Currency Wars

Brazil’s Finance Minister Guido Mantega’s claim that the globe was in the grips of an all-out currency war is a reflection of the pain being endured by many emerging market countries as they suffer the results of the monetary and foreign exchange policies that are being pursued by China, Europe and the U.S. The most affected countries are Brazil and South Africa, with the former witnessing a 37% appreciation of its currency since the end of 2008. Attempts to cool down the appreciation of the Real, through central bank intervention, led to a sharp accumulation of international reserves—recently cresting over the $275 billion mark. This is the reason why Brasilia is threatening to impose a new tax on short-term fixed income investments. Of course, it is unfair for Brazil to lay all of the blame elsewhere. The country’s massive investment programs, such as Petrobras’ recent $70 billion share offering and Sinopec’s decision to pay $7.1 billion for a 40% stake in Repsol’s offshore operations are the main factors pushing the currency higher. Moreover, the Brazilian real is not the only emerging market currency that is appreciating. The reallocation of global portfolios into the BRICs is pushing almost all of the major emerging market currencies higher. The Russian ruble, Indonesian rupiah and Peruvian sol are just some of the currencies that are soaring.

The real effects of the currency appreciation are illustrated in purchasing power parity analyses (PPP), such as The Economist’s Big Mac index. The most recent report highlighted the loss of competitiveness being felt by many of the emerging market economies. The Brazilian real, for example, is 31% overvalued against the dollar. The Colombian peso is 18% more expensive than the dollar and the Turkish lira is 4%. However, not all of the emerging market countries have suffered the same fate. The Mexican peso is the main outlier in the Western Hemisphere. It dropped 26% against the dollar over the course of the last two years. The spill over effects of the slowdown in the U.S., along with the negative image portrayed by the escalation of drug-related violence, tarnished the allure of the Mexican peso. The effects of the devaluation on Mexico’s relative prices are again showcased by the Big Mac Index, which has it 33% undervalued in comparison to the dollar. This makes the Mexican peso the cheapest currency in Latin America, and among one of the most competitive in the emerging markets. It also leaves it poised to appreciate significantly, as the economy diversifies into new markets and the U.S. economy begins to show signs of life. Although Chinese exports into Mexico have been on the rise, there has been a lag of Mexican exports to China. One of major problems has been infrastructure. Meanwhile, Mexico is brimming with commodities, such as metals, agriculture and energy, that are actively sought by the Chinese, most of the country’s transportation infrastructure, such as roads and railroads, is directed north-south. Mexico’s Pacific ports are also shallow and under-developed. Fortunately, several major initiatives to modernize the country’s infrastructure are finally coming to fruition, and Mexico should soon see a major improvement in Asian trade flows—which should lead to an appreciation of the currency.

Finance Minister Mantega’s claim of an ongoing currency war is a stark reminder of the Beggar-thy Neighbor policies of the 1930s, the last time that the global economy was in turmoil. A series of competitive devaluations across Europe, particularly of the German mark and French franc, along with the severe restrictions to trade imposed by the Smoot-Hawley Traffic Act, generalized the recession in the U.S. and Europe into a global depression. Now, the emerging market governments are making similar accusations. Another round of quantitative easing (QE2) by the Federal Reserve is pushing the dollar lower. At the same time, the European Central Bank (ECB) continues to maintain very low interest rates. Meanwhile, the Chinese are not taking any steps to allow the yuan to appreciate. As a result, many emerging market currencies are on the rise. This is resulting in a deterioration of current account balances. Fortunately, most of the capital inflows are associated with foreign direct investment. Short-term speculative inflows remain limited. Nevertheless, a further appreciation of emerging market currencies will be a trend that will persist for some time.