Thursday, September 23, 2010

War By Other Means

Chinese Premier Wen Jiabao is sitting on a powder keg. He knows it, and he wants U.S. government officials to know it, too. The U.S. is pressing China to revalue its currency upward relative to the dollar as a way to redress the huge trade imbalance between the two countries. That would mean more jobs in the U.S., fewer in China. Good for us, bad for them.

“We cannot imagine how many Chinese factories will go bankrupt, how many Chinese workers will lose their jobs, and how many migrant workers will return to the countryside, ” said Wen last night in New York. If the yuan were allowed to appreciate by 20 percent to 40 percent, “China would suffer major social upheaval.”

Similarly, Japan is relying on a cheap yen to boost its own exports. Twice this week Japan has intervened in foreign-exchange markets, dumping yen to weaken the currency against the dollar. Not to be outdone in the race to debase, Federal Reserve Chair Ben Bernanke hinted earlier this week that the Fed was contemplating another $1 to $2 trillion in quantitative easing to goose the U.S. economy. Should QE2 set sail (after the November elections?), the dollar would lose value in the currency markets. First currency to the bottom wins. "No country wants a strong currency," observes David Rosenberg at Gluskin Sheff. "All we have seen this year, and the past few years in fact, is a series of rolling bear markets in various currencies."

As for the Fed's next intervention, Minyanville's James Kostohryz explains, "the Fed pretty much must expand its balance sheet in order to avoid an economic contraction." Continuing:

A crowding out of credit to the private sector [by federal deficit spending] would obviously have deflationary consequences. In a modern economy, characterized by fractional reserve banking and highly leveraged financial institutions, even a modest contraction of credit to an important sector of the economy can produce a severe system-wide contraction of liquidity (available money). This point was amply proven in late 2008 and early 2009 when the contraction of credit to some sectors of the economy produced a massive economy-wide liquidity squeeze. This is the money multiplier effect in reverse. Thus, many Fed officials feel that they must avoid such a deflationary crowding out by 'accommodating' the expansion of fiscal deficits [i.e. purchasing U.S. Treasuries].

And how about the European periphery (a.k.a. "PIIGS")? How are those currencies doing? Glad you asked. Examining the chart below, we can see that the interest-rate spread between Portuguese and German 10-year bonds has surged to over 400 basis points:

Difference in rates for the Portuguese 10-year and the German bund

Ditto the spread between Irish and German bonds:

Difference in rates for the Irish 10-year and the German bund

As you can see, the spreads exceed the flash-crash highs of last May, when the prospect of sovereign defaults started to get serious attention. The higher the spread, the greater the perceived risk of default. The fear is that the first default will trigger a chain reaction, crushing the currencies of those nations (including the U.S.) lugging the heaviest debt loads.

If it gets that far, it will be every nation for itself, a gloomy scenario indeed.

[update, 09-24-10:]

In its race to the bottom, the U.S. dollar this morning has hit another record low against the Swiss franc, one of the few stable currencies left.

number of dollars needed to buy one franc

[update, 09-27-10:]

Brazilian Finance Minister Guido Mantega:

"We're in the midst of an international currency war.
This threatens us because it takes away our competitiveness.
The advanced countries are seeking to devalue their currencies."

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