Is the currency war over?

November 1, 2010

The communiqué from last week’s IMF G20 finance minister’s meeting was the first step in trying to resolve the so-called global currency war. The ministers released a joint statement on October 23 which pledged that all countries would “move towards more market determined exchange rate systems that reflect underlying economic fundamentals and refrain from competitive devaluation of currencies.”

Even fears that the U.S. and China could have a bust-up over the U.S.’s charge that the renminibi is undervalued relative to the U.S. dollar were put to bed when it was reported that Treasury Secretary Geithner popped in to China on his way back from the G20 in South Korea to meet Chinese Vice Premier Wang Qishan.

While there was hope that a full-blown war could be avoided, reports were soon hitting the wires that South Korea (the host of this year’s G20 meetings) was back intervening in the FX markets to weaken the won, which has strengthened more than 10 percent against the U.S. dollar since June. Later in the week South Africa joined Brazil, Indonesia and Thailand by announcing measures to stem the value of its currency by loosening domestic capital controls to get money flowing out of the country rather than pumping up the value of the rand, which has appreciated by 12.5 percent against the dollar in five months. So beggar thy neighbour policies are still alive-and-well even after the G20 finance ministers’ show of unity over exchange rates.

If you boil down the currency war to its crudest form then you’ll get emerging market countries with positive financial positions and strong growth trajectories lamenting the weakness of the dollar, which has been falling in value since making a high in June. They are concerned that further quantitative easing from the Federal Reserve will only cause the dollar to fall even further. In contrast, authorities in the U.S. are unlikely to talk up the dollar until they see some meaningful commitment from Beijing to allow the renminbi to appreciate.

Reaching an international FX accord is going to be an incredibly difficult thing to achieve due to conflicting view points and each country thinking they are right to protect their own economies first and consider global FX harmony second.

This might sound like the chances of a resolution are remote and we’ll lurch from one diplomatic nightmare to the next. But luckily the FX market is deep enough and liquid enough to swallow political rhetoric and set its own rules. Ultimately the currency war will be solved by the markets: genuinely weak currencies will continue to weaken, while undervalued currencies will strengthen.

There are tentative signs since the G20 finance ministers’ meeting that this has already started to happen. Some dollar short positions have been unwound as investors get nervous that the Fed won’t turn on the monetary taps indefinitely when they meet on November 2-3. This has put upward pressure on the greenback, which has risen by more than 0.5 percent this week, stemming its losing streak. Likewise, the Swiss franc has fallen as the economic outlook continues to deteriorate. The pound also had a stellar run, after economic growth surprised to the upside in the third quarter, thereby easing expectations that the economy may need more monetary support. Not even the Bank of Japan can stem the rise in the yen while investors continue to pile into the Japanese currency. Who knows what the market will do next, but if the euro continues to strengthen, which then hurts growth in the Eurozone, it could be investors’ next target.

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