Thursday February 14, 2013 12:59
Talk of a Currency War is becoming much more frequent these days. What’s meant by this is that the competitive devaluations of currencies, which has gone on for such a long time –many years in fact—is going to become destructive to real currency values! This brings into question the entire system of exchange rates.
Now we have the assurance that the euro will not be ‘managed’ down to gain a competitive advantage. Let’s watch the rate to see if this is true? Actions speak louder than words, especially those of a politician.
Past Fixed Exchange Rates
Go back in history to the time when exchange rates were ‘Fixed’ under the Gold Standard. In those days they appeared to be valued against the price of gold, until the U.S. broke ranks by devaluing the dollar against gold from $20 per ounce of gold to $35 per ounce in 1935. At that time they did not devalue against other currencies, which did not devalue against gold. Arbitrageurs, dealers who bought in one market to sell in another, then bought gold in Europe for the equivalent of $20 and then sold it at $35 to the U.S., causing the U.S. to acquire 26,000+ tonnes of gold ahead of WWII and inflating their money supply way beyond what the impact of the confiscation of gold had two years prior to that. After the war, while the gold window was open, gold from Europe returned there at higher prices as war was no longer a threat.
‘Floating’ Exchange Rates
When the U.S. closed the gold window in 1971, exchange rates began to move from their fixed levels to those that reflected the trade and capital flows more accurately. This was commonplace in Europe. For instance, you knew that the German Mark was going to be revalued when the Bundesbank informed the public they would not revalue. But the capital and trade flows forced their hand, and they had to revalue. It was on a ‘bet’ like this against the British Pound that George Soros made a billion pounds almost overnight, last century.
Then the Italian Lira was on a permanent slide to lower levels reflecting their profligacy. Likewise, the French Franc was the object of repeated devaluations during the seventies. But each time a country revalued or devalued, it was thought to reflect the entire Balance of Payments position. Even then the Deutschmark got stronger and stronger while others got weaker and weaker.
The theory included the concept of the ‘J-curve’, which said as a currency weakened, the export product prices of a county became more competitive and exports rose. Each time a currency revalued its export, prices rose. The theory postulated that this would even out trade flows and ensure that capital stayed in the banks of weaker countries, so that one country would not attract all the capital and dominate export markets.
Then they used to be thought of as reflecting the Balance of Payments –both trade and capital—in markets that naturally found their own levels and reflected the ‘so-called’ value of a currency.
‘Dirty Floating’ exchange rates
Then central banks agreed that it would ‘stabilize’ exchange rates more effectively if they could intervene in their currencies foreign exchange markets. At least this would prevent brutal exchange rate moves. The ideal way to do this, and to restrain the more aggressive of speculators, was to intervene without warning so as to catch speculators out and deter them from hurting the nations involved.
Eventually this was just not enough as the efficient manufacturers of northern Europe made the finances of their nations strong, and the inefficient nations to the South kept getting a competitive advantage through their inefficiencies.
In 1999 in an innovative way to halt this process, “United Europe” was formed with a common currency. This was even better than a fixed exchange rate because with one currency among 17 nations, there could be no revaluations or devaluations!
So over the next decade and more, in this revolution, the formation of the euro was a major currency manipulation. The political aspect of the formation of the E.U. obscured this, but the net result was that the strong nations prevented the lifting of its currency (as happened with the Deutschmark continually before the arrival of the euro) because they had the same currency. This has allowed the wealth of the South, including the loans they took out, to return to Germany and other strong nations in the North. But it was a huge act of self-interest for the stronger members.
What must be pointed out is the more sophisticated methods of managing exchange rates by the Fed and the E.C.B. who currently use ‘swaps’, which is borrowing each other’s currencies for use in ‘adjusting’ exchange rates. This has removed any brutal moves in exchange rates so far, holding the euro to dollar exchange rate between $1.2 – $1.40 over the last few years.
But the most recent action in this revolution came from Switzerland and Japan. It was natural that wealth sought a place to hide protected from a loss of value. Safe-haven currencies were sought and as they had such strong Balance of Payments Japan and Switzerland became the targets. That is until the last two years at which time they too decided that it was expedient to force their currencies lower through Q.E., selling their currencies and other acts of self-interest to protect their exports and to boost their economies. Let’s be clear –these two governments and their central banks embarked on programs to directly weaken the exchange rates of their currencies in favor of exports.
Now there is no such thing as a ‘safe-haven’ currency! You can be sure that the statement from the G-7 will be ignored and likely by their own members.
But the world of currencies is changing, as all nations are fully aware. The main change came as the impact of the development of China started to impact the global economy heavily…
Arrival of China
Many will say that “China started it!”, but the Chinese Yuan is not yet an international trading currency. China pegged itself to the U.S. dollar which allowed them to improve their competitive position through the export of cheaper goods than could be produced in the developed world. They kept the ‘peg’ at a level that brought forward calls of currency manipulation (but their very low wages was a key factor in the cheap export pricing). This even the U.S. did not validate by deeming the Chinese government as a “currency manipulator” as the Chinese then allowed their currency to appreciate 8.8% in the last two years from 6.84 to 6.23 Yuan for $1. In real terms, this is a token gesture.
But over the last two years, China has been slowly building up its expertise in using the Yuan internationally through a series of contracts with key trading partners such as Australia and Russia where the Yuan is now used in that bilateral trade. The next step is for China to take the Yuan to the next level and use it as their global trading currency in place of the USD, at least where non-U.S. trade and where it does not suit them to use their dollars. (We expect for imports to lower the dollar’s percentage of their reserves.) It is only a matter of time, when it suits China to do so before China lets the Yuan become a global reserve currency.
So what exchange rate would China like to see for the Yuan against the USD? Why is it a pertinent question? Because it will be entirely China’s decision, one that will suit their interests alone. They will decide how many Yuan will be released into the market at that point. This will dictate the exchange rate too.
China has been encouraging its citizens to buy gold so will not want the Yuan price of gold to fall because of the Yuan exchange rate. We also know that they will want to protect their international trade competitiveness too. But they will not follow the developed world’s dictates unless it suits them to do so. All of this points to the same, or weaker, USD exchange rate as we are seeing now. Meanwhile their policy of using their dollar reserves for paying for imports will remain intact until these reserves are much lower.
Currency ‘War’ or ‘Revolution’?
We are all becoming familiar with the term Currency War. But we feel this is more of a revolution than a war. After all a war usually has two sides that battle each other. In a revolution, it is authority that is the target and self-interest the objective. Quantitative Easing, encouraging the loss of value in currencies and any actions that result in the manufactured fall in exchange rates, are the weapons of this revolution. On top of this, the most powerful seven nations issue a duplicitous statement that says that, “the macroeconomic policies (of this seven) will be conducted based on domestic objectives and will not be used to target exchange rates”. Now you can be sure the process will carry on from top to bottom on an ongoing basis.
No longer will nations attempt to keep their exchange rates related to the condition of their Balance of Payments, but the statement from the G-7 will allow for internal policies that do lead to exchange rates being lowered!
The Revolution’s Beginning
It was in the U.S. that the revolution started surreptitiously. A policy of exporting dollars in vast amounts began after the war. That was when President Nixon closed the ‘gold window’ forcing foreigners to keep their dollars. This worked because everybody had to pay for their oil in dollars, so they weren’t stuck with them. But the perpetual Trade Deficit of the U.S. that followed was a supreme act of self-interest (the exorbitant privilege) and the only reason that the dollar has not fallen over the last few decades is that outside nations re-invest their massive dollar surpluses back into the States. But once they become convinced that interest rates will rise, the capital flow back into the States will drop like a stone. The U.S. can only then hope that they have turned their perpetual Trade Deficit back into a surplus through oil, exports, etc. If they haven’t, then watch the dollar fall! It may well be that foreign Treasury owners will then sell their bonds too while the value of the dollar then holds up.
Today the U.S. is debasing the dollar and doing so knowingly, while ignoring its exchange rate; Federal Reserve Chairman Ben S. Bernanke has unleashed the power of the central bank to buy unlimited amounts of Treasury and mortgage-backed securities in a bid to end a four-year period of unemployment above 7.5%.
The European Central Bank has pledged to buy unlimited quantities of government bonds if necessary to save the euro, while the Bank of Japan said last month it will shift to open-ended asset purchases next year.
The system of currencies has already degenerated to looking out for No. 1. It will lead to the fragmentation of the global monetary system as we now know it.
In revolutions you have chaos, which spreads across the nation until systems are brought down. Once the feeling that this is on the way, confidence in the overall system will collapse. Trust between governments and their banks suffer badly. Mobile, internationally-accepted replacements for national currencies will be brought solidly back into the system. Gold is the prime one of these. But it will have to represent a ‘value-anchor’, measuring values, as well as serving as the one asset that will ensure that nations do perform as they promise to. The loss of the gold reserves will still be the same as the loss of the family jewels.
This is why the World Gold Council sponsored report by the O.M.F.I.F. came to their conclusion that gold will move back to a pivotal position in the monetary system. Its need will be at its greatest, as the Yuan arrives on the scene.
These consequences will also have ripple effects that will produce additional ripples. Banco de Mexico Governor, Agustin Carstens, expressed it in this way, “My fear is that a perfect storm might be forming as a result of massive capital flows to some emerging market economies…Risk appetite among investors has returned and the search for yield is in full force. Concerns of asset-price bubbles fed by credit booms are starting to appear. This could lead to bubbles, characterized by asset mispricing, and then face a reversal in flows as the major advanced economies start exiting their accommodative monetary policy stance.”
The ‘carry trade’ is blossoming as monetary easing from Japan to the U.S. spurs demand for higher-yielding assets and boosts inflows into emerging markets.
Russia warned last month that Japan’s currency-weakening policies may lead to reciprocal action as nations try to protect their export industries, while South Korea and the Philippines have said they’ll consider how to reduce the impact of such funds.
Carstens said, “We have to live with this unconventional monetary policy in the largest economies. We need to take care of the hazards that these inflows represent from the financial vulnerability point of view.”
Philippine central bank Governor Amando Tetangco said he’s studying more measures to counter excessive capital inflows lured by growth.
South Korea is to consider taxes on currency trading and bonds to help limit “speculative” inflows of capital.
M.D. of Singapore’s central bank said, “We need to avoid competitive currency devaluations. Past episodes of currency friction have only led to more misery and further downward spirals.”
Gold to be Chased After!
A return to using gold to facilitate and produce greater levels of liquidity and generally shore up the current global monetary system is on the way, despite its being studiously ignored at present.
Once this happens the race to get as many ounces of gold into the central bank and the banking system itself will be on. How will this happen?
There isn’t enough free market supply to feed this demand. Only higher prices that precipitate selling of currently held gold will increase this amount. If the banking system joins the picture, then substantially higher supply will be needed, which will bring with it substantially higher prices.
One way nations will increase their holdings is for nations that produce gold to take local production directly into their coffers. This will lower newly mined supplies of gold even more than at present. We do believe that China is doing this already, but will be followed by others. Canada with so little gold currently has a good amount it can harvest locally. Such a drop in supply will take gold prices higher until ‘scrap sales’ of gold become the main source of supply.
We also expect to see more and more developed and emerging world central banks repatriate their already owned gold out of prudence and as Carstens of Mexico said, “We need to take care of the hazards that these inflows represent from the financial vulnerability point of view.”
But then the cheapest source and perhaps the largest source of gold a nation has is the gold of its own citizens. In such times of monetary need we have no doubt that, out of concern for the nation’s financial security, the confiscation of their citizen’s gold will happen.
And not just as a currency collapses, but ahead of it, when payment in that currency is viable to the holders of that gold. Just as the confiscation of gold in 1933 was ahead of 1935’s devaluation of the dollar for money supply purposes, so a future confiscation will happen ahead of the major devaluation of a nation’s currencies.
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