Why has Currency Volatility Jumped?

Excerpts from the full report:

"The latest plunge in the US dollar has been met with consternation in many World capitals. Emerging market (EM) economies that shadow the greenback have been forced to purchase some US$250 billion of US Treasuries over recent weeks simply to hold down their soaring units. An angry Brazilian official provocatively dubbed these actions a ‘currency war’.

(...)

Nominal exchange rates, like national soccer teams and state anthems, have become political counters. Inertia frequently rules. The important fact for investors today is that nominal exchange rates are often ‘sticky’, particularly upwards. So, if many consumer and traded goods prices are increasingly determined globally, the only national ‘prices’ left to adjust, and so shift the real exchange rate, are domestic asset prices. Therefore, the more that, say, the Asian currencies shadow the US dollar, the greater the odds that policy-makers will inadvertently inflate a domestic asset price bubble, be it in real estate, stock markets and even domestic art works.

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Looking ahead, perhaps, there are really only two things that investors need to know:

• Chinese policy-makers misinterpret Japan’s experience with the Yen
• China has ‘stated’ a desire to match America’s gold holdings in Fort Knox.

China is still ‘consulted to’ by Robert Mundell, the 1999 Nobel Prize winner, architect of the Euro and long-time devotee of fixed-exchange rates. Under Mundell’s tutelage, Chinese analysts point to Japan’s bubble-economy experiences to counter current demands that she too allow her currency to rise against the US dollar. They argue convincingly that by
yielding to American hectoring and letting the Yen appreciate, the Japanese devastated their domestic economy, punishing it with two decades of economic malaise.

Unquestionably, the ‘strong’ Yen was a deliberate response to this industrial success and it proved a major contributor to deflation from the early 1990s onwards. But, paradoxically, it cannot be blamed for earlier economic failures in the 1980s. Rather, the decision not to allow the Yen to appreciate faster during the early 1980s directly contributed to Japan’s ‘bubble economy’.

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Thus, the resolution of fast-productivity growth largely comes through rapid asset price appreciation. In short, the more that EM policy-makers resist the necessary rise in their nominal exchange rates, the more we will see asset price bubbles in EM.Already, as we noted, EM policy-makers are being ‘forced’ to monetize large US dollar inflows."

Increasing Demand for Gold and Increasing Supply of Paper Monies

"We have been emphasizing the high importance of currency choice in asset allocation decisions. Which currency to hold wealth in has become the central question for investors? Two weeks ago in an article in the People’s Daily, an ‘official’ stated China’s desire to emulate the size of America’s gold stock. It is already on its way.

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In 2000, China owned 395 tonnes of gold but has since increased holdings to 1,054 tonnes, admittedly a still tiny 1.5% of her whopping forex reserves by value. This gold stockpile looks even smaller set against America’s 8,134-tonne gold mountain.If China attains her aspiration, she will absorb the equivalent of t he entire World gold production for three years. Other EM may copy this appetite for gold, either directly or indirectly, by increasingly holding RMBs in their reserves.

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Staring into the eyes of history, we realise that we have been here before. The 1930s saw a similar transition as economic power shifted from Europe to the USA. The associated wealth transfer largely occurred through the conduit of exchange rates. The American dollar was the big winner over the following decades. In much the same way, the British pound sterling was the big winner after the Napoleonic Wars, at the start of the nineteenth century. The economic record of the nineteenth century, and more ominously the military record of the twentieth century, is testimony to what can go wrong.

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The fiscal lesson from the nineteenth century was the high frequency of debt defaults. Even the USA defaulted on its European borrowings. It was admonished by Europe’s bankers who promised: ‘...they will never borrow another dollar, not a dollar.’ Debt default was hastened by the proximity of so-called debt traps. These curse economies whenever the growth of tax revenues falls below the cost of debt service. In other words, when printing money does not necessarily add to debt, but it does almost certainly change the average maturity and duration of debt because the State is issuing more short-term liabilities. A forced shortening in asset duration is unlikely to have any implications for faster high street inflation, but it will have significant implications for asset price inflation.

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The other feature evident today that parallels the 1930s is heightened paper currency volatility. 2010 will likely suffer the highest currency volatility since the 1970s; itself a post-1930s peak."

Conclusion

"The current backdrop for EM looks eerily similar to that faced by Japan in the mid-1980s. These parallels are worth spelling out because in our view we are again travelling this same bubble-path. Japan then, like EM now, enjoyed more rapid productivity growth than the US (or indeed the entire West).

Two facts underscore the current relevance of this model. First, emerging markets today are collectively even more ‘trade focused’, and therefore probably even more worried about maintaining their exchange rate competitiveness, than Japan was twenty-five years ago. Second, the increasingly pivotal Chinese economy has allegedly ‘learnt’ from Japan’s sufferings that the strong Yen ultimately destroyed Japanese prosperity. The first statement is irrefutable. The second is a dangerous misinterpretation.

A legacy of the 1930s is the perception that economies that were among the first to devalue became the first to emerge from recession. If this encourages a greater willingness to devalue, then the desire of the fast-productivity economies to match these moves warns that paper currencies will spiral downwards in value as national governments try to leapfrog each other to gain a competitive edge. Gold is the unequivocal winner from this process."

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"Part of the solution to our long-term problems might, therefore, involve some return to a Gold Standard and stable money. However, not only is this alone insufficient, but it would be a singularly inappropriate policy to enact just now, before Western nations have purged themselves of the excessive debts built up in the previous crisis."

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"Major wealth transfers typically always occur through the conduit of fast -changing currency parities. Thus, Australians have lately become the World’s richest people per capita. Holders of the British pound and the former Hungarian pengo have suffered the other side of the coin, i.e. falling wealth. With China muscling forward, it can only be a matter of time before the RMB becomes a major World currency, and alongside Chinese wealth levels will leap."