3rd November 2010
At the heart of the ongoing global currency saga is the spat between the US and China, with Washington accusing Beijing of deliberately manipulating the yuan to favour its exporters, as reported in this Mindful Money article.
The G20 meeting in Seoul over November 10-12 will certainly be focused on resolving the ongoing ‘currency wars'.
But just yesterday, as reported by Reuters, even Washington moved to downplay expectations on this front, saying it does not foresee China bowing to pressure over its yuan currency or a solution being found for smoothing out current global imbalances in general.
Instead, it reckons the discussions will merely be ‘part of an ongoing effort' to resolve these issues.
But, as Philip Poole, global head of investment strategy at HSBC points out, currency wars and the lack of global adjustment between countries with big surpluses, like China and Germany, and those carrying deficits, the US in particular, have major implications for relative inflation rates between developed and emerging economies too.
Fears of deflation across much of the developed world are palpable, and central banks remain in easing mode. This week, for instance, the US Federal Bank, is expected to reveal plans to inject more stimulus into the economy, as The Daily Telegraph reports.
And while recent surprisingly strong UK GDP figures have put easing here on the backburner for now, we may yet see a UK QE2 next year.
But with financial systems "still broken" in much of the developed world, the likelihood is that much of this QE will translate into broad money creation not in developed economies but in emerging countries where banking systems are in better health.
For Poole, the overall impact of such a scenario will be inflationary pressures in emerging markets coupled with a growing risk of asset bubbles.
Indeed, as he points, worries on these fronts are already evident, with some central banks in the emerging world, most recently China's, tightening monetary policy in response.
And as The FT reports, India raised rates for an astonishing sixth time in the space of year to curb inflation.
According to Poole there are three main sources of inflationary pressures in many emerging economies.
The first is food price inflation, which has been a problem in a number of markets, for example India. In some markets it can account for 60% of the consumer price index, magnifying its importance enormously.
The second is ‘unsterilised' currency intervention, whereby a central bank looks to influence exchange rates and its money supply by not buying or selling domestic or foreign currencies or assets.
Poole explains that in the ‘currency wars' that are being played out across the globe, many emerging market central banks are intervening in FX markets, buying dollars in an effort to cap appreciation pressures.
A number of them have also introduced capital controls to curb portfolio inflows. "If inflation does end up being the result, there would be real appreciation through the backdoor – via an adverse inflation differential with the developed world – and currency intervention would ultimately prove to be self-defeating."
The third reason for inflationary pressures in emerging markets relates to their performance during the ‘Great Recession' that afflicted most of the developed economies.
"It should not be forgotten that markets like India and China did not suffer a decline in output during the ‘global' recession. In fact, in these two cases, there was only a slight moderation in growth," says Poole.
Having come up to speed pretty quickly in terms of growth performance, pricing power in terms of product output and labour has returned in a number of these markets, most notably China.
Indeed, Poole believes the labour market in buoyant emerging countries could be an important transmission channel for inflation pressures. "If real wages grow at a faster pace than productivity, inflation pressures will increase, with the risk that central banks fall behind the curve."
He cites Brazil as a good example of how wage inflation has taken off in key emerging countries.
Having been robust throughout the credit crunch crisis, Brazil's unemployment rate has now fallen to just over 6% and tightness in its labour market is being translated into pressure on wages.
That in turn means there is a risk of inflation, with Poole pointing out average wages in Brazil were up by more than 11% year-on-year in September, or just over 6% in real terms.
Other countries where a similar story is unfolding include Korea, Poland and Chile where the unemployment rate has fallen to previous cycle norms. India has also seen sharp rises in wage rates for skilled workers. Wages in China meanwhile are increasing sharply in key export sectors of the economy.
For Poole, all this points very necessarily to the need for a tightening of monetary policy in emerging markets.
There is a catch however: by raising rates when the US Fed and other developed world central banks are on hold only increases the interest differential and the carry on these emerging currencies.
That means yet more hot money flowing into emerging markets assets and currencies as investors continue with their hunt for yield and return.
It all amounts to an unholy collision as hot money moves from developed to emerging economies, meeting with continuing robust growth and the several inflationary pathways that are opening up in these economies.
Carry currency trading, of course, provides much upside potential but Poole urges investors in emerging markets to buy some inflation protection via inflation-linked securities for their portfolios.
Inflation-linked bonds, for instance, typically guarantee repayment of capital, adjusted for the change in the consumer price index between the date on which the bond was issued and the date on which it is repaid, plus a return above the inflation rate.
Such bonds will help protect income against inflation but not necessarily beat it so are best used within the context of a fund constructed to provide an income.