Currency wars conjure images of trade wars

Michael Collins | 03 Dec 2012

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Michael Collins is an investment commentator at Fidelity Worldwide Investment, a global asset manager.

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The Great Depression became great, in part, because it featured a trade war. The so-called Great Recession since 2008 has so far escaped the same disaster.

Instead, it is hosting a so-called central bank currency war that could damage many countries, including Australia. But there's a difference between a trade war and currency war that makes the latter less venomous at a global level.

The trade war of the 1930s was kicked off by the US Tariff Act of 1930, which is better known as the Smoot-Hawley Tariff after its sponsors.

President Herbert Hoover approved the bill, which imposed record high tariffs on more than 20,000 goods, to protect US farmers from imports. US trading partners retaliated and world trade plunged by about two-thirds from 1929 to 1934, when measures were taken to reduce slugs on imports.

Not only did the tariff war wreck global trade, it thwarted collaboration between countries to fight the global economic slump. The General Agreement on Tariffs and Trade signed in 1948, which was a precursor to the World Trade Organisation, was designed to prevent a repeat of this self-destructive behaviour.

The start of today's currency war is harder to pin down. It certainly gained speed on 6 September last year when the central Swiss National Bank unexpectedly said it would "with the utmost determination" purchase "unlimited quantities" of foreign currencies to block the Swiss franc's rise against the euro, the currency of most of its trading partners.

Up to that day over 2011, the Swiss franc had jumped 13 per cent against the euro as doubts mounted that the single currency would survive the euro zone’s financial crisis.

China, Brazil and other developing countries would date the currency war to no later than August 2010, when the Federal Reserve flagged its second round of quantitative easing.

Although the premise is unproven, many - especially forex dealers - think central-bank-financed asset buying creates inflation, which in theory lowers a country's exchange rate.

Guido Mantega, Brazil's finance minister, immediately used the term "currency war" to describe the results of the Fed's asset buying. By November of that year, Beijing berated Washington for risking a "currency war" by adopting "self-serving macro-policies".

The Fed's quantitative easing, since it aims to promote consumption and investment by lowering interest rates, encourages more imports to the US as much as it might aid exports through a lower currency.

The battle lines

Whenever it started, today's currency wars fall into two broad skirmishes. The first group involves oil exporters and Asian countries that for a long time have tied their currencies in some way to the US dollar. It's just that now they need to take bigger steps to hold their targeted rate to the greenback.

The second bunch groups the non-euro zone countries with more-or-less market-set exchange rates that are taking action to prevent their currencies soaring, as central banks and investors diversify away from US-dollar and euro-denominated holdings because they are losing faith in these currencies.

Brazil, Denmark, Israel, Japan and Switzerland fall into this category. The Japanese and Swiss are doing the most fighting, for their currencies are regarded as havens.

Countries like Australia, Canada, New Zealand, Sweden, South Africa and the UK fit into neither category for they are taking little, if any, action to prevent their currencies climbing against the US dollar.

The Australian dollar, for instance, has averaged US$1.02 over the past two years as central banks and investors sought havens, compared with 72 cents over the prior decade.

Even if it's falling since the Reserve Bank of Australia cut the cash rate by 100 basis points over May, June and October, the Australian dollar is not too far from the post-float record high of US$1.10 that it set in July 2011.

That's a feat given that Australia's terms of trade have slumped over 2012 and evidence is mounting that China, our biggest export market, confronts an economic slowdown.

According to a freedom of information request by Bloomberg News, a Reserve Bank of Australia spreadsheet created in July 2012 shows at least 23 central banks now hold Australian-currency reserves.

That list didn't include the central bank of the Philippines, which in September admitted to building up its Australian-dollar reserves. A debate is underway in Australia on whether the Reserve Bank should counterattack to protect exporters.

Dire predictions are floating around about how badly today's currency wars could end. James Rickards, the author of Currency Wars: The Making of the Next Global Crisis, sees that the outcomes could include a collapse of faith in the US dollar and the rise of multiple reserve currencies, a return to the gold standard or chaos, his most likely ending.

Alarmist predictions can be a trap and help sell books but no one can rule out an uncomfortable outcome for the currency wars. What can be said, however, is that a currency war is more benign than a trade war.

The difference

A trade war is damaging because it upends one of the most central tenets of classical economics, the law of comparative advantage.

The theory, which originated with David Ricardo in the early 19th century, postulates that everyone is better off when people and countries specialise in areas in which they are the most efficient and then engage in trade to acquire the goods in which they are less efficient at producing.

In short, everyone loses in a trade war, even those US farmers the tariffs in 1930 were designed to protect, because a failure to specialise creates vast inefficiencies.

Currency wars are much less damaging than trade wars because they create winners and losers. They benefit the side suppressing their currency in terms of making that country's goods more competitive, even if there are side-effects for the winning side.

The gain for China from its low-Yuan policy of the past three decades is clear - the low Yuan helped it become the world's biggest exporter and lifted hundreds of millions out of poverty.

The cost to the Chinese of this policy is more obscure - the purchasing power of the Chinese is lower than otherwise, much of the country's wealth is tied up in more than US$3 trillion worth of low-yielding US Treasuries and these securities incur losses when the Yuan rises.

Those fighting to suppress their currencies these days are reducing the purchasing power of their citizens and face similar risks, even if their exporters are better off than otherwise.

The decision by the Swiss National Bank to place a ceiling of 1.2 Euros on the franc risks fanning inflation in Switzerland. This is because the central bank must create Swiss francs to buy the foreign currency and, unless fully offset or sterilised, this action will boost the local money supply.

The Swiss National Bank's foreign reserves have soared to 407 billion Swiss francs ($430 billion), about 71 per cent of GDP, a tenfold increase from 2009, when it first acted to stem the Swiss franc's rise.

If the Swiss central bank loses its battle against a rising Swiss franc, much wealth will be wiped out. So far, the Swiss National Bank has broad political support for its action, even though it lost 19.2 billion Swiss francs fighting the Swiss franc's ascension in 2010.

The losing countries in the currency wars are shedding their competitiveness, upsetting their balance of payments and, in some cases, risking a deflationary shock, even as their consumers enjoy higher purchasing power.

If you look back over the past three decades, the cost to the US of the high US dollar versus the Yuan was a perennial current-account deficit and a credit bubble that ended up ravaging government finances, even if the country benefited from lower inflation due to cheaper imports and faster economic growth leading up to 2007 thanks to the low interest rates that slower inflation allowed.

It's too soon to calculate the cost to the losers of today's currency wars, but it would be marginal so far. So don't think another episode of the 1930's tragedy is playing out. Unless, of course, the currency wars morph into trade wars.