Dollar Thrives in Age of Competitive DevaluationsA. Gary Shilling
Jan. 29 (Bloomberg) -- In periods of prolonged economic pain -- notably the 2007-2009 global recession and the ensuing subpar recovery -- international cooperation gives way to an every-nation-for-itself attitude. This manifests itself in protectionist measures, specifically competitive devaluations that are seen as a way to spur exports and to retard imports.
Trouble is, if all nations devalue their currencies at the same time, foreign trade is disrupted and economic growth is depressed.
A country can intervene directly in markets by selling its own currency as a way to reduce its value or stop it from getting stronger. Switzerland has been pegging the franc at 1.20 euros to prevent increases in the exchange value from cutting into its exports to euro-area countries. In November, South Korea’s central bank sold won to buy at least $1 billion in foreign currencies to contain the steep gain in its currency.
Decreasing the value of a currency is much easier than supporting it. When a country wants to depress its own currency, it can create and sell unlimited quantities. In contrast, if it wants to support its own money, it needs to sell the limited quantities of other currencies it holds, or borrow from other central banks.
The extent of currency interventions is measured by the jump in global central-bank foreign-exchange reserves to $10.53 trillion in mid-2012, from $6.7 trillion in 2007, according to the International Monetary Fund. Switzerland has shown the largest increase.
Nevertheless, currency interventions have seldom had lasting effects, as shown by unsuccessful Japanese efforts in recent years that failed to depreciate the yen.
Easy central-bank policy, especially quantitative easing, may not be intended to depress a currency, though it has that effect by hyping the supply of liquidity. Also, low interest rates discourage foreign investors from buying those currencies. Prime Minister Shinzo Abe has accused the U.S. and the euro area of using low rates to weaken their currencies.
“Central banks around the world are printing money, supporting their economies and increasing exports,” Abe said recently. “America is the prime example. If it goes on like this, the yen will inevitably strengthen. It’s vital to resist this.”
It seems clear, however, that the Federal Reserve’s objective is to spur U.S. economic growth and increase job creation, not to depreciate the dollar. Furthermore, Treasuries and the dollar are the ultimate havens, regardless of Fed policy.
Still, Abe’s response has been to seek retaliation and to press the Bank of Japan to pursue “unlimited easing” to restrain the yen until deflation turns into inflation of about 2 percent a year. And he has threatened to end the BOJ’s independence, which it has had only since 1998, if it doesn’t come to heel. The central bank has complied by raising its inflation goal to 2 percent from 1 percent.
The BOJ forecasts inflation at only 0.9 percent for the fiscal year starting in April 2014. It’s hard to believe that staid central bankers who congenitally hate inflation want it to return, but that is what they must do if they value their jobs. The Abe government has the supermajority in the lower house of the Diet needed to override the upper house, and can appoint a majority bloc on the nine-member BOJ policy board. The prime minister also has revived the Council on Economic and Fiscal Policy to further pressure the BOJ.
The central bank plans $113 billion in additional asset purchases, though not until 2014 and after the current $1.2 trillion program is completed this year. The slower pace of the new acquisitions may reflect criticism from Europe and elsewhere of Abe’s overt competitive devaluation plans and the already-curtailed independence of the BOJ.
Abe also plans more fiscal stimulus to revive the recession-prone Japanese economy, and says he won’t be bound by the previous administration’s $511 billion cap on government-bond issuance. That will obviously add to Japan’s huge government debt, and Japanese bond yields are rising in anticipation.
Regardless of the Abe government’s plans, I continue to believe that the yield on Japanese government bonds will be much higher in the long run. Until now, Japan has had enough domestic saving, from households in the 1990s and from business more recently, to fund its huge government deficits and still have money to export. That surplus is measured by the current-account surplus. Because all but 8.7 percent of government bonds are owned domestically, interest rates are isolated from global markets and remain very low, making it easier to finance the massive public debt, which was 126 percent of gross national product in 2011, net of intra-government lending.
Yet Japan’s trade balance is now negative and the current-account balance is likely to follow suit. Like export-driven economies, Japan is suffering as the European recession deepens and slow growth persists in the U.S. Japan is importing materials to rebuild after the March 2011 tsunami and earthquake. It is also importing energy to substitute for the closed nuclear reactors, though Abe wants to review nuclear-energy policy.
As government bonds mature and are replaced by higher-cost imported capital, the interest on government debt will leap. Depending on your assumptions for Japanese government-bond rollovers, market reactions and BOJ activity, you can get almost any result you want. But there is a distinct possibility that the leaping interest rates on Japanese government debt will add so much to the deficits and debt that an uncontrollable spiral will unfold. It would take years to roll over a significant part of government debt at higher international interest costs, but markets anticipate.
In anticipation of Abe’s Dec. 16 election landslide, the yen started to weaken as investors bid up stocks, envisioning a much more profitable era for Japan’s exporters. In the first half of 2012, a total of 51 Japanese companies with heavy debt and significant exposure to the strong yen went bankrupt, twice the number in the previous four years. And exports are the key to Japan’s economy as they rise and fall in step with gross domestic product. Because Japan is the world’s third-largest economy, behind the U.S. and China, other countries are watching and may emulate Abe’s currency-busting plans.
The South Korean central bank said it would look at the configuration of the economy, especially the crucial export sector, in reviewing its interest rates each month. Despite weak commodity prices, the Australian dollar has been strong, precipitating calls for more monetary ease as manufacturing and tourism suffer. And China, which has succumbed to immense foreign pressure to allow the yuan to appreciate only in good times, still holds the currency flat when times are tough in order to aid the exports that continue to drive the Chinese economy.
Brazil’s economy isn’t exclusively export-driven, though it is commodity-oriented and therefore at the mercy of subdued Chinese manufacturing. And the Brazilian government has been doing whatever it thinks is necessary to protect domestic business, first raising interest rates as inflation and the economy heated up three years ago, then cutting rates as global economies cooled, and then taking steps last September to prevent the real from appreciating after the Fed undertook its third round of quantitative easing. Brazilian economic growth dropped to about 1 percent in 2012, from 2.7 percent in 2011 and 7.5 percent in 2010.
Competitive foreign-exchange devaluations always pit one currency against others. Since competitors often retaliate, no country wins and all lose because of the disruptive effects of this dynamic on foreign trade. This model is valid if all currencies are essentially on the same footing, but it collapses when one, specifically the U.S. dollar, dominates as the primary international trading and reserve currency. That makes competitive devaluations of the dollar difficult.
A review of history reveals six characteristics of a dominant global currency, and the dollar is likely to meet the criteria in at least five of the six for many years.
Rapid growth in the economy and GDP per capita, promoted by robust productivity growth: In the last decade, the U.S. has excelled among developed countries and its emphasis on entrepreneurial activity and superiority in new technologies suggest this lead will persist.
A large economy, usually the world’s biggest: With rapid productivity growth and relatively open immigration, the U.S. will probably continue in this role. The population is falling in Japan, a trend that will soon emerge in other developed lands as well as China with its one child-per-family policy.
Deep and broad financial markets: U.S. stock-market capitalization is four times that of China, Japan or the U.K. and is more than three times that of the euro zone. Almost 50 percent of Treasuries are held by foreigners. As noted above, just 8.7 percent of Japan’s government net debt is owned by non-Japanese.
Free and open financial markets and economies: These conditions persist in the U.S. but are more fragile in Europe after the debt crisis. China will probably continue to tightly control its financial markets and currency, which is anathema for an international trading and reserve currency. Chinese leaders are so worried about losing control of the Internet that they now require users to give their real names when signing up for online services. Also, illegal information, which can be broadly defined by officials, must be removed by service providers and forwarded to the authorities. In China, Big Brother isn’t just watching, he’s reading e-mail, too.
Lack of substitutes: The rigidly controlled Chinese economy and financial markets eliminate the yuan as a rival to the dollar for the foreseeable future. Export-dependent and inward-looking Japan doesn’t want the yen to be a primary global currency. And the European crisis eliminated the euro for at least a number of years. The U.K. is a relatively small economy, which curbs the pound’s appeal, and the solid Swiss franc is now tightly controlled.
The credibility of the dollar has been strained by its overall decline since 1985, but still is substantial. The troubling U.S. current-account deficit will probably shrink as retrenching consumers moderate imports and U.S. production becomes increasingly competitive and the nation moves toward self-sufficiency in energy.
In effect, competitive devaluations will ultimately work against the U.S. dollar. This will only add to the currency’s luster as the only haven in an uncertain world.
(A. Gary Shilling is president of A. Gary Shilling & Co. and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the second in a five-part series. Read Part 1 and Part 3.)
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