The Great Debate UK

Ten years on – is it the end of the 9/11 moment?

-Sir Robert Fry is chairman of McKinney Rogers. His career in the British military includes being director of operations in the Ministry of Defence, advising then prime minister Tony Blair on the military strategic direction of the UK’s response to the September 11 attacks. The opinions expressed are his own.-

In his recent book “On China”, Henry Kissinger rather immodestly, but entirely knowingly, echoes the title of Clausewitz’s seminal work, “On War”. If you’re Henry Kissinger, you can do that. If you’re Henry Kissinger you can also offer a view of unrivalled authority on the politico/strategic landscape of the modern era, which is why his suggestion that China in the 21st Century might reprise the role of Germany in the 20th demands some attention. After the pre-occupation with terrorism of the last 10 years, this sounds rather different. Political ends may be timeless, but the means to prosecute them are rapidly changing, and currency, water, cyber and nuclear instruments may be the weapons of the post 9/11 era.

Chinese maritime capability now includes a missile inventory with the capacity to deny sea control in the Asian littoral to U.S. carrier groups, but why would China pick a conventional fight when its ownership of U.S. foreign debt offers profound strategic leverage without a shot ever being fired?

Timothy Geithner, speaking after the fall of Lehman Brothers, first raised the spectre of currency wars with charges that China was manipulating the yuan in a form of exchange rate mercantilism. But this is a complex and ambiguous area and Sino/American relations are underwritten by what looks like a re-run of the Cold War concept of mutually assured destruction, with the greenback playing the role of nuclear weapons: any large scale dumping of Chinese dollar holdings would not only torpedo its role as a reserve currency, but also devalue remaining Chinese reserves, leaving both nations in a mutually dependent financial embrace.

A more immediate cause of conflict is the voracious appetite of emerging economies for resources; above all, water. The Nile Basin, the swathe of the Middle East fed by the Tigress and Euphrates and, perhaps most important of all, the Tibetan headwaters of the North Indian river systems all provide potential flashpoints for inter-state confrontation, with the last of these coinciding with a Sino/Indian territorial dispute – water will be a weapon in its own right; it is also likely to be the recurring pretext for the use of others.

While water wars are in prospect, cyber wars are a reality. With the capacity to bring down critical national systems, cyber weapons succeed nuclear weapons in their capacity for mass effect; but unlike nuclear weapons, which have been used only twice in human history, cyber weapons are used on a daily basis, targeting everything from private bank accounts to national infrastructure. It is this very ubiquity that makes it difficult to distinguish between a criminal act and enemy action, and if the crooks, geeks and cyber terrorists are to be isolated a formal and declaratory deterrent framework may be necessary to distinguish the enthusiastic amateur from the determined state actor.

Germany at the crossroads

By Laurence Copeland. The opinions expressed are his own.

Baby-boomers like me, who grew up in the shadow of World War II, have to acknowledge with gratitude that the Germany which again dominates Europe is in most respects a model democracy – multiracial, prosperous and contented. However, there is one worrying aspect of the German mentality which seems to have survived intact from its unhappy history, and it is an aspect which is likely to be tested to the full in the coming weeks and months.

From the moment when the Maastricht Treaty was dreamed up in the early 1990s to the inception of the euro zone in 1998, Germany had any number of opportunities to kill the project off and indeed, time and again, policymakers in Bonn or Berlin or Frankfurt voiced their reservations in public. The Bundesbank, in particular, with its overwhelming prestige, spoke out forcefully against what it saw as the dangers of premature monetary union.

Yet, while Tony Blair, who dared to take Britain to war in Iraq in the face of overwhelming public opposition, nonetheless baulked at taking his country into the euro zone without a referendum, and while France actually had one (which the pro-Maastricht side only won by a whisker), Germany’s leaders felt no such need. On the contrary, Chancellor Kohl famously rejected the idea of consulting his electorate on the grounds that, if the opinion polls were to be believed, he would almost certainly lose.

What is it about the Germans that makes them willing blindly to follow a leader, even though they fear he is taking them over a cliff? Am I alone in finding this a worrying national peculiarity?

I raise this question now because the problem of what to do about Greece means that Germany stands at another fork in the road. Forget the technicalities and the small print, important though they are, and focus on the critical issue of principle which precedes it: is Germany going to give in and allow some form of fiscal integration to be introduced by the front door (unlikely), by the back door, the tradesman’s entrance or the catflap? It is coming under increasing pressure to do so from all sides – euro-politicans, commentators, economists, right-thinking or unthinking members of the chattering classes – in fact, almost everyone except those who will end up footing the bill i.e. the taxpayers of Germany itself, who for some obscure reason are a lot less enthusiastic.

This may be the last chance for Germany. One shudders to think what will happen if Germans are saddled with supporting the rest of Europe in perpetuity – which is what is involved, as Frau Merkel seems only too well aware.

Units and unities: can currency change really resolve the Greek tragedy?

As the Greek tragedy goes into what looks like its final act, there is increasing talk of the country leaving the euro zone and refloating the drachma. Perhaps the Athens street mobs favour this “solution”, but what would it involve, and would it work?

It is a bizarre situation, without precedent as far as I am aware (though I am no economic historian). Usually, new currencies are introduced to replace old ones which have become discredited (typically after hyperinflation), whereas here we are talking about the absolute opposite: abandoning the euro because it is too strong, in favour of a new drachma, which will be a weak currency by design – rather like launching a ship, in the hope it will sink!

Equally bizarre is the fact that many people seem to think this course of action will somehow be less painful for ordinary Greeks than the austerity measures being demanded by the IMF, EU and ECB. But just consider what is involved.

The immediate problem would be the changeover mechanism. New currency launches take time, normally many months or even years, so even if this reversion to the drachma can be rushed through at Olympic speed, we must surely be thinking of January 2012 at the very earliest. But what happens in the interim? The situation could be completely unmanageable.

In the first place, Greek savers are not going to wait around while their cash, bank deposits and other assets are forcibly converted into drachma (and their banks go bust too). Instead, they are going to do everything in their power to put them beyond the reach of the Greek monetary authorities, which may simply be a matter of moving their accounts to foreign banks, if they haven’t already done so, or possibly something more sophisticated or devious. (In any case, you can be sure middle-class Greeks will already have had years of practice at hiding funds from the taxman).

In fact, since, legally or illegally, euros will continue to circulate long after a new currency is launched, the only feasible way to refloat the drachma is in a dual-currency regime in which, at least initially, drachma are only used for transactions involving the government and nationalised industries. So, for example, civil service salaries and welfare payments could be paid in drachma, which would then be accepted by the government-owned utilities, and presumably by banks, which would have to be nationalised, de facto if not de jure. The private sector would then use drachma alongside euros, which would for the foreseeable future remain the currency of choice for all their big-ticket transactions.

Post-hyperinflation experience in Latin America, Israel and Eastern Europe suggests that this sort of dual-currency scenario can be as stable and durable as any other type of regime in the unstable world of international monetary arrangements.

Would the euro solve Switzerland’s problems?

By Kathleen Brooks. The opinions expressed are her own.

While some market commentators are questioning if the euro zone should even exist, authorities in Switzerland might be looking with envy at the 27-member currency bloc.

But why would a nation as renowned for political as well as financial stability like Switzerland desire the euro? The chief benefit is for its export sector.  Swiss companies including watch marker Hublot have complained recently about the strong Swiss franc weighing on their competitiveness. And watch markets are not alone. Exporters in sectors as diverse as cheese and chocolate to engineers, pharma companies and chemical firms are all suffering from the same problem: a strong franc.

In its last quarterly bulletin the Swiss National Bank (SNB) forecast weakening growth throughout 2011 due to increased competitive pressure and narrowing margins for many Swiss export firms. Indeed, it noticed a considerable slowing in momentum in exports since spring 2010, which it claimed was directly attributable to the Swiss franc. The currency has appreciated more than 20 percent versus the dollar in the last year and 10 percent versus the euro.

The Swiss economy relies heavily on exports to generate its wealth for two reasons. One, it has virtually no natural resources to rely on to generate income, and two, the size of its population is tiny at just under 8 million. So Swiss companies need to look abroad to generate demand. Luckily foreign markets love Swiss goods, which is why its current account surplus is more than 14 percent of GDP.

Finances like these as well as a stable political system and low inflation have boosted the attractiveness of the franc in an uncertain global environment. But these virtues are now eroding the country’s competitiveness.

Since the  euro zone and in particular Germany is the largest trading partner of the Swiss, sharing the same currency would negate this problem. But would the Swiss want to join the euro zone that is plagued with sovereign debt problems in its periphery? This is obviously the downside, especially since Switzerland would have to contribute to bailout funds including the European Stabilization Mechanism if it were to join.

from Breakingviews:

Low expectations should make China do more on yuan

By Wei Gu

The following article is part of Reuters Breakingviews' e-book, Predictions for 2011. The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

HONG KONG -- The Chinese currency rose just 3.6 percent in 2010. As political pressure ebbs and euro zone trouble spreads, traders now expect an even smaller gain for 2011. Beijing has said it wants to make the yuan more flexible. If it really means that, low expectations create a window of opportunity.

The People's Bank of China managed to hold the yuan tight even in a year of high political pressure. Despite stern rhetoric from U.S. politicians ahead of mid-term elections and two G20 meetings, the currency strengthened 2.8 percent on a trade-weighted basis as at the end of November 2010. By contrast, the yen, Thai baht and Malaysian ringgit each rose 11 percent against the dollar in 2010.

Less external pressure for Beijing in 2011 may lead to complacency. The threat of U.S. trade tariffs and G20 pressure both produced small upticks in the yuan. But the U.S. Treasury has delayed the currency report that might label China as a currency manipulator. The Senate and Congress failed to pass punitive bills on Chinese trade before mid-term elections. As for pressure from G20, France, the host in 2011, has been encouraging China to style the yuan as a reserve currency, so may be less inclined to complain about the exchange rate.

Besides, China's authorities have other things on their minds. China's next leadership reshuffle is scheduled to take place in late 2012. The debt crisis in the European Union, China's biggest export buyer, has not been resolved. Chinese exports fell 6 percent in the month of October. These things help explain why non-deliverable yuan forwards are pricing in just 2.3 percent appreciation, around the lowest level in a year.

But this might in fact be the best chance for China to make changes to the yuan for its own good. Beijing could strengthen the currency more without appearing to reward speculators, or cave in to foreign pressure.

Is the currency war over?

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.

Is there a way out of the currency war?

Competitive devaluation is no longer a possible danger – it is already here. Many people are worried that, after global stock market crashes and a collapse of most of the world’s banking system, a war over exchange rates completes a sequence of events that looks awfully like a rerun of the 1930’s. There is however one crucial difference. The Chinese role certainly makes matters more complicated, though it is as yet unclear whether it makes the outlook better or worse.

The key point to understand about the belligerents is this. In the context of purely self-interested beggar-my-neighbour economic policy, devaluation makes good sense for the Eurozone countries as a whole, the British, the Japanese, Swiss, Koreans… for everyone except the Americans. Whether they are deficit countries, like Britain, or surplus countries, like Switzerland, Korea or Japan, devaluation will increase demand for their exports and make their imports more expensive, giving a boost to their output and employment. And if other countries retaliate by counter-devaluation, they can tell themselves that their situation would have been worse if they had not taken the initiative and got their retaliation in first.

By contrast, America’s situation is very different. As long as China keeps its exchange rate more or less fixed, the dollar is not a wholly US currency – it is the currency of two countries, one massively in deficit , and one massively in surplus. The fact that they are separate countries in every other respect makes no difference. De facto, China and USA share a single currency every bit as much as France, Germany, Italy, Greece and the rest share the same currency, the Euro. The only difference is that in the Eurozone everyone uses Euros, whereas in the dollar zone the overwhelming majority use a dollar-certificate, a piece of paper bearing a picture of Mao Tse-tung and exchanging for about 15 U.S. cents.

It is hard to understand why China has voluntarily accepted this arrangement, which forces it to accept whatever monetary policy the U.S. Federal Reserve chooses. In any case, the implication is that the dollar cannot be devalued against one of its most important trading partners, because the two of them are bound together in a de facto currency union. In its desperate attempts to shake China off, like a celebrity trying to shake off a stalker, the Fed is printing more and more dollars, which are used by America’s consumers to buy more and more Chinese exports, thereby sending the new dollars flooding into China to swell the reserves of the People’s Republic, which must now be approaching $3trn.

There are two consequences of this linkage. First, it is the struggle over the dollar/RMB which has caused the other countries to devalue their currencies. The more the US drives down the value of the dollar, the more the exchange rate of the RMB is dragged down relative to all the other currencies, so the harder it is for third countries to live with the competition from ever-cheaper Chinese products. It was hard for them before, but with a cheaper RMB, life becomes impossible – so the Japanese try to devalue the Yen, the Swiss start to push down the value of their currency, and the Pound had already fallen a lot by the end of last year. In a sense, these other currencies are caught in the crossfire of the U.S.-China war.

The second consequence is this. China has now made a heavy investment in disaster. In the last few years, the world’s supply of dollars has expanded many many times faster than the U.S. economy. The result would have been a collapse in the value of the dollar, if China had not chosen to accumulate the massive excess supply in its own reserves.

Like second marriages, fixed exchange rate systems represent the triumph of hope over experience. History shows that in the end the dike never holds back the flood. When the dollar’s value collapses and the upward pressure on the RMB can no longer be resisted, China will suffer double pain – facing increased trade competition from a near-bankrupt USA with the dollar at its lowest-ever level, and at the same time losing hundreds of billions, possibly even a trillion dollars or more through the fall in the value of its reserves in terms of RMB (or indeed in terms of any currency other than dollars).

Does the world need more QE from the Fed?

- Kathleen Brooks is research director at forex.com. The opinions expressed are her own -

The minutes from the Federal Reserve’s September meeting seems to suggest that more quantitative easing is a done deal for November. So far, the argument has centred on whether or not the U.S. economy needs another shot in the arm from the Fed to boost growth. The Fed certainly thinks it does. According to the minutes “many” members felt that the status quo – sluggish growth, inflation grinding lower  and no sign of a recovery  in the jobs market – was enough to justify more easing in policy.

These are pretty compelling reasons for more QE to stimulate the flagging U.S. economy, but what about the rest of the world? Any action by the Fed has huge implications for the global economy. Usually, when the Fed shifts its stance from easing to tightening or vice versa it starts a global chain reaction.

But now that we are in unusual times, the Fed’s actions are even more important. Turning on the printing presses will have three main consequences. Firstly, it may not have the desired effect on the U.S. economy. If it doesn’t make companies hire more staff, and corporations continue to sit on huge cash piles, then the liquidity generated by the Fed will start to seep out of the US economy.

If you can borrow cheaply but don’t want to expand your business, perhaps because you don’t have strong enough faith in U.S. householders who are busy retrenching and paying off debt rather than spending, then you’ll chase returns elsewhere. This will create liquidity bubbles. The immediate beneficiaries will be stocks and commodities. We have already seen gold reach new highs, and equities are looking like they are popping up. It’s great if you are at the receiving end of the liquidity, however if you are not, then you’ll be left out in the cold.

If the U.S. doesn’t boost demand with more QE, then domestic retailers will soon feel the chill of prolonged high unemployment. Likewise, if the money chases investments in high-growth economies, then it will leak to emerging markets, by-passing the sluggish, debt-laden west.

Capital inflows to emerging markets is what is fuelling the so-called “currency war”. While capital flows will put upward pressure on local currencies across emerging economies, the market hasn’t been focusing on the real problem – the prospect of Fed money fuelling the next financial bubble. In this sense, authorities including Brazil and Thailand who have imposed capital rules to try and stem the flow of money into their asset markets, have done not only to keep their export markets competitive, but also to prevent unsustainable asset price bubbles.

Waiting for the other shoe to drop

-Laurence Copeland is professor of finance at Cardiff University Business School. The opinions expressed are his own and do not constitute investment advice. -

The unemployed and the terminal insomniacs who have nothing better to do than read my blogs will know that I have long been gloomy about most of the Western economies. How can you fail to be pessimistic when the world economy is still dominated by the U.S. – a basket case, becoming weaker every day, with a political class too blind or too scared to admit in public the obvious fact that the country cannot carry on living beyond its means?

Now house prices are plunging again and, with the dollar still strong, the prospects for an export-led recovery look bleak. In fact, a return to recession is far more likely, and the markets are starting to show signs of that sickening here-we-go-again feeling.

How will it all end?

Anyone who claims to know how this will all play out is on no account to be trusted, but there’s nothing wrong with trying to guess – in fact, that’s exactly what we have to do before we can decide what assets to invest in, or whether to invest at all rather than simply blowing it all on a long bankruptcy binge.

So here goes. I start from the observation that the bond and currency markets, in their infinite lack of wisdom, seem to have divided the whole membership of the United Nations into two classes, high-risk countries and low- (or no-) risk countries.

Bank of England Inflation report offers markets a reality check

-Mark Bolsom is Head of the UK Trading Desk at Travelex Global Business Payments. The opinions expressed are his own.-

Sterling tumbled to a one week low against the dollar in trading this morning, after the Bank of England delivered its latest quarterly inflation and growth forecasts today.

In his speech, Bank of England Governor Mervyn King downgraded his economic growth forecasts and raised inflation expectations, saying he expected inflation would fall well below its 2 per cent target in two years, even if interest rates stay low.

While markets had expected growth forecasts to be lowered, the Quarterly Inflation Report has been a bit of a reality check. The preliminary reading of Quarter 2’s GDP figure had put the markets in a good mood, as it looked like the economy was back on track.

But King was unequivocal in his belief today that the bias of policy was leaning towards additional quantitative easing, rather than monetary tightening.

This confirms the view that the economy is not out of the woods yet, and we’re not in a position to withdraw stimulus or even tighten monetary policy.

King was also very defensive about the Bank’s record of inflation, but they have overshot their inflation target for 42 out of the past 51 months. January’s VAT rise is definitely not going to help either – and they have been forced to increase their inflation forecast.