China’s Currency War:

Enemy #1 for Global Economy

When Brazil’s finance minister said the world was in a currency war, it came as big news to many people — a surprising “new” economic threat. But there’s nothing new about a currency war. China has been waging a war — an economic war — with its currency for a long time.

Over the last 14 years, China’s economy has grown four times as fast as the U.S. economy, and it has quickly soared to become the world’s second-largest. The key to China’s success has been a weak yuan — it’s method of manipulating a sustained advantage over its competitors in global trade.

This strategy of manufacturing an artificially weak currency to corner the world’s export market has led to a massive imbalance in global trade. It was a key contributor to the current economic crisis, and it’s proving to be a key barrier to a sustainable global economic recovery.

Put simply, these global trade imbalances have proven a recipe for more frequent boom and bust cycles.

That’s why the G-20, the IMF, the OECD — all of the major institutions and central banks of the world have been harping on the importance of repairing global imbalances. And all along they’ve been speaking directly to China.

Yet after all of the negotiations, threats from U.S. Congress and concessions China is said to have made, it has managed to gain an even bigger trade advantage through the three years of global economic crisis!

Consequently, we’re seeing the rise in currency market interventions from some of China’s key trade competitors as a way to combat their damaging currency disadvantage.

This is a clear sign the team effort pledged by G-20 members to combat the economic crisis is falling apart …

Last March, when the G20 assembled during the depths of the worst economic crisis, they broke camp with a vow to fight the battle together — to act in coordination.

Central bankers slashed interest rates. Governments rolled out fiscal stimulus packages, and the world economy started producing what many thought was an impressive recovery.

But it turned out to be nothing more than a stimulus-induced flop.

Now leaders around the world are seeing the writing on the wall — a long period of deleveraging, littered with more economic pain and shocks. And the vow of coordination is giving way to every man for himself.

Growing Division

Japan stepped in last month to weaken the yen with its biggest daily intervention on record, buying more than $23 billion in the open market. Historically intervention in a major currency is a coordinated event, supported by other major central banks. But this time Japan went in alone.

South Korea, Thailand and Singapore have been consistently intervening to stem the tide of strength in their currencies in recent months.

And Brazil has been doing the same, plus tacking on additional taxes on foreign capital to deter the influx of hot money flooding through its borders — i.e. currency controls.

Take a look at the chart below and you’ll understand why …

You can see the strong rise in Asian currencies over the past year — with one exception, the Chinese yuan. China’s manipulation of the yuan has consistently allowed it to corner the lion’s share of global exports.

But now its trade competitors are fighting back through currency manipulation of their own. Consider these growing responses to the weak yuan the early warning signs of a spreading …

Threat of Protectionism

I’ve said in past Money and Markets columns that ultimately, the rest of the world will have to choose action over diplomacy in dealing with China. And now we’re starting to see it.

The next steps will likely be imposing sanctions on China and trade restrictions on Chinese goods — an effort that is already progressing through Congress.

But the problem with protectionist activity is that it tends to bring about retaliation, and it becomes contagious. That’s exactly what happened in the Great Depression. And it’s what brought global trade to a standstill.

Today, with unemployment sustaining high levels, the political support to act is there. Many would think that “standing up to China, is standing up for us.”

Of course, when jobs are tight the perception by most workers towards globalization becomes more negative. And studies show that during these times, the number of people who favor the idea of higher tariffs on imported goods rises considerably.

As it becomes increasingly evident that China will not play ball on allowing its currency to appreciate to a fair value, geopolitical tensions are bound to elevate, and protectionism will likely follow.

And given the sovereign debt crisis that’s already underway, protectionism is yet another risk to the global economy that increases the probability of another bout with recession.

In fact, protectionism has historically put fragile economies in a deeper and more prolonged crisis …

Take a look at this chart of the S&P 500 from the Great Depression years. It gives you a clear understanding of why protectionism is so dangerous.

You can see that the stock market topped in 1929 and fell 45 percent in just three months. Then, it had a sharp correction, recovering 47 percent from the November ‘29 low.

In June 1930, two U.S. Congressmen, Smoot and Hawley, championed a bill to slap a tariff on virtually every foreign good. And that was the catalyst for the second leg down … a massive plunge in the stock market and arguably the catalyst for the Great Depression.

As an investor, it’s always important that you anticipate plausible scenarios. If a China conflict scenario plays out, you can expect the outcome to be bad for global growth and bad for global financial markets.

Regards,

Bryan

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