Metals to profit from Currency War

“War, what is it good for? Nothing, absolutely!” Many would agree with this line from the lyrics of a song performed by Edwin Starr, at least for a war like the Gulf War II. However, as Brazil’s finance minister Guido Mantega talked of a currency war, there appears to be more disagreement. The IMF warned of the consequences of a currency war. We take a look at the impact of a currency war on metals.

We don’t think that gold would be the winner of a currency war for the very simple reason that gold is not a currency. Gold might be an instrument for profitable speculation, even for multi-year trends, as has been seen since the beginning of the new millennium. However, it is not even a perfect store of value as those investors, who bought gold in late 1979 and early 1980, have still suffered a loss in real terms. Besides serving as a store of value, a currency has also to be in circulation. Gold also does not fulfill this required function. Sir Thomas Gresham, the founder of the Royal Exchange in London, observed that bad money drives out good. This became known among economists as Gresham’s law. Thus, gold could be horded but the currency in circulation would be still paper money. Nevertheless, gold and other metals could profit from a currency war just as Halliburton was profiting most from Gulf War II.

Since Brazil’s finance minister coined the term currency war, this notion is associated with countries taking measures with the intent to weaken their currencies and to gain a competitive advantage in international trade. The underlying assumption is, like in the Great Depression of the 30^th in the preceding century, countries want to export out of economic difficulties by a beggar the neighbors’ policy. The main culprits in many discussions are the Fed and the Bank of Japan by implementing measures of quantitative easing, in the case of the BoJ also via direct interventions in the FX market. However, from our point of view, this focus is to narrow. It has to include the foreign exchange policy of China, which we regard as the root cause.

China had fixed the exchange rate of the yuan versus the US dollar. In combination with the most favored nation status granted under the Clinton administration, the undervaluation of the yuan has led to a rising export surplus of China and an accelerating accumulation of US dollars as foreign reserves. In July 2005, China introduced some flexibility of the exchange rate of the yuan versus the US dollar. Its central bank, the People’s Bank of China was allowed to set the daily exchange rate within a small percentage change in both directions from the previous day’s close. Thus, the yuan appreciated versus the US dollar, but as the range was too small, it could not eliminate the imbalances in the trade balance between the US and China. During the financial crisis in 2008, China fixed the exchange rate again. This year, China allowed again a bit more flexibility, but again it is insufficient to reduce the imbalances.

Even in systems of fixed exchange rates, markets would normally force a country to appreciate its currency by buying the undervalued currency and selling the overvalued one. This would require interventions with an impact on domestic macro-economic aggregates and financial market rates. However, this requires a free flow of capital and a full convertibility, both lacking the yuan. Thus, China is in a position to maintain its competitive advantage against the US.

China is only in a position to fix its exchange rate against the US dollar but not against all other major currencies, as this would create arbitrage opportunities. Thus, there would be a possible scenario that China gains or maintains a competitive advantage against the US by undervaluing the yuan, but could suffer a loss of competitiveness against other currencies. But China also played this card very well. Initially, they got a helping hand from foreign exchange analysts and strategists. They focused on the rising US current account deficit and were worried about the financing of this deficit. However, they overlooked that this deficit was almost self-financing. China did not only deliver the goods, which caused the widening trade deficit, but also the capital imports of the US to purchase the Chinese goods. China became the most important investor in US Treasury bonds and notes. However, the worries of analysts and strategists led to a pronounced weakness of the US dollar, especially against the euro.

During the financial crisis in 2008, the US dollar strengthened against major currencies. This was not in the interest of China as Europe, in particular German exporters, got more competitive. However, China countered this development by questioning the status of the US dollar as a global reserve currency. Investors sold again dollars for euros and thanks to the fixed CNY/USD exchange rate, Europe got less competitive again.

We regard the accusations against the monetary policy of the US as not justified. While we do not expect that the US economy would slip back into a recession, we admit that US GDP growth would probably be too anemic to create more jobs and to reduce unemployment considerably. As laid out in this blog two weeks ago, we have some doubts whether quantitative easing would have the desired results. But to judge a measure fully, one has to compare it with the alternatives. Doing nothing and praying that the supposed self-heeling forces of a free market economy would lead to full employment again appears to be the worst of all options.

Unfortunately, two of the major culprits of the sub-prime crisis are a major obstacle for a stimulus, which might be the most efficient under normal conditions. The rating agencies did not only rate junk as triple A and thus misguided investors in the market for mortgage backed assets. Now they attack the ambulance which came to the rescue of financial markets. The financial crisis, the measures to stabilize the financial systems and to stimulate the economies led to rising budget deficits of many states. Partly, some measures taken only have a one time effect on the budget deficit, but led to a jump in the debt/GDP ratio. The rating agencies have already downgraded some European sovereign debt. The member countries of the eurozone had to come to support Greece and to introduce a fund to assist other member countries in the case of a crisis. However, this support came at a cost of introducing austerity measures and to exit from expansionary fiscal policy. Especially the German chancellor Merkel appears to be obsessed of a pre-mature exit from fiscal stimuli. Bond investors followed again the advice of the rating agencies and sent yields on the weaker eurozone countries to new highs since the introduction of the single currency, which is counter-productive to solving the problems. Bund yields have declined and spreads of even other sound countries over bunds have risen considerably. Fiscal policy to stimulate domestic demand is currently regarded as not being an option by governments and bond investors in the eurozone.

The rating agencies have not yet downgraded other Western countries like the US and the UK, which also run a high budget deficit. But they threaded that the top rating would not be for granted. In the UK, the new government is following an austerity policy and is determined to bring down the budget deficit. In the US, the mid-term election makes it impossible to implement a new fiscal stimulus package. Thus, fiscal policy is at best neutral but in many countries it is contributing to a slower growth or extended recession. Therefore, it should not come as a surprise that the Fed and the Bank of England consider a new round of quantitative easing to stimulate domestic demand.

The Bank of Japan is in a very uncomfortable situation. The economy is already in a deflation and GDP growth fell back to almost zero. Weakness of the US dollar leads to a strengthening of the yen and there is no hope that carry trades would trigger a reversal of yen appreciation. While some central banks valued an appreciation of their currencies because it made their job easier to keep inflation close to the target, the BoJ could not be happy with a stronger yen. The falling USD/JPY exchange rate implies that the deflationary pressure is increasing. One instrument to apply is a quantitative easing by intervening in the foreign exchange market without sterilization. Of course these interventions also have a positive impact on exporters. However, outright deflation lead to a wait-and-see position not only by consumers, but also companies would delays purchases. Thus, taking measures against deflation is an absolute necessity from domestic economic policy reasons for Japan.

The thread of rating agencies to downgrade the rating of sovereign debt as well as the risk aversion of bond investors, which only buy the safe haven government bonds, are a major reason that monetary policy has to stay or even to become more expansionary in some countries. The key to avoid a currency war is primarily the stance of China towards a more flexible exchange rate policy and an appreciation of CNY/USD. As long as China is resisting making any concessions, which could have an impact on its export sector, quantitative easing by the Fed appears to be unavoidable and is likely to led to dollar weakness against the major currencies. This remains a positive factor for investors demand for precious as well as base metals. But a stronger CNY/USD does not need to be negative for metal markets if China were taking corresponding measures to reduce domestic saving and to increase domestic demand. Thus, we expect that base and precious metals will profit from tensions in foreign exchange markets.