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Magazine Issues » December 2010

CURRENCIES: it's all a matter of imbalance

tightrope_balanceCurrency tensions between China and the West have caused fund managers to think deeply about the impact on portfolios. Amid perhaps predictable optimism for emerging markets, Fiona Rintoul finds confidence in European equities too

“It’s always a good time to be a currency manager,” says Monica Fan, senior currency product engineer at State Street Global Advisors. But now is perhaps an even better time than most.

So many imbalances, and a little currency war brewing as the tired old stag of the US locks horns with young buck China in an attempt to force it to allow its currency – the renminbi, or people’s currency – to appreciate.

The currency war is one that will have no winners or losers and so it’s not really a war at all: more a jostling for position. If the US dollar tanks – and that’s starting to look inevitable – everyone will lose a little something.

In the meantime, for fund managers and their investors it’s a question of managing the situation. Or as Fan puts it: “When the world is imploding, people look for downside protection.”

Almost everyone agrees that the ‘war’ has involved a great deal of hot air, mainly emanating from the US, and quite a lot of vague, warm and cuddly comments designed to appease the great nation. No one is blunter in their assessment of the situation than its own sons and daughters.

“There’s a misguided feeling that US policies had nothing to do with the situation we’re in, and they [the authorities] are therefore looking for someone else to blame,” says Horacio Valeiras, chief investment officer at Allianz Global Investors Capital, in San Diego.

Accordingly, China, which, says Valeiras, “has enjoyed the benefit of our benign neglect”, is accused of manipulating its currency.

But is this accusation fair? Fan says not.

“There is more reason to accuse Japan or Switzerland where the central banks have intervened to manipulate the currency. Thus far, China has not been labelled a currency manipulator.”

However, some in Washington blame China so much they are calling for trade sanctions. This recalls the 1930s when protectionism led by the US contributed to the Great Depression. And, according to Jerome Booth, head of research at Ashmore Investment Management, you need to go back almost that far to understand what is happening now.

In 1944 when the Bretton Woods system of financial cooperation between major industrial nations was being established, John Maynard Keynes argued for a more balanced approach that would punish surplus as well as deficit countries. But the US vetoed the suggestion.

“The idea of taxing surplus countries is more unworkable today than it was in 1944,” says Booth. “But this does explain why the global monetary system is the way it is.”

In 1971, the last time the world faced massive global currency rebalancing, the Bretton Woods system collapsed and convertibility of the US dollar into gold was suspended, leaving the US currency to find its own level in the markets. Which all goes to prove, says Booth, that when something is unsustainable it will stop. He therefore sees two potential scenarios for the US dollar: it goes down gradually or it crashes.

A crash wouldn’t just be bad news for the US; it would be bad news for China and other Asian economies too, which are sitting on massive reserves of US treasuries.

“All it’s about now is how to exit,” says Booth.

In the meantime, China has allowed its currency to appreciate, albeit it not as quickly as some would like.

Pierre Lequeux, head of currency management at Aviva Investors, says the Chinese authorities understand the problems and would like more flexibility – however, their banking system isn’t ready for it. China will enlarge its banks more and more and introduce more flexibility, but it wants to go at its own pace and won’t do anything to jeopardise the Chinese economy.

In any case, Lequeux says, the currency war isn’t necessarily focused just on the US and China.

“It didn’t come from China or the US, but from Brazil,” he says. The world is not as integrated and globalised as it was in 2007, continues Lequeux, and what we see is the result of a fragmented world.

In a fragmented world, policies that suit one country don’t necessarily suit another, and there is more likelihood of a clash. Nonetheless, for the US dollar the primary problems lie not externally, be that in China or elsewhere, but at home.

“They have to relaunch the economy,” says Lequeux.

At the moment, US consumers aren’t spending much and unemployment is high. And the Federal Reserve has limited room for manoeuvre.

“Interest rates can’t go much lower and taxes can’t be cut much more,” says Lequeux. “The other route is to flood the balance sheets of banks, which is pretty much what they are doing, and hope consumers will take risks.”

In the Eurozone
In the midst of this, comes Ireland’s recent decision to apply for an EU-led €90bn bailout. Some believe this spells the end of the euro. Three strikes and Germany will call time on the euro, suggested Lawrence Galitz, CEO of ACF Consultants, in a recent commentary. In other words, if Portugal or Spain calls for an Irish-style bailout, Germany will take its ball home.

“Portugal and Spain are almost certain to go next, hand in hand, and the threat of default to a larger economy, such as Italy, will be the last straw for a financial powerhouse such as Germany or France,” said Galitz. “Unless deficits can be curbed, a fracture in the structure of the Eurozone could bring the whole project down and see the reintroduction of legacy currencies, like the Deutschmark.”

Others, such as State Street's Monica Fan, believe the risk of the euro breaking up is overstated. She sees the euro, along with gold, as the ‘anti-dollar’.

“What has been very negative for the US dollar has been positive for the euro,” she says. “There’s been a pullback in the euro as a result of the Irish government having to accept bailout funds, but overall the fact that the Fed is in the process of implementing quantitative easing and the European Central Bank is keen to reverse emergency liquidity measures is good for the euro.”

Whatever else it may mean, the Irish bailout certainly underlines Lequeux’s point about fragmentation. Even within the Eurozone, what’s good for one country isn’t necessarily good for another.

Where does this leave investors?
For some, such as Ashmore’s Jerome Booth, the global currency imbalances are simply another nail in the coffin for the developed markets.

“Investors need to be long currencies in emerging markets,” he says. “They need to play global rebalancing as an insurance against catastrophic falls in the US dollar.”

Noting that he has 95% of his own money in emerging markets because he’s a very conservative investor, he adds: “Investors should take advantage of some of these global shifts. They have huge implications for asset allocation. It’s all part of the emerging markets story.”

For others this is too drastic. “The problem with emerging markets is that the valuations are not there to put 95% of your money there,” says Valeiras.

Allianz Global Investors is still investing in core European countries, such as Germany, and indeed has been increasing its allocation to Europe. “Relative to the US it looks good,” says Valeiras.

This may be damning with faint praise, but with a developing-market powerhouse importing more, European companies aren’t just about what’s happening in Europe.

“You can buy some great German industrial companies that have a lot of their business in emerging markets,” says Valeiras.

One thing’s for sure: there’s no quick fix for the current global currency imbalances. China will most likely allow the renminbi to appreciate – but slowly. And with most commentators agreeing that US unemployment is considerably worse than official figures suggest, there is no sign as yet of quantitative easing reflating the US economy and kick-starting the economic growth.

“That will take at least a couple of years,” predicts Fan.

In the meantime, expect more crises. “We will have at least some more Ireland-like crises, but not in Ireland – maybe in some of the US states, such as California or Illinois,” says Valeiras.

One factor that mitigates in favour of a rebalancing happening sooner rather than later is that China now has inflation, according to Booth. Because many companies borrowed money to last them several years when credit was cheap in China after Lehman Brothers, interest rates are not currently as effective at controlling inflation as they were in the past, so the exchange rate has to do more of the work to tighten.

More pain to come
“China fully understands these issues,” says Booth. “That the Chinese State Council has not yet made a decision should be put in the context of the Chinese economy.”

Domestic consumption has to rise before China can allow its exchange rate to increase to a point where it might dent exports. And as it’s not possible for foreign central banks to buy renminbi, China can’t be forced to revalue before it feels ready.

Ultimately, of course, most commentators believe the dollar’s weakness is not about China at all. And the solution is not about easing, but about pain.

“The US needs to get poorer,” says Valeiras. “People need to stop living beyond their means.”

Until then, Lequeux’s appointment to the new role of head of currency management at Aviva Investors is unlikely to be an isolated move. “There’s a need for currency overlay and for protection against downside risk in large portfolios,” says Lequeux.

There most certainly is.

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