Yesterday, the fine folks of Tradition Analytics were kind enough to explain (once again) just how it is that the Fed has boxed itself into a corner, where in order to maintain the already outlierish growth rate of monetary supply, the Fed will have no choice but to print (same with the ECB), or else risk a massive economic collapse (thank you Austrian theory). Today, the same group provides an update on what everyone knows has been the status quo's only way of dealing with the deleveraging tsunami since March 18, 2009: currency warfare. In the note below, they provide a recap of the recent history of FX warfare, as well as an update of where we stand currently. Keep in mind, currency warfare only works to a point. Then it escalates into other, more violent forms, first trade wars, then real ones.
From 1999 to 2011, the average growth rate of global foreign exchange reserves is just over 16% annually. At the start of 1999, global foreign exchange reserves stood at $1.6 trillion, before climbing above $5 trillion in 2006, before doubling and breaching the $10 trillion mark for the first time ever in Q2 2011.
Of particular interest is that a breakdown of this growth between developed economies (DMs) and emerging and developing economies (EMs) shows that EMs have debased their currencies at a much faster rate than DMs over the past decade. The average rate of EM reserve growth over the past 12 years is 23%, compared with 10% for DMs. This means that EMs have been creating massive monetary inflation in their domestic economies, and this is confirmed in money supply data, and was also reflected in the accelerating price inflation that these economies experienced from 2005 to 2008.
Noting the pie charts included on the following page, see how DMs holdings as a percent of total global reserves have grown since 1999. From 38% in 1999, DMs now hold 68% of global foreign reserves.
And here is where we are now:
Current phase of the currency wars
As shown on the chart above, EM economies are currently stepping up foreign reserve accumulation, outstripping the pace of forex accumulation of DMs by a substantial margin. This comes at a time when EM economies are slowing substantially, which means EMs are likely to see accelerating price inflation in 2012 as this new money seeps into their respective economies.
The very aggressive forex accumulation by EMs during the boom phase of 2002 to 2008 now has them in a sense trapped; they must continue to create money supply at the same or faster rate as before in order to keep domestic growth supported. These central banks can buy all kinds of assets to achieve this goal, but if they don’t continue to support and buy DM currencies, the major currencies may weaken to such an extent that emerging economies lose their export markets as their currencies strengthen. Also, if they did not buy DM currencies but rather bought domestic assets with newly printed base money, it would result in tremendous asset price inflation as well as consumer price inflation in their domestic economies. As a result, emerging economy governments are forced into buying USD, JPY, GBP and EUR to hold as part of their reserves.
Of course, the more EM governments acquire DM currencies, the more influence the former governments will have on the global stage, as a BRIC economic block. It creates the potential for the currency war to evolve from a currency debasement issue to EM governments using this as a way to force DM governments into submission. To illustrate, should China threaten to dump huge chunks of USD and EUR if NATO was to start a war with Iran, it could prove very effective as it would threaten the collapse of these currencies and potentially trigger a hyperinflationary economic collapse that would send interest rates skyrocketing in the US and Europe. Of course, this would threaten Chinese export markets, so it is unlikely to happen. However, the strategic implications of holding more of someone else’s debts are clear.
That said, note that there is a major shift in the composition of global FX reserves taking place at present. All governments have scaled down the pace of USD, GBP and EUR purchases by a significant margin over the past year, while “other currencies”, the JPY and CHF have seen rising interest as foreign reserve assets. “Other currencies” include mainly emerging market currencies that are becoming more reservable, as well as the AUD and CAD.
From Q1 2010 to Q2 2011, USD, GBP and EUR assets forming part of total global reserves grew by 14%, 14%, and 15%, respectively.
“Other”, JPY, and CHF in total reserve holdings have grown 59%, 52%, and 34% respectively over the same period. There is a very definite shift taking place, whereby emerging economies are beginning to buy up increasing amounts of currencies with lower interest rate and currency risk.
Ultimately, the currency war is won by the government that can debase its currency at the fastest rate while still boosting employment creation and manufacturing capacity in its domestic economy. This is why China’s currency policy is scorned by the West, they have managed to maintain a weak currency while becoming an economic powerhouse. Other countries feel China has achieved this at the expense of their own economies.
While all governments are simultaneously in the process of debasing currencies against one another by increasing respective money supplies, they cannot debase the value of real assets as they do not and cannot control and manipulate its supply. As a result, the global economy is bound to see continued increases of commodity prices across the board in nearly each and every currency denomination. It is set to result in a global price inflationary environment if the currency wars continue, which we expect will. Monetary metals such as gold and silver stand to benefit tremendously as the currency wars continue.