Among a lot of other things, 2010 will be the year where the phrase “currency war” was popularized by Brazilian Finance Minister Guido Mantega and IMF Chief Dominique Strauss-Kahn.
When even China’s Commerce Ministry admitted in early November that “the currency war” was intensifying, it was clear to everybody that this was an accurate description of the ongoing currency policy battle between the United States and China.
If anything, 2010 saw the forces driving the conflict intensify, particularly during the second half of the year. As one measure of this, it is worth recalling the dollar began to lose ground against even the euro in early June despite the fact that the eurozone’s sovereign debt markets were still in turmoil.
Even with Treasury Secretary Timothy Geithner’s heartfelt support for the “strong dollar” policy, the harsh truth is that the last two months of 2010 has seen both a QE2 in the United States and further fiscal accommodation with the possibility of seeing debt-to-GDP ratio approaching 10 percent in 2011.
If the combination of loose monetary-and-fiscal policy settings is normally seen as the ideal recipe for currency weakness, then the settings currently seen in the United States speak of a lower — rather than a higher — greenback. But the story doesn’t end here …
Equally, while it is certainly true that China has allowed the yuan to move with somewhat of a greater degree of freedom during the second half of the year, where we have seen it rising 2.5 percent against the dollar, I think Chinese authorities will probably try to keep their currency relatively stable through 2011.
With the target inflation rate having been raised from where it stood through 2010, and a distinctly more dovish note being seen in recent comments on monetary policy settings, it looks as if the authorities will do their best to limit their currency’s gains next year.
All this suggests that if — and that’s a big “if” — the eurozone's troubles begin to ease sometime in 2011 (which is certainly far from sure and which is certainly not going to happen soon), then we could face a serious weakening of the dollar.
Investors shouldn’t forget that the debt bailouts for Greece and Ireland were designed to completely “isolate” those countries from debt markets by providing them all of the cash they would need to fund their budgets for three years.
Now, making any EU permanent rescue fund “credible" means applying that precedent to all the eurozone states facing high debt pressures. Using the most current data available, that puts the price tag at just below 2.2 trillion euros ($2.89 trillion). Adding in enough extra so that the eurozone has sufficient ammo left to fight any contagion and we’re looking at a cool 3 trillion euros or nearly $4 trillion dollars. That’s serious stuff that can’t be overlooked by anybody.
But again, if all the eurozone worries, including the structural ones, improve faster than expected, then the focus for the markets should switch very quickly back to the decline of the dollar.
It’s also worth recalling one telling comment from People's Bank of China Governor Zhou Xiaochuan, speaking in Washington in October, when he said: “We can diversify more the foreign reserves, to consider not only smaller countries, but some emerging-market economies … (with increased assets) you can shift some to riskier, but higher-return investment instruments.”
In other words, expect even further upward pressure on emerging-market currencies as long as the Chinese money bubble doesn’t burst, along with commodity-backed currencies and the “unique” currency units such as the Swiss franc and Japanese yen.
We should certainly expect further intervention in a wide range of markets and yet more capital controls.
As such, it is worth noting that both South Korea and Brazil have seen a distinct slowdown of flows into both their debt markets and currencies during the past two months following either the threat or the actual imposition of taxes on foreign ownership of fixed-income securities. No doubt other emerging-market nations will have taken particularly careful note.
That said, looking at 2011, to me the biggest risk in 2011 to the global economy is the monetary bubble in China and the extent this has permeated into the emerging markets’ equities and perhaps more importantly into commodities — which if China hits a serious pothole would cause a sizable upset in these “super hot” markets.
In simple words, it’s the threat of China's money bubble bursting that could put emerging and equity markets at risk of a serious downward correction, which by itself could create for those who have cash available in “safe places,” after having wisely cashed in good parts of their gains, interesting new buying opportunities could arise depending on how far that correction, if it occurs, would go.
The Chinese bubble will burst — when it happens, not if it happens, in my opinion — from growing controls and cutbacks by banks in lending under various forced regimes rather than explicit interest-rate raises which would complicate the Chinese exchange-rate manipulation.
Amid wide-spread optimism for the new year and deep internal divergences in major markets that promises an interesting 2011, I wish you all a merry and joyous Christmas with family and friends.
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