Competitive Currency Devaluation: The Feeding Frenzy
That the world is grossly overindebted is perhaps an obvious point. But by how much — and why — are less clear. Today total global debt stands at approximately $150 trillion, or 194% of global gross domestic product. And according to a new study by Boston Consulting Group, the developed economies of the world would need to reduce total debt by approximately $21 trillion in order to return to a maximum total debt-to-GDP ratio of 180%, a level considered to be a manageable burden.
This sum, $21 trillion, is almost incomprehensible. It amounts to more than $3,000 for every man, woman, and child on the planet — all 7 billion of us.
How and why is the world in this predicament? As Roger Bootle, the managing director of Capital Economics pointed out at the recent CFA Institute European Investment Conference in Paris, international trade imbalances are one easily overlooked cause of this debt crisis. Such imbalances have fueled excessive debt buildup as deficit countries import more than they export and make up the difference with ever more debt. Theoretically, exchange rates would change in response to — and thus autocorrect — trade imbalances. However, many governments interfere with the free flow of currency exchange in the interest of protecting their export markets. The net result can be a sort of currency feeding frenzy as various countries each try to outdo the other in driving down the value of their currencies relative to competitors.
The Fed’s actions to manage the debt crisis and stimulate the U.S. economy have had the effect of weakening the dollar. And, because the dollar serves as the global reserve currency and the United States is still the world’s largest economy, the Fed’s policy has had global ramifications. For instance, Japan had been experiencing strong appreciation in the yen, so the Bank of Japan has stepped up its efforts to stem the rise of the yen with open market interventions. Within Europe, Switzerland has become very aggressive in defending the Swiss franc (CHF). As the European debt crisis has accelerated, the CHF had appreciated strongly — that is, until the Swiss National Bank (SNB) decided to peg the franc to the euro. Note the recent acceleration of the monetary base in Switzerland, which of course reflects massive money printing.
Source: The Swiss National Bank.
In its official statement, the SNB said it would “no longer tolerate” an exchange rate below the minimum of 1.20 francs per euro and would “enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities.” This is Switzerland’s way of protecting its export markets, and hence its economy.
This isn’t a new phenomenon, of course, as many countries attempt to protect their exports in this environment. Since exiting the gold standard in 1971, the United States has evolved into an “import model” country that consumes more than it produces, as noted in the graph below, which illustrates the dramatic decline in U.S. net exports and consequent rise in net imports beginning in 1996. Over the past 15 years, the cumulative U.S. trade deficit checks in at about $5 trillion, substantial by any measure.
There are two ways to pay for a trade deficit: by liquidating existing assets or by acquiring additional debt. As illustrated in the graph below, U.S. growth has been fueled by the latter — a massive increase in debt. (Not shown here is that there was no corresponding drawdown of assets at any point during the time frame noted above, meaning that consumption was fueled by debt growth and not by liquidation of assets.)
Under a gold standard, trade imbalances correct naturally as deficit nations are forced to deliver or purchase enough gold to compensate foreign trading partners for goods and services that they deliver. However, under the fiat money regime that has been in place for the past 40 years, deficits (such as the U.S. trade deficit) and surpluses (such as China’s) persist over time. The problem is that when one country pegs its currency to another’s — for example, China pegs the renmimbi to the U.S. dollar — currency markets cannot correct the imbalance. As noted by Niall Ferguson in “The End of Chimerica,” the American-Chinese import-export model has reached its limit thanks in part to the world hitting a wall of debt. Moreover, the United States is in a greater position of power as the unwinding of Chimerica leads to larger unemployment in China and greater growth and balance in the US.
National priorities like growing the economy can easily trump the free market mechanism of Bretton Woods II. Unfortunately, none of this occurs in a vacuum. One country’s strong currency is another country’s weak currency. So, the game spawns a competitive frenzy.
In the coming years, perhaps the most critical rate to watch is the renmimbi to the U.S. dollar. Normally, there is an explicit trade-off between domestic inflation and currency movements that central banks attempt to manage. However, this trade-off can be suspended temporarily through the accumulation of debt. The trade-off of inflation and currency movement must resume now that virtually all major economies have hit their debt limit — including China, which has a total debt-to-GDP ratio that may be greater than 200%. (Of course, this is just an estimate as reliable data from China is difficult to find, but evidence of the country’s massive spending on real estate is not. This massive “investment” is clearly visible in the recent development of numerous ghost cities.) As China chooses to fight the appreciation of the renmimbi, it will experience greater inflation, thereby offsetting the country’s cost advantage. Thus, higher prices will reduce the Chinese export business on the margin. In contrast, if China raises rates to quell inflation, it will see its currency appreciate, which of course increases prices to foreign buyers. This dynamic has been offset over the past 15 or so years due to the buildup of debt.
Now that the world has hit a wall, it seems the renmimbi has nowhere to go but up. And if the renmimbi doesn’t go up, then Chinese GDP must slow down. Welcome to the currency wars!