dollar) would have in reducing imported inflation. Such appreciation would, however, undermine the value of their foreign-exchange reserves, and would additionally affect China’s exporters, whose main trading partner is the US. China has amassed unprecedented levels of US government paper, and the US, with its growing budget deficit, is still reliant upon the readiness of the Chinese to buy its debt. A decline in the dollar would lead to diminished buying of US Treasuries, but at the same time Chinese exporters would suffer.

So, from both sides’ perspectives, there is a necessity either to maintain the status quo or, perhaps, to allow only a gradual adjustment in the relationship between the dollar and the renminbi. Given only a modest appreciation of the Chinese currency against the dollar since June, and the still-vast Chinese trade surplus (not to mention the high US unemployment rate), we would expect further ‘noise’ to emanate from US politicians in the run up to their mid-term elections in November. As a result, the trend of modest renminbi appreciation, which had stalled, is likely to resume.

A further fall in the value of the dollar against the yen seems unlikely, given the ticking time-bomb of Japanese indebtedness, which will only worsen, owing to the country’s demographic challenges. A meaningful devaluation of the US dollar against the euro also seems unlikely, in light of the significant eurozone debt challenges that persist.

However, there are a number of other candidates against which the dollar could lose ground.

There is a growing group of countries that appears to have weathered the 2008 storm better than the G3 nations (US, Japan and Germany), and which has started to raise interest rates in order to contain domestic demand. In this category we would include Sweden, Canada, Switzerland, Australia and a selection of Asian economies. The challenge presented is that, as rates rise, those countries attract significant inflows of ‘hot’ money, which pushes up their exchange rates. In some cases, this has led to foreign-exchange intervention by respective central banks. In other cases, however, the increase in the exchange rate can help bring about monetary policy tightening; this is especially likely in those countries where authorities fear the corrosive effects of imported inflation.

In Asia, we see countries (such as Singapore) using currency strength explicitly as a monetary tool. Indonesia has sought to resist the rise in its currency but, with the cost of imported food increasing, authorities there may be more inclined than before to let the currency appreciate against the dollar.

The dollar is the main currency in which commodities are priced. Commodity prices have remained elevated despite the fact that most of the Western economies appear to be, once more, on the brink of contraction. This is attributable to the perception that demand from China is insatiable, and also to some marked changes in weather patterns. For many developing nations, food is a much higher percentage of consumption than it is in the West and it tends, therefore, to have a significant impact on headline developing-world inflation figures. For central banks, this poses some problems, as higher interest rates (the conventional monetary tightening tool) do little to counteract imported inflation. Allowing the currency to appreciate against the dollar is one way to tackle this issue.

What about the effect of an appreciating currency on the value of a country’s reserves? This is less of an issue because many of the countries that would benefit from allowing some currency appreciation are not large holders of US-dollar debt, and the US Treasury does not rely upon them to help fund the deficit.

The following table shows, in the blue area, the largest holders of US debt, whose currencies we anticipate will move only modestly versus the dollar. In the yellow area are those countries which provide limited financing to the US and whose currencies, we believe, have greater scope for appreciation against the dollar.

If devaluation is one way to help an indebted country out of its difficulties, it is necessary to find a currency against which to devalue. Countries with strong domestic demand, and which are sensitive to imported inflation, could be prime candidates.

For now, we prefer to allocate our currency exposure to the growing band of currencies in countries where authorities either have a need to revalue or are less likely to intervene to try to weaken their currencies. We are maintaining underweight exposure to the ‘ugly three’ (yen, US dollar and euro). The list of ‘beautiful’ currencies is growing longer.

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