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As the WSJ recently pointed out, there is a bizarre disconnect between equities and currency markets regarding the Euro. On the one hand, the Euro was the world’s worst performing major currency in 2010, and some analysts insist that its breakup is inevitable. On the other hand, stock market investors are increasingly bullish about Europe: “We remain positive on the outlook for [European] stocks in 2011, with a favorable macro backdrop, solid earnings and attractive valuations.” Who’s right?
In fact, both sets of investors are justified. As you would expect, stock market investors are focusing on corporate earnings and the macroeconomic environment. In this regard, the fact that the EU economy expanded in 2010 – buoyed by a cheap currency and loose monetary policy – should certainly be reflected in a stronger stock prices. On the other hand, the sovereign debt crisis in EU has not yet abated, and accordingly, it is still being priced into EUR/ exchange rates.
In the immediate short-term, it’s possible that stock market investors will prevail and that that their collective view will be adopted by currency markets. According to Deutsche Bank, “The euro may rise to $1.45 by the end of the first quarter of next year, as concerns about the single-currency area’s indebted periphery diminish.” Meanwhile, China recently pledged its support for the Euro via a promise to purchase up to €5 Billion in Portuguese Sovereign debt. Over the short-term, then, it’s possible that (currency) investors can be persuaded to temporarily forget about the prospect of default, and focus instead on the Eurozone’s nascent economic recovery.
Over the medium-term, however, the markets will have no choice but to return their attention to the possibility of default, which is why the same team of analysts from Deutsche Bank “forecasts the euro will fall back to $1.40 by the end of the second quarter and to $1.30 by the year-end.” For example, Eurozone members will need to issue more than €500bn in debt in 2011, including €400bn that needs to be refinanced by Spain and Italy. In this context, China’s purchases will fade to the point of becoming trivial.
Meanwhile, Moody’s has warned that it could follow up on its 5-notch downgrade of Ireland’s sovereign credit rating with further downgrades for Spain and Portugal. Fitch added that it might bump Greece’s rating to junk status, which would deal a significant blow to its solvency. Default is now rapidly on course to becoming a self-fulfilling prophecy, as fleeing investors cause yields to rise and credit ratings to fall, further scaring away more investors.
The EU response has been to “set up a permanent mechanism from mid-2013,” while investors continue to push for an expansion of the European Financial Stability Facility or the joint issuance of European sovereign bonds. As a result, the Center for Economics and Business Research has issued a striking forecast that there is an 80% probability that the European Monetary Union will dissolve over the next decade: “If the euro doesn’t break up, this could be the year when it weakens substantially towards parity with the dollar.” Already, spot market traders are once again increasing their short bets for the Euro, and options trading remains “skewed toward euro puts.”
To be fair, some analysts continue to insist that it is better to think of the sovereign debt problems as a crisis of credit, rather than of currency. In that sense, there is hope that a solution can be engineered (perhaps encompassing a default) that doesn’t endanger the existence of the Euro. In addition, the Euro finished 2010 on a high note, formally welcoming Estonia into the fold. It is 10% above its June trough, including a 2% rise in the month of December. Given all of the bad news in 2010, that might just be cause for optimism.
Brazilian Real Supported By Fundamentals, but Obstacles Remain
Despite all of the talk of currency war (a term first introduced by Brazili’s Finance Minister) and volatility in forex markets, the Brazilian Real is on pace to finish 2010 only slightly higher from where it began the year. While fundamentals would seem to support a further rise, Brazil’s government and Central Bank have made it clear that they will do everything in their combined power to prevent such an outcome. In short, the outlook for the Real in 2011 is incredibly uncertain.
There are two (somewhat contradictory) trends that have played a role in driving the Real to its current level. The first is the resurgence of the carry trade, whereby investors shift capital from low-risk, low-yield investments to higher-yield, higher-risk alternatives. With interest rates that are among the highest in the world – and certainly the highest among stable currencies – Brazil has been one of the prime recipients of carry trade funds. Since 2009, when concerns over the credit crisis began to ebb, the Real has risen a whopping 40%!
Moreover, the Central Bank might have no choice but to hike its benchmark Selic rate further over the next couple years. Inflation, at 5.5%, has already breached the Bank’s 4.5% target, and is projected to remain at an elevated level throughout 2011. According to futures prices, investors expect the bank to lift the Selic rate (currently at 10.75%) by 1.5% over the next twelve months, including a 50 basis point hike at its scheduled meeting in January. When you factor in low rates in the rest of the world, this would lift the yield spread between the Brazilian Real and most other comparable currencies to astronomical levels.
Alas, this first trend started to abate in the second half of 2010, due primarily to the EU sovereign debt crisis. Fortunately, the consequent move towards risk aversion hasn’t hurt the Real much. To be sure, Brazil is still an emerging-market economy, and is still perceived as being fraught with risk. However, when you consider that (certain) commodities prices (sugar, cotton) are at record highs and that the Brazilian economy barely dipped during the credit crisis, there are certainly riskier locales to park capital. Besides, many investors have determined that the interest rate premium that they receive from investing in Brazil is more than enough to compensate them for any added risk.
All else being equal, then, the Brazilian Real would probably continue rising at a measured pace in 2011. As I said, however, all else is not equal, since Brazil has pledged to do everything in their power to hold down the Real. According to the WSJ, “Earlier this year Brazil raised the IOF tax on foreign investment in fixed-income securities to 6% from 2% and also raised the tax for guarantees on derivatives investments.” Meanwhile, the Central Bank has intervened regularly in the spot market to purchase Dollars. The Bank’s newly appointed President, Alexandre Tombini, has voiced concerns over the Real’s rise: “We can’t let the economic policies of other countries determine the direction of foreign exchange.” On the day that he testified before the Senate’s Economic Affairs Committee, the Real fell by a substantial margin, suggesting that investors take his warnings seriously.
The Central Bank will also work closely with the new Brazilian administration to combat inflation, in a way that doesn’t cause the Real to appreciate. Rather than raise interest rates – which invites speculative capital inflows – the Bank will probably put pressure on the government to rein in spending and tighten access to credit. Over the long-term, this should allow it to lower rates to more sustainable levels, and prevent an expensive Rea from eroding the competitiveness of its export sector before it is too late.
Over the short-term, however, the immediate focus is to bring down inflation, most likely through rate hikes. That means that the Ministry of Finance will have to resort to more conventional weapons – such as taxes and intervention – to stem the Real’s rise. It managed to hold the Real to a 3% rise in 2010, but it remains to be seen whether it can repeat this feat in 2011.
Currency Wars: Will Everyone Please Stop Whining!
I read a provocative piece the other day by Michael Hudson (“Why the U.S. Has Launched a New Financial World War — and How the Rest of the World Will Fight Back“), in which he argued that the ongoing currency wars are the fault of the US. Below, I’ll explain why he’s both right and wrong, and why he (and everyone else) should shut up and stop complaining.
It has become almost cliche to argue that the US, as the world’s lone hegemonic power, is also the world’s military bully. Hudson takes this argument one step further by accusing the US of using the Dollar as a basis for conducting “financial warfare.” Basically, the US Federal Reserve Bank’s Quantitative Easing and related monetary expansion programs create massive amounts of currency, the majority of which are exported to emerging market countries in the form of loans and investments. This puts upward pressure on their currencies, and rewards foreign speculators at the expense of domestic exporters.
Hudson is right that the majority of newly printed money has indeed been shifted to emerging markets, where the best returns and greatest potential for appreciation lies. Simply, the current economic and investing climate in the US is not as strong as in emerging markets. Indeed, this is why the (first) Quantitative Easing (QE) program was not very successful, and why the Fed has proposed a second round. While there is a bit of a chicken-and-egg conundrum (does economic growth drive investing, or do investors drive economic growth?) here, current capital flow trends suggest that any additional quantitative easing will also be felt primarily in emerging markets, rather than in the US. Not to mention that the US money supply has expanded at the same pace (or even slower) as the US economy over the long-term.
While the point about QE being ineffective is well-taken, Hudson completely ignores the strong case to be made for investing in emerging markets. He dismissively refers to all such investing as “extractive, not productive,” without bothering to contemplate why investors have instinctively started to prefer emerging markets to industrialized markets. As I said, emerging market economies are individually and collectively more robust, with faster growth and lower-debt than their industrialized counterparts. Calling such investing predatory represents a lack of understanding of the forces behind it.
Hudson also overlooks the role that emerging markets play in this system. The fact that speculative capital continues to pour into emerging markets despite the 30% currency appreciation that has already taken place and the asset bubbles that may be forming in their financial markets suggests that their assets and currencies are still undervalued. That’s not to say that the markets are perfect (the financial crisis proved the contrary), but rather that speculators believe that there is still money to be made. On the other side of the table, those that exchange emerging market currency for Dollars (and Euros and Pounds and Yen) must necessarily accept the exchange rate they are offered. In other words, the exchange rate is reasonable because it is palatable to all parties.
You can argue that this system unfairly penalizes emerging market countries, whose economies are dependent on the export sector to drive growth. What this really proves, however, is that these economies actually have no comparative advantage in the production and export of whatever goods they happen to be producing and exporting. If they can offer more than low costs and loose laws, then their export sectors will thrive in spite of currency appreciation. Look at Germany and Japan: both economies have recorded near-continuous trade surpluses for many decades in spite of the rising Euro and Yen.
The problem is that everyone benefits (in the short term) from the fundamental misalignments in currency markets. Traders like to mock purchasing power parity, but over the long-term, this is what drives exchange rates. Adjusting for taxes, laws, and other peculiarities which distinguish one economy from another, prices in countries at comparable stages of development should converge over the long-term. You can see from The Economist’s Big Mac Index that this is largely the case. As emerging market economies develop, their prices will gradually rise both absolutely (due to inflation) and relatively (when measured against other currencies).
Ultimately, the global economy (of which currency markets and exchange rates represent only one part) always operates in equilibrium. The US imports goods from China, which sterilizes the inflows in order to avoid RMB appreciation by building up a stash of US Dollars, and holding them in US Treasury Bonds. Of course, everything would be easier if China allowed the RMB to appreciate AND the US government stopped running budget deficits, but neither side is willing to make such a change. In reality, the two will probably happen simultaneously: China will gradually let the RMB rise, which will cause US interest rates to rise, which will make it more expensive and less palatable to add $1 Trillion to the National Debt every year, and will simultaneously make it more attractive to produce in the US.
Until then, politicians from every country and hack economists with their napkin drawings will continue to whine about injustice and impending economic doom.
