We are in the midst of a global currency war. While the roots can actually be traced back to the time Britain abandoned the Gold Standard, let’s not go that far but look to recent history as a guide. This post will be lengthy because it’s going to use a lot of charts.
The above charts show the extent to which the US Dollar has appreciated against the Canadian Dollar, Australian Dollar, Brazilian Real, Indian Rupee, Japanese Yen, Mexican Peso and the Russian Rouble since April 2011. Why did I pick these currencies, this timeframe, and what am I trying to illustrate? Read on.
The Federal Reserve fires the first shot
In response to the subprime crisis of 2008, the Fed embarked on a historically unprecedented program of money printing, dubbed QE, with the intent of flooding the world with dollars while keeping dollar interest rates at zero percent. Had any other country, say Zimbabwe, tried this, their currency would have been toast. The US dollar, however, was different. It was the world’s reserve currency, in circulation all over the world, and recognized as a better store of value than the native currencies of third world Asian, African and South American countries.
The markets responded to QE by borrowing in dollars and investing in emerging economies to capture the yield differential, a phenomenon known as a carry trade. With dollar interest rates at zero, as long as the countries they invested in managed to keep their exchange rate stable, this was a risk-free return. Emerging economies witnessed capital inflows, increased their debt levels, and enjoyed a Federal Reserve financed economic boom.
But wait – what about all that subprime debt and the recession it caused? Shouldn’t that have induced a bust and not a boom? The answer to that lies in a report published by the McKinsey Global Institute in February 2015 titled “Debt and (not much) deleveraging”. The report found that global debt levels have increased by $57 trillion (yes, trillion) since 2007. In terms of debt to GDP, it has increased from 269% to 286% of global GDP. China alone has quadrupled its debt levels, injecting over $21 trillion into its economy since 2007.
The Commodity Boom
An economic boom is a period of false prosperity, a time when demand for both consumers’ goods and producers’ goods increase, financed by cheap debt. With China, the world’s largest consumer of commodities, financing its economic boom by injecting massive amounts of money into its financial system, little wonder that the effect was a commodity boom.
New capacity was brought online, previously marginal projects were now profitable, and commodity exporting nations enjoyed the fruits of this China-led boom.
The (Inevitable) Bust
The cure for high prices is high prices. With new supply being brought online, and the debt-fuelled boom showing signs of having run its course, commodity prices started to plummet, slowly at first and then rapidly as the signs of the bust became apparent. Initially, the pundits cheered as the narrative was that lower prices would boost consumption. Soon, it became apparent that this is an epic bust which is an indicator of difficult times ahead. The Bloomberg Commodity Index has hit its lowest level since 1999, mining companies have seen their market cap erode drastically and commodity investors are running scared.
Back to the Dollar Story
What does this side track have to do with the dollar? Simple. Commodity prices and the dollar move in opposite directions. Commodities are priced in dollars. A commodity price rise implies a fall in the price of the dollar. And a commodity price decline implies a rise in the price of the dollar. In other words, the dollar started to strengthen. I picked April 2011 in the charts above to mark the inflection point, where commodities peaked and the dollar strength began.
The Carry Trade Blow-ups
Dollar strength is certainly not good news for those involved in the dollar carry trade. To illustrate, say an investor had borrowed money in US dollars to invest in Indian equities in 2011. He would have exchanged $1 for Rs. 45. If he can earn a 10% return in India, this is quite an attractive trade. Hence, capital flows in, Indian assets are bid up, and the investors enjoy their excess returns.
The trouble arises when the rupee starts to decline. If the rupee declines 5% while the investment returns are close to 10%, this is still manageable. When returns decline along with the currency, this becomes a serious problem. Prior to this situation, the rupee strength against the dollar was due to capital in-flows exceeding capital out-flows, thus boosting demand for the rupee. When the trend reverses and capital out-flows start to dominate, it becomes a self-fulfilling prophecy as outflows trigger a weakness in the rupee which triggers more outflows, until there is a healthy correction. This is the situation central bankers are afraid of. When outflows dominate, the country’s monetary policy is dictated by the markets. The excesses of the prior boom are liquidated, asset prices fall and the economy enters a recession.
Why Should This Happen?
In a free market, it wouldn’t. Exchange rates and interest rates would adjust to prevent this. In a central bank dominated world, where exchange rates and interest rates are not allowed to adjust, this does happen.
In a free market, the carry trade should have strengthened the rupee against the dollar and arbitraged away the excess returns, or dollar interest rates would have risen to make the carry trade less appealing. None of these corrective mechanisms were allowed to work. The emerging economies increased their money supply in order to prevent their currencies from appreciating against the dollar. Why? To promote exports of course! The central bankers mistakenly believe that their country’s economic engine is driven by exports, and they need to maintain a cheap currency to get it.
The above chart shows the USD to INR exchange rate since pre-crisis. Notice that even though the Fed engaged in several bouts of QE, the rupee did not strengthen against the dollar. From this, we can infer that the money supply in India increased at a faster rate, an inference supported by the price inflation statistics.
The Indian situation isn’t unique. As a response to the Fed’s QE, central banks all over the world have cut interest rates and engaged in some form of QE or the other. The Bank of Japan has been directly engaged in buying Japanese stocks (they have been buying Japanese Government Bonds for a long, long time). The ECB launched its own QE. 23 central banks have cut interest rates this year, in a desperate bid to stave off the inevitable. As Ludwig von Mises wrote, “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
The Fed voluntarily abandoned further credit expansion as other central banks rushed headlong into the race to the bottom. They have kept interest rates at zero, but in this global monetary madness, they are still the hallmark of sanity. In the land of the blind, the one-eyed man is indeed king.
Tying It All Together
The debt fuelled boom is in its endgame. The Fed fired the first shot in the currency war, and other central banks responded by weakening their currencies in a race to the bottom. The Fed got out of the race, while other central banks have started to go all-in to stave off a collapse. The resultant dollar strength is going to further crush the global economy, with emerging economies slated to bear the brunt of it. The rupee has held up well so far, since India is not a commodity export dependent economy, but the end of the stock market boom is going to accelerate the capital out-flows and cause further rupee weakness.
They’re trapped. Cutting interest rates to prop up the stock market will weaken the currency, triggering more capital out-flows. Raising interest rates to stabilize the rupee will trigger a recession. Capital controls will be anticipated and front-run by the markets, and keep investors off for a long time to come. Forex intervention will deplete much needed dollar reserves, and might not even be successful, as already evidenced by Russia and China. They could do nothing, but given India’s trade deficit, India Inc.’s dollar denominated debt and the high fiscal deficit-cum-debt, the end of the boom will still have consequences.
The easiest choice to make is to sacrifice the rupee. It’s the choice preferred by central banks and the government, throughout history. There is systemic risk in the rupee, which will not be revealed by the daily volatility. It will happen suddenly, as it always has. The time to prepare is now, before the event.
Better 10 weeks too early than 10 minutes too late.