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Thursday, October 7, 2010 - 12:03
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Thursday, August 15, 2013 - 11:09
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Thursday, October 7, 2010 - 12:03

What the Global Currency Wars Mean for Your Portfolio

Thursday, October 7, 2010 - 12:03pm

Even as the high-profile spat between the United States and China over the too-cheap Chinese currency gets much press coverage, currency wars are brewing all over the place. And how these battles shake out will determine whether the global economy will move into harmony, or come apart at the seams.

For many years, the U.S. stood by a "strong dollar" policy, which meant that a robust dollar was in America's best interests. The strong dollar enabled the U.S. to consume massive amounts of imports at a discount, which worked out just fine when the economy was doing well. It also allowed U.S. manufacturers to move jobs offshore to places where a weaker currency meant low wages.

That policy has come to an abrupt end. Congress is set to deliver a bill to President Obama that aims to amp up the rhetoric against China. If China doesn't act to let its currency rise in value (and economists believe it would need to rise +40% to achieve global parity), then the U.S. may start to enact steep tariffs on Chinese goods. That would be a clear positive in some domestic industries such as steel-making or electronics, but would prove quite troublesome for any industries that want to gain a foothold in the massive Chinese market. Chinese counter-moves that restrict access of U.S. goods would be almost inevitable.

For nearly 200 years, we have been taught that free trade and open markets are the key to rising global living standards. And myriad academic studies bear that out. But free trade theory assumes that everyone plays by a fair set of rules with regard to free-floating currencies and minimal trade barriers. In many respects, China is ignoring those rules by using a weak currency that is good for China and bad for its trading partners. These are known as "Beggar Thy Neighbor" policies, and have led to major conflicts in past centuries.

Nobody anticipates these currency battles to escalate into an all out war, but recent comments from Brazil sure were heated. Brazil's currency has surged in 2010 to a point where its domestic businesses are becoming less competitive when compared to neighboring businesses in Argentina, Chile and Mexico. [Read: "The Number One Reason Brazil Could be Headed for a Pullback"] And that led Brazil's Finance Minister to tell the Financial Times this week that financial leaders are "in the midst of an international currency war -- a general weakening of currency," adding that the situation, "Threatens us because it takes away our competitiveness."

In a similar vein, Japan has spent massive sums of money to buy back its currency -- the yen -- on foreign-exchange markets in a desperate but perhaps futile effort to weaken the yen and keep its exporters competitive.

Part of the burgeoning global currency problems stem from the fact that we've moved into a bipolar world. Some countries consume lots of imports, while others focus on exports. The latter strategy worked fine for Japan for many decades, but with China emerging as the new global export powerhouse, Japan is now adrift with a domestic economy that generates minimal demand and an export economy that may flounder.

The G-7, G-20 and the International Monetary Fund (IMF) are set to meet soon and will express concerns that currency battles are detrimental to global growth. Even as these meetings will yield diplomatic pronouncements, individual countries are likely to speak with much more vitriol and more likely to try to use policy tools to try to change the currency dynamics.

Yet even as policy makers look to take action against China and take steps to weaken their own currencies, the real long-term solution is to change consumption habits. In an ideal world, countries like China and Japan would develop much more robust levels of domestic spending to erase chronic trade surpluses. And countries like the U.S. would look to live with fewer imports to curtail trade deficits. That process is already underway as the U.S. starts to import less oil as auto fuel efficiency standards rise. And President Obama has stated a goal of doubling U.S. exports in the next five years. Trouble is, the only way that can happen is for the U.S. dollar to become a lot weaker. And despite repeated jaw-boning about other countries' currencies, the dollar remains relatively strong.

Judging by comments and actions by the Chinese government, it seems as there is a wish for the issue to simply continue to be ignored. But as recent events and comments in the U.S., Japan and Brazil underscore, currency conflicts look set to become more heated in the months to come.

Action to Take --> Even as policy makers try to push their currencies down, natural forces may overwhelm their efforts. Thanks to an expected economy-priming move by the U.S. Federal Reserve, the dollar has begun to sharply weaken in recent weeks, and it now stands at all-time lows against the Australian dollar and the Swiss franc, a 15-year low against the Japanese yen, and more recent lows against the euro. That could prove very beneficial for multi-national profits in the near-term, and a real boost for the U.S. manufacturing sector down the road.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.