AFTER the crash in 1929, nations retreated inside protectionist walls. In 2009, they managed to refrain from the same action – but they may yet succumb to another ’30s blight on world trade: currency wars.
A currency war consists of states pursuing competitive devaluations in an attempt to increase the attractiveness of one’s exports. But the perverse effect of an all-out forex war is actually to make all international goods less attractive, because businesses never know what rate they will have to pay or be paid for imports or exports.
“War” was declared by Brazilian finance minister Guido Mantega a fortnight ago and since then there has been little cause for cheer. Aside from a 21 per cent increase in Brazilian Central Bank intervention last month (see chart), we have seen promise of further intervention in Japan, a tax on foreign bond purchases in Thailand and David Cameron declaring that he’s a “monetary activism” kind of guy. Most worrying of all, just a couple of days after Mantega’s comments the US Congress voted through the US Currency Reform for Fair Trade Act: the act promises reprisal in the form of good old-fashioned tariffs should China fail to let the yuan appreciate. So perhaps the ’30s aren’t as faraway as we think.
The recent unusual volatility in exchange rates has already prompted businesses to hedge their risk, but now many are considering more extreme measures. Investec Capital Markets’ Lee McDarby says that some UK wine importers affected by recent euro strength are looking into more complex products that enable them to benefit from growing volatility. Investec analysts are considering revising their forecasts: “Euro-dollar is capable of moving over $1.40 and sterling-euro could tip back into €1.13-€1.12,” says McDarby.
Now that the weekend’s IMF currency negotiations have failed, the key dates are 2-3 November, when the Federal Open Market Committee next meets (the dollar fell on the release of doveish minutes last night). Its decision – to QE or not to QE – could well determine whether the forex skirmishes kick off into an all-out war. As BNP Paribas’ Ian Stannard says: “It’s hard for them to point the finger at anyone else as a currency manipulator when they’re about to flood the market with dollars.”
So what to do if the Fed does bite the bullet? The problem with currency war is that it’s unpredictable – that’s why it is so damaging to world trade. But in the near-term, most analysts are not anticipating any further dip in the greenback in November unless the scale of the QE announced takes the market by surprise. Either way the dollar is likely to remain volatile, which makes gold a safe bet in the short-term if the Fed does go ahead with stimulus.
The truth is, however, that if the currency war escalates, all bets are off.