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Currency wars and deflation

22 October 2014  |  Economics

WarsTrying to predict the direction of currencies is a mug's game. They do not necessarily reflect the fundamentals of what a currency is "worth", or how the host economy is performing. This is in part because there is so much trading going on everyone is trying to pick everyone else's bet. Those bets are partly based on fundamentals like the value of a nation's exports or its underlying economic performance. But they are also about trying to pick the other traders' sentiment (feelings about where the market is heading) and outwitting them.

Add in the massive amount of high speed, computerised trading, and what you are witnessing has more in common with a high tech casino than a means of exchange.

But something different in the currency wars seems now to be happening. Instead of countries trying to keep their currencies low to make their exports more competitive, they are starting to try to keep their currencies low in order to keep inflation up. When the currency is low, the cost of imported goods is higher. That means that when you pay more, the level of inflation increases.

So many countries are worried about deflation, which is one of the after effects of the GFC. They will do anything to head deflation off, including making the cost of their imports more expensive. It is yet more evidence that the cost of capital, the interest rate, is almost absent in the developed world. The damage of the GFC is still with us.

Bloomberg describes the situation:

Currency wars are back, though this time the goal is to steal inflation, not growth.

Brazil Finance Minister Guido Mantega popularized the term “currency war” in 2010 to describe policies employed at the time by major central banks to boost the competitiveness of their economies through weaker currencies. Now, many see lower exchange rates as a way to avoid crippling deflation.

Weak price growth is stifling economies from the euro region to Israel and Japan. Eight of the 10 currencies with the biggest forecasted declines through 2015 are from nations that are either in deflation or pursuing policies that weaken their exchange rates, data compiled by Bloomberg show.

“This beggar-thy-neighbor policy is not about rebalancing, not about growth,” David Bloom, the global head of currency strategy at London-based HSBC Holdings Plc, which does business in 74 countries and territories, said in an Oct. 17 interview. “This is about deflation, exporting your deflationary problems to someone else.”

Bloom puts it in these terms because, when one jurisdiction weakens its exchange rate, another’s gets stronger, making imported goods cheaper. Deflation is a both a consequence of, and contributor to, the global economic slowdown that’s pushing the euro region closer to recession and reducing demand for exports from countries such as China and New Zealand."

 

There are the usual predictions about where the currencies are headed, which are anything but reliable:

 

After the Argentine peso, which is plunging following a debt default and devaluation, the yen will be the biggest loser among major currencies by the end of 2015, according to median strategist forecasts compiled by Bloomberg as of yesterday. A 6 percent decline is predicted, which would build on a 5.5 percent slide since June.

The euro is also expected to be among the 10 biggest losers, with strategists seeing a 4.8 percent drop. The yen traded at 107.21 per dollar 10:18 a.m. in New York, while the euro bought $1.2658.

 

New Zealand is in on the act:

 

New Zealand, where second-quarter annual inflation was the fastest in 2 1/2 years, announced last month its biggest currency intervention in seven years, sending the local dollar to a 13-month low.

The so-called Kiwi will drop 5.7 percent to 75 U.S. cents by the end of 2015, the median estimate of 33 strategists surveyed by Bloomberg shows. That follows an 9.2 percent slide since mid-year, the third-biggest among 31 major currencies.

Goldman Sachs Group Inc. lowered its forecast for the shekel on Oct. 6, citing the Bank of Israel’s efforts to combat its first slide into deflation since 2007. Its measures have included rate cuts and local-currency sales. Goldman Sachs sees the shekel falling to 3.9 per dollar in 12 months, from 3.7438 today and compared with a previous estimate of 3.66.

“Deflation is such a major part of the story that dealing with that, by whatever means necessary, is key,” Simon Derrick, the London-based chief currency strategist at Bank of New York Mellon Corp., said Oct. 17 by phone. “If that involves getting the currency lower, then so be it. You have to deal with it.”

 

What it means for the $A is difficult to say. But because Australia does not have a deflation problem -- inflation is within a reasonable range -- it may mean it "loses out" in these wars by "winning" -- the currency rises. But only a fool thinks they can really predict currencies.

 



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