James Rickards in his book “Currency Wars” describes the ongoing struggle between governments to weaken their currencies, and focuses on what he calls the three “supercurrencies”, the dollar, yuan, and euro. Rickards identifies three theaters of this war, the Asian, the Eurasian and the Atlantic theaters. The participants in this war go beyond the respective central banks to include the IMF, the World Bank, the BIS, the UN, and banks, hedge funds, politicians, and MNCs. The current currency war is called Currency War 3, and is following the two previous wars of 1921-1936 and 1967 -1987.
The Asian theater is being fought between the U.S. and China and is considered to be the main front in the various currency wars today. The yuan was seen to be overvalued against the dollar up until 1983, when it stood at 2.8 yuan to the dollar. This allowed the growing Chinese economy, which did not yet have a large export component, to import capital goods for the creation of a modern infrastructure. As the time came for exports to form a larger part of the Chinese economy the yuan was gradually devalued against the dollar so that, by 1993, the exchange rate was 5.3 to the dollar (compare this deft move to the disastrous Import Substitution Industrialization policies in Latin America). On January 1, 1994, China devalued the yuan to 8.7 to the dollar, causing the U.S. Treasury to label China a currency manipulator. China, for its part, seems to be more concerned with the millions of workers it has which are dependent on export based jobs and the political instability which would result if unemployment sets in.
China, eager for cover to control its own Muslim population, supported the U.S. “War on Terror”, which thawed relations between the two countries and allowed an expansion of what Rickards calls investment codependence. This time also saw the initiation of the Fed’s policy of low interest rates, which began in 2000 after the Tech Bubble collapse, where the fed funds rate fell 4.75 percent from July 2000 to July 2002. The fed funds rate stayed below 1.8 percent until October 2004.
Greenspan feared deflation, which he saw as being caused by, among other things, China’s exportation of low prices allowed by their cheap labor. These low rates also made otherwise marginal investments appear attractive and caused investors to look for yield in riskier places, including the sub-prime real estate loan market and the commercial real estate market, setting off the real estate bubble of 2002-2007.
Ben Bernanke, who advocated the Treasury issuing debt financed by Fed money printing for the purpose of buying the stock of private companies and a broad tax cut financed by money creation as a way to stimulate the economy, was appointed to the Fed Board of Governors in 2002. Bernanke feared deflation as much as Greenspan did and proved a strong ally.
The U.S.-China trade deficit, which was at $50 billion in 1997, had grown to $234 billion by 2003, when concern about the effects of the weakness of the yuan began to intensify in the U.S. As mentioned above, low Chinese labor costs are exported to the U.S. and cause fears of deflation. Newly printed dollars, hoped to create inflationary pressure by the Fed, are instead held by the People’s Bank of China as reserves, which acts as a way of China absorbing U.S. inflation. The dollars are bought with newly created yuan. This move allows the Chinese to keep the dollar strong and the yuan weak and thwarts the Fed’s attempts at inflation. Since the PBOC prints yuan to buy newly printed dollars, it has in effect decided to follow the Fed’s monetary policy. The PBOC, looking to earn a yield on its dollar reserves, buy U.S. Treasuries, and owns close to one trillion dollars of these securities. These purchases also help keep U.S. interest rates low and allow borrowing to continue, which is in China’s favor.
As the American economy began to decline and the Greenspan/Bernanke easy money policies were no longer able to hide the problems in the U.S. economy, American politicians began to blame China for stealing U.S. manufacturing jobs. Responding to pressure from the U.S., China allowed the yuan to strengthen from 8.28 per dollar in 2005 to 6.29 per dollar today. With employment concerns in both the U.S. and China, the currently quiet currency war could come back to the surface at any time.
What could the unseen consequences of all this manipulation, from both sides, be? China’s economy has obviously been skewed towards mass production for the foreign, largely American, market. This has not taken place due solely to comparative advantage but to a weak yuan/strong dollar policy by the Chinese. China would be in a precarious position if U.S. demand for Chinese goods dropped, whether due to changing consumer preferences or to U.S. protectionist policies. In contrast, the American manufacturing sector has been sent offshore, where cheaper labor and less stringent regulations are to be found and from whence cheap goods can be imported with a relatively strong dollar. So the U.S. is also in a dangerous place. Both the U.S. and China have made their economies less robust, the Americans with a less diverse economy and the Chinese with an export/weak currency dependent economy (the Chinese economy is not less diverse because it was starting from such a low point).
How to take advantage? Some say to buy yuan, since it is “obviously” undervalued and has to go up at some point. Unfortunately “obviously” undervalued assets are not always obvious to others; just ask me and my fellow TBT investors.