Currency wars

If you ever wondered why currencies appreciate or depreciate as they do then the natural assumption is that if one country’s economy is strong then its currency will appreciate relative to the next country’s currency. That’s all very well in theory but what if that country does not want its currency to strengthen?


Our natural tendency is to believe that if something is strong then it is good, but there comes a point with currencies where strength can be crippling or counterproductive to your country’s economy. This is more so relevant if your country is a strong exporting nation. A strong currency obviously decreases the demand for your products on an international level and discourages tourism. Central banks are usually tasked with the job of trying to find the optimum level for their currency i.e. one that both encourages trade with other countries and keeps the domestic economy in check.


Central banks around the world all have different mandates, but the usual ones are to control inflation & encourage growth. These competing mandates often lead to what most call “currency wars” i.e one central bank indirectly fighting another to weaken/strengthen their currency. You will often hear Timothy Geithner of the NY fed talking about how China is directly keeping the value of the Yuan low in order to keep exports strong and the Brazilian finance minister is constantly referring to currency wars.


The most obvious example of these currency wars or actions taken by a central bank to directly impact the value of their currency was acted out by the SNB or Swiss national bank. To give you some background the Swiss franc is one of the strongest currencies out there. The Swiss have the advantages of a very strong export driven economy and a decent tourism sector and they have the advantage of not being in the Euro. All these positives for the country though stack up and make the Swiss franc the currency of choice to flee to when times are tough in the global economy. It’s  called a “ flight to safety” i.e investors reduce their investments in riskier assets and lump into safe haven assets like gold or strong currencies. Traditionally the Swiss franc has always been one of these safe haven currencies so you can imagine how difficult it makes controlling the Swiss economy that every time there is uncertainty in the world of which there is  A LOT  at the moment then all of sudden your currency appreciates by a considerable amount thereby exaggerating the impact of the crisis on your own economy i.e. reducing demand for your exports.


About six months ago during a period of extreme uncertainty in the global economy the Euro was trading at extreme lows against the CHF one of its biggest trading partners. The SNB made a bold move, catching the market unaware they announced that they are pegging the level of EUR/CHF to 1.2 i.e one Euro equals 1.20 Swiss francs at the time the rate was as low as 1.10 so the market jumped a massive 10% in about 5 minutes which is a huge move for a currency and unlikely one that I will ever see again in my career.


Basically what the SNB had said was we are willing to use the resources available to us as a central bank and print as many Swiss francs as possible to then sell them in the open  market, thereby driving down the value of the Swiss franc against the Euro. The key words that they used were “ unlimited”  i.e they were 100% ready to do whatever it took to depreciate their currency.  Actions like this occur frequently around the world but they often fail as the given central bank does not have the kahoonas to see it through. The SNB however fronted up and took on the market and won and stabilised their currency. Now all it takes is a rumour of the SNB being active and traders and investors stay away from trying to buy Swissies for fear of being ripped to shreds by the SNB again. As I said earlier sometimes in the market you have to tell people you have a bazooka and not afraid to use it.


Other forms of currency wars are usually more subtle than this. The US have managed to keep their currency weak in the face of a declining euro by engaging in a process called Quantitative easing or QE, in simple terms this means printing money and distributing it into the money supply thereby diluting the value of your currency.  However this can have very negative effects as it creates inflation ( think of Zimbabwe and what went on there) but is being used as a stimulatory measure by the FED to try and create growth in the US i.e “ money makes money.”  In contrast this approach makes the governors of the ECB sleep uneasy as they are dead against inflation. The ECB prefer to try and control the economy by keeping the level of inflation steady, they target 2%. Too much inflation is a bad thing but too little inflation is also a bad thing as it shows no growth. The ECB usually try to manipulate this by moving interest rates up and down. This is a very  Germans approach, Zee Germans are afraid for their life to let inflation get out of hand as it ravaged their country after the world war, so in keeping with their now very conservative nature they refuse to allow inflation to rise and willing to sacrifice growth for this. However they have proved that it is possible to have both sustained long term growth and avoid inflation through this approach by enforcing discipline that is rarely matched by other countries around the world.


This is another reason why the Euro has held up relatively well against the USD considering the mess that the EZ is in you would expect the EUR/USD to be back to parity i.e 1 for 1. The ECB have interest rates set at 1% whereas the Fed has interest rates set at 0-0.25% so simple demand and supply says the higher interest rate currency will be stronger than the lower interest rate currency. A good example of this can be seen by the recent rate cut in Australia. The Ozzie dollar was trading at a relatively high valuation against the Dollar above the parity mark for some time, reason for this is Australia is a commodity heavy export driven economy but also because it is pegged to the USD and had very high interest rates relative to the US. A recent 50bps rate cut and in implied further 25bps cut to come has seen the Aussie dollar depreciate by approx 5-7% over the last month or so. This has a dual effect of decreasing the demand for the currency vs the dollar and also making the majority of their exports cheaper.


Currency wars will always go on, some actions fail miserably and some are a great success but the underlying principle of them always is to find the fine line between keeping your country competitive on an international scale while not killing the domestic economy and allowing inflation to ravage the consumer. The SNB made a bold move and I thought it was impressive how they managed it, it has been relatively quiet for a while but if for example Greece were to leave the Euro then the currency markets will go berserk and you can expect to hear lots of comments from all central bankers around the world to defend their currencies, it will be interesting to see if the SNB can hold firm in the face of this potential circus.

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