Currency Wars!

by Filipe R. Costa

When you’re at a restaurant and there’s a fork missing on your table, you have two options for solving the issue. The first is to call the waiter and tell them about the missing fork. It eventually takes some time and effort but the problem will definitely be solved.

The second option involves a shortcut.

You can always try to grab a fork from a neighbouring table! While both solutions solve your particular issue, the second will not solve the problem completely but just pass it to the next client who will sit at the table from which you stole the fork.

Competitive devaluations of currency, aka currency wars, are not much different from the second option depicted above, as they involve stealing growth and inflation from neighbouring countries.

When a country fails at creating growth or reflating its economy, the central bank can just try to take a shortcut, which involves exporting unemployment or deflation to neighbour countries. That’s why these policies are frequently described as beggar thy neighbour. In the end anything goes, as long as you can get rid of your problems.

Since Shinzo Abe was elected Prime Minister in Japan, the country engaged in a bold monetary quantitative easing plan. The aim was to reflate the dormant Japanese economy, which wasn’t able to get rid of its deflation state by means of conventional measures.

The BOJ then adopted an aggressive plan to expand its balance sheet at the pace of 60-70 trillion yen per year. While not being a direct competitive devaluation measure, as selling the yen in currency markets is, this kind of QE is a disguised tool, which ends with similar effects. It changes investors’ expectations about the yen such that they themselves sell the currency.

This way Japan was able to boost exports while preventing imports from rising, as domestic prices become relatively cheaper than external prices. The domestic industry is stimulated and employment expected to grow.

But, there’s another side of the coin.

Those who buy Japanese products and sell their products to Japan will see their domestic products become less competitive, which will contribute to a deterioration of their job market and to a decrease in general prices. In other words they will import unemployment and deflation from Japan. The chart presented bellow very well depicts the effect of Abenomics.

Since the beginning of 2013, the euro is almost 40% higher relative to the yen.

Of course, when adding the tight fiscal policy that has been conducted in the Eurozone to a less expansionary monetary policy, we could only observe what is depicted in the next chart.

It is very clear that Japan’s reflation is a match for Eurozone’s deflation.

Now think about the peripheral Eurozone.

The IMF and the EU urged countries like Portugal, Spain, Greece and others for the need to achieve competitiveness through painful and prolonged internal devaluations. Translating this into just a few words, they urged for wage cuts (as that is much quicker to achieve than productivity increases). But then Japan gained 40% competitiveness out of thin air…

With this in mind the ECB had no other option than to fight back and embark in an European version of QE (even if a poor one), which involves purchasing covered bonds and asset backed securities, while cutting on its main refinancing rate to near zero and pushing its deposit facility rate to negative terrain. It’s like the second client has arrived at the restaurant and it found a fork is missing (as the first client has stolen it). So, he decided to steal from another table. Can you guess from which table?

That’s right! It is Ms Yellen’s table. Mr Kuroda stole a fork from Mr Draghi, who stole another fork from Ms Yellen. From 1.40 the Euro is now near 1.24, which will be an invaluable help for the Eurozone’s exporters!

In a few quarters optimistic US investors will notice the bite on Corporate America’s earnings. Those companies with a presence in Europe will show significant margin losses due to the huge decline in the euro. Apple will see all those millions of iPads and iPhones sold during the festive quarter yielding 10% less than before.

At that point I’m not sure Ms Yellen will be willing to call the waiter, as long as there is another table from which she can grab the missing fork…if this isn’t a currency war, then I guess I don’t know what one is…