Who Wins the Currency War: Emerging Markets versus the Big Four?

Who Wins the Currency War: Emerging Markets versus the Big Four?   By Jim Rickards**

For better or worse, emerging markets have become roadkill in the currency wars. Perhaps ‘collateral damage’ is a better term for it, since collateral damage is used to describe innocent victims of fighting among hostile adversaries.

All wars produce collateral damage, and the currency wars are no exception.

The major adversaries in the currency wars are the US, China, Europe and Japan. Each of these four economic powers is confronted with the same dilemma. There is too much debt in the world, and not enough growth.

If growth were strong, the debt would be manageable and countries wouldn’t care much if one player tried to manipulate its currency. But growth is not strong; it’s weak. And getting weaker all over the world.

And sovereign debt just keeps growing.

It’s easy to make fun of countries like Japan that have debt-to-GDP ratios over 200%, but the US and China are not that far behind and are catching up fast.

The whole world is beginning to look like Greece.

The key to solving the sovereign debt problem is nominal growth, which consists of real growth plus inflation.

If nominal growth is rising faster than your deficit, then the debt-to-GDP ratio goes down and your sovereign debt is viewed as sustainable.

The opposite is happening.

Deficits persist in the major economies, but nominal growth is weak. In fact, nominal growth in some countries, including the US and Japan on occasion, is actually negative, in part because inflation has turned to deflation.

Real growth is important, but when it comes to paying your debts, nominal growth is what counts, because debt is paid in nominal dollars. In a world of deflation, nominal growth is actually lower than real growth. The world of sovereign debt management has been turned upside down.

The major economic powers are fighting deflation by devaluing their currencies.

A devaluation raises the price of imports such as energy, commodities and manufactured goods.

These higher import prices feed through the supply chain and put upward price pressure on finished goods and competing products.

The problem is that not everyone can devalue at once; countries have to take turns. China had a weak yuan policy in 2009. By 2011, the US had engineered a weak dollar. Beginning in late 2012, Japan orchestrated the weak yen with Abenomics.

By mid-2014, it was time for the weak euro, which was achieved by the ECB using negative interest rates and quantitative easing. The major economies keep passing the currency wars canteen, hoping that everyone can get just enough relief to keep the game going.

Still, robust global growth is nowhere in sight.

Where does this leave emerging markets?

Unfortunately for them, emerging markets are simply not large enough or important enough to factor into the calculations of the major economic powers.

It’s not that the big central banks don’t care; it’s just that there are limits to what they can do. The US, China, Japan and Europe, the ‘Big Four’, account for almost two-thirds of global GDP. All of the other developed economies and the emerging markets combined account for the remaining third. As far as the Big Four are concerned, the rest of the world are just along for the ride.

When the Big Four fight the currency wars, sometimes they win and sometimes they lose.

But the emerging markets always lose. The emerging markets have been painted into a corner and cannot escape the room.

Here’s why.

When an emerging-market currency weakens, capital leaves the country and heads for strong-currency areas such as the US. This capital flight causes declines in asset markets such as stocks and real estate.

A weak currency in an emerging-market economy also makes it harder to pay off dollar-denominated corporate debt. This can lead to debt defaults and even more capital flight.

In a worst case, you can have a full-blown emerging-market meltdown of the kind that happened in 1997–98.

But when an emerging-market currency strengthens, its exporters suffer, and its tourism sector can be hurt also. This is happening in Korea today.

The relatively strong won has the Korean economy on the brink of recession because they are losing export competitiveness to Japan, Taiwan and other competitors.

So a weak currency causes capital flight and asset crashes, and a strong currency causes recession and hurts exports.

Emerging markets are between a rock and a hard place, and they will stay there as long as the Big Four are fighting the currency wars.

One solution to this dilemma is a resumption of strong economic growth in the Big Four. In a world of strong growth and stable exchange rates, emerging markets can prosper with exports of commodities and manufactured goods as well as tourism and services.

But strong growth is not in sight.

Another solution is capital controls. But capital controls are discouraged by the IMF and are viewed as a sign of desperation.

Neither strong growth nor capital controls are on the horizon right now, so emerging markets will remain in this ‘heads you win, tails I lose’ posture relative to the Big Four.

Emerging market economies don’t have the right type of weapons to defend themselves in currency wars.

The emerging markets stand to lose both ways.

Reproduced from:

Jim Rickards
Author: Currency Wars - the making of the next global crisis