Policy switch leads to shift in ‘FX wars’

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Investing in Asia – February 2016

Policy switch leads to shift in ‘FX wars’

Gong Xi Fa Cai! The Mandarin for Happy New Year ironically translates literally to “wishing you enlarge your wealth!”

But be it lunar year 4710, or Gregorian 2016, financial markets in Asia and globally have produced substantial wealth destruction to date.

What started with concerns about China’s new stockmarket circuit breaker has quickly morphed into broad global growth concerns.

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The monetary toolbox has historically proven effective in reining in inflation, but central banks’ ability to reflate economies has, so far, proven less effective. As policymakers embrace unconventional measures, such as negative interest rates, the scope for unintended consequences increases – for example, the jury is still out on the impact on banks’ profitability.

Monetary policy has been a key driver of asset prices post the global financial crisis, so if policymakers’ credibility erodes, volatility should be expected to increase.

Since the start of 2016, we have seen a step-change in the ‘FX wars’. The impact of Haruhiko Kuroda’s negative interest rate policy on the yen was offset by the [US] Federal Reserve’s dovish tone as it lurched back from its December ‘dot plot’ guidance. The European Central Bank has adopted a similar approach.

The attraction of a weaker currency is clear for exporting countries as they improve their price competitiveness, leading to improved net exports. Unfortunately, competitive devaluation of one’s currency is a zero-sum game at best. The historic experience from the 1930s was that heightened currency volatility depressed international trade and compounded the global growth slowdown. Beggar thy neighbour.

On the subject of currency, it would be remiss not to comment on a devaluation in the renminbi. Looking back over the past five years, a depreciation would be justified, considering the renminbi has appreciated around 25 per cent against China’s trade-weighted basket.

In terms of international competitiveness, China has faced several headwinds, not least double-digit compound wage growth inflating the unit labour cost base. Meanwhile, China’s Asian neighbours have taken an increasing share in a decelerating global trade environment.

Nevertheless, the People’s Bank of China has stated that further devaluation is not on the cards, and official capital controls are unlikely. Pursuing internationalisation of the renminbi suggests a gradual move to floating, through wider trading bands, would be consistent with the rulers’ 13th five-year plan. Clearly, doing this from a position of strength would be preferable to being forced to spend FX reserves through persistent $100bn (£70bn) per month capital outflows.

Good communication, as always, is critical for a successful transition.

Examining the components of China’s GDP reveals other structural trends – the ongoing anti-graft movement has reduced consumption, at least domestically. From an investment perspective, the supply-side reform of China’s state-owned enterprises is needed in the five targeted overcapacity sectors of aluminium, cement, coal, flat glass and steel.