We’re not in a currency war yet, even if the market fluctuations have been unexpected
Hannah Anderson writes that a currency war would be the result of a conscious decision by central banks to lower the values of their currencies to give them an edge over their trading partners. What we’re seeing instead is a renminbi driven down by concerns over trade and an unexpectedly strong dollar
Just as reporters are quick to attach the suffix “-gate” to any story with the whiff of scandal, investors are keen to label any disruption to markets a “war”; recall that around the implementation of broad quantitative easing programmes, we had the “battle of the banks”, or how rising US protectionism quickly became a “trade war”.
Over the past couple of weeks, more investors have been asking me if we are in the early stages of a currency war.
“Currency war”, like “trade war”, is a loaded term. A currency war is when countries directly try to push the value of their currencies down so that they may gain an advantage over trading partners, also called competitive devaluation. Around the 2008 financial crisis, most major central banks were accused of purposefully trying to lower the value of their currencies through their aggressive policy response to the crisis. The term “currency war” does not spring up on its own – discussion of a currency is always tied to discussions of ongoing market phenomena.
Currencies reflect investors’ perceptions of the market outlook in countries relative to one another, as well as the relative availability of assets in each currency. Currencies rarely, if ever, move in response to contained domestic developments in their issuing markets; their values reflect investors re-pricing the relative outlook.
When considering movements in currency markets, investors should always ask, “Relative to what?” For example, contrary to consensus expectations, the dollar has risen, relative to other currencies, instead of falling this year. Investors had priced in growth and policy expectations for the US relative to the rest of the world.
The rapid rise in the dollar in prior years meant it was substantially overvalued compared to its own history. On top of this, rising twin deficits – the US is running both a current account and fiscal deficit – would add even more dollar supply to currency markets. All of these conditions spelt a period of dollar weakness.
Although the US dollar did fall sharply at the start of the year, it gained back the ground it had lost by the end of April, and has risen further since; relative expectations for the US versus the rest of the world shifted. The moves in the US dollar-Chinese yuan exchange rate merit the most attention. The ongoing US-China trade war has fed this narrative. Since exchange rates are closely tied to a country’s exports, many have wondered if China is devaluing its currency to offset the effect of US tariffs.
Trade has certainly played a role in year-to-date renminbi weakness. However, the potential for lower Chinese exports contributed to already declining investor expectations of China’s relative growth outlook. A slightly weaker macroeconomic outlook than earlier in the year, as well as relatively less attractive domestic assets, meant lower relative attractiveness of renminbi assets compared to those denominated in other currencies.
Chinese authorities have tolerated the resulting renminbi weakness thus far. Cheaper exports would offset some of the effects of trade tensions, but at the cost of the more politically important domestic consumption boost the authorities have been trying to engineer.
Chinese officials are wary of a too-rapid weakening, particularly if it looks likely to spur capital flight and financial instability. Thus, officials are likely to continue to be active in the forwards market to manage future price expectations and to use their regulatory power to make selling renminbi more expensive.
As usual in currency markets, it’s all relative. Currency wars are not spontaneous events, nor have policy choices in 2018 pushed the global economy to the brink of one. Reconsideration of investors’ relative expectations for market outlooks, as well as rising trade tensions, are to blame.
Currencies are inherently volatile instruments, subject to movement as quickly as investors can change their minds. Volatility in currency markets is likely to remain high as trade tensions continue to rise and investors recalculate how they believe late-cycle US markets will perform relative to the rest of the world.
Hannah Anderson is a global market strategist at JP Morgan Asset Management