The Great Game
In the 1800s, Great Britain and Imperial Russia fought for riches at the ends of the world. In the deserts and mountains of Central Asia, young men played as knights and pawns in the Great Game, searching desperately for glory, and in doing so redrew the map of the world. Central to the Game was the expansion of the homeland’s economic reach. Men like Sir Henry Rawlinson and Henry Pottinger helped open new markets for British and Russian goods, which flowed into present day Afghanistan, Pakistan, and Uzbekistan. It was zero-sum, with Russia’s victories coming at the expense of Britain, and vice versa.
A similar Great Game is being played out today, as the economic map of the world is being redrawn. The competition is intense and it is similarly zero-sum. This is the Great Game of exchange rates.
With domestic production stagnate and unemployment high, countries are looking to the end of the earth in order to export their way out of recession. The plan is to increase domestic production and sell goods to other countries, thereby creating jobs at home. There is the added bonus that growing exports will reduce balance of payment deficits that many nations have wracked up after years of excessive consumption.
While this Game promises the glory of economic stability for some, losing holds the possibility for disaster—not just for each nation, but also for the global economy. Countries are struggling to maintain their competitive advantage as their goods and services become more expensive relative to their competitors. Other countries are fighting to protect domestic producers. And should every country try to export their way to growth, it could mean a dip back into recession. There is also the possibility of political turmoil from angry, unemployed constituents.
For the emerging economies of Brazil, China, India and Russia—forevermore linked as the BRICs—this is a chance to cement one’s place at the center of the world’s economic map. How they are playing this Great Currency Game is revealing. It shows their current standing in the world, how their economies operate, and offer a glimpse of what they may be like in the coming decades.
The First Salvo
Markets tumbled across the globe as keystones of the global economy ceased to exist. Lehman Brothers, AIG, Fannie Mae and Freddie Mac, Royal Bank of Scotland, and many others collapsed under the weight of unpaid debt and contagion fears. In response, the Federal Reserve and its fellow central banks slashed interest rates and flooded the marketplace with cheap money in an effort to mitigate the severity of the downturn.
Three years on and recovery is still illusive. Over the intervening years, policy makers and investors continue to worry about the health of the U.S. economy. Consensus is building around the need for a second round of quantitative easing, where central banks buy up assets to further expand the money supply, which done when interest rates cannot be cut any further. The hope is that increasing the supply of dollars will stimulate lending and economic growth. The side effect would be a depreciation in the value of the dollar. As of the publishing of this article, investors are strongly anticipating more easing and have responded by driving down the dollar.
The European Union has also seen its currency, the Euro, tumble on the fears about the health of its members’ balance sheets. The unlovingly termed PIIGS—Portugal, Ireland, Italy, Greece and Spain—have massive deficits and investors are no longer willing to lend them money at reasonable rates. Money and workers are being drawn from these economies as the governments struggle to implement draconic budget cuts. The European Central Bank has been purchasing government bonds to stabilize the financial markets with some success. As a result, the Euro depreciated for much of 2010.
With the world’s two great currencies depreciating, American and European goods are relatively cheaper to buy on the global market. However, there is another great currency that has seen its value fall—the Chinese renminbi.
For years, China’s currency has been one of the hot button issues in international relations. (This publication covered the topic in its Winter 2007 Issue.) It became even more contentious at the height of the crisis when the Chinese government halted its crawling appreciation against the dollar. As the greenback hit new lows against the euro and the British pound, the renminbi has followed suit.
Beijing achieved this feat through “sterilization,” buys dollars with renminbi and then sells its central bank bills, thereby maintaining its desired exchange rate. The scale of the operation is incredible; Beijing increased its foreign exchange reserves by a record $194 billion in the third quarter of 2010, taking its total holdings above $2.6 trillion.
Along with a major stimulus package, which plowed money into infrastructure projects across the country, the currency peg helped the Chinese economy maintain its astonishing growth rates, even as other countries tumbled into recession. In 2008, its economy expanded by nine percent, and by a further 9.1 percent in 2009, thanks in large part to the country’s many producers and exporters who sell their goods overseas.
The combination of the euro and dollar depreciations and China’s peg has put pressure on many of the other emerging markets. Other BRICs do not maintain a peg to the dollar and have seen their exporting sectors struggle as a result.
India has been an outsourcing hub for technology, pharmaceuticals and telecommunications for decades now, largely because of its cheap labor. The country has faired relatively well during the recession and is currently enjoying strong growth. In the second quarter of 2010, the country’s economy expanded at a brisk 8.8 percent growth.
However, this growth has been a mixed blessing. There have been huge inflows of capital into India, as foreign investors take advantage of lucrative IPOs and the booming economy. The result has been an appreciation in the Indian rupee, which rose to two-year highs against the dollar in October. Suddenly the outsourcing calculus becomes difficult, especially as India’s $60 billion outsourcing sector gets more than 50 percent of its business from the U.S.
Brazil has also tasted the sweet and sour of a booming economy. It enjoys a strong manufacturing and service sectors, as well as huge resource deposits—it is home to the world’s largest iron-ore producer, Vale. These factors make Brazil an increasingly attractive place for investors. Five hedge funds with over $1 billion in assets are based in the country, while the world’s fourth-largest fund manager, Brevan Howard, is planning to open an office in São Paulo. Like India, this has led to a flow of money into the country and an appreciation in the currency.
By contrast, Russia’s economy contracted painfully by eight percent in 2009 as credit dried up and industrial construction halted. The country is home to massive raw material deposits, especially oil and natural gas. Due to fears about inflations, investors have piled money into these assets leading to a rebound in 2010. However, markets are struggling to decide whether high commodity prices will compensate for the weak fundamentals in the country at large. As a result, the rouble has fallen against the euro and the dollar in recent months.
The Currency Wars
The countries now claim to be standing on the precipice of “currency war.” Last September, Brazil’s central bank governor warned that “there is a very serious currency problem and should be addressed,” and that his country “is not going to pay the price” for economic imbalances. The country’s finance minister complained that the world was “in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness.”
Similarly, India’s central banker hinted at intervention in the currency markets should domestic growth be harmed. Reserve Bank of India Governor Duvvuri Subbarao said “Our intervention will be to keep liquidity conditions consistent with activity in the real economy and to maintain financial stability, and not to stand against developments driven by change economic fundamentals.”
By contrast, Russia is calling for “peace.” The central banks first deputy chairman, Alexei Ulyukayev, said that Moscow was “not taking part in any currency wars.” Just ignore the rouble’s fall. This looks to be true as the central bank recently stepped in to prop up its currency.
The question now, though, is how many of these countries can actually follow through on their tough words? And to do so in a lasting manner?
It is not as easy as Beijing makes it seem. Huge reserves and a real commitment are needed to establish and maintain a peg on the order being discussed.
For example, in September of 2010, the Bank of Japan intervened in currency markets, selling an estimated ¥1 trillion after it neared record highs against the dollar. The result was a three percent fall in the yen. Markets quickly undid that work, as the yen marched back up to new highs.
India and Brazil may be talking about intervention, but at the time of publishing, no actions had been taken. There are reports that India cannot even intervened because it is short of cash, which have been allocated to much-needed infrastructure projects.
Certainly there are other options. Last October, Thailand imposed a 15-percent tax on foreign holdings of bonds in an attempt to curb capital inflows, which have seen the baht appreciate to its highest level since before the Asian crisis of the late 1990s. India has so far discounted the use of capital controls, but how long will it allow its status as the outsourcing capital of the world to be undermined?
These actions smack of protectionism, though, which the International Monetary Fund has fretted about. In April 2010, the IMF recognized the pressures on governments to protect their workers, but such policies “would cause significant harm to global trade and stifle the broader economic recovery.” Just five months after this warning, pushed on by angry constituents who complained that cheap Chinese exports are cost America job, the House of Representatives fired a shot across Beijing’s bow, passing a bill that would allow the U.S. to impose tariffs on a broad swath of Chinese goods. How much longer will governments stand on the sidelines?
Redrawing the Map
Right now, the threat of a currency war is a warning, rather than a reality. Instead, the current situation is more like a map being redrawn, with the great and rising powers jostling for position. (Unlike the Great Game of the 1800s, this one is not likely to include massive blood shed or an invasion of Afghanistan.) In the wake of the sub-prime crisis, the foundations of the global economy are shifting. The American consumer, which had accounted for 77 percent of U.S. GDP growth between 2000 and 2007, has slashed spending and is reducing its debt. New consumers and a new, more balanced global economy are needed.
Economists the world over hope that China will provide those consumers and reduce its savings rate.
However, Beijing has shown very little willingness to do so, in part out of fear of sparking of a “lost decade” similar to Japan in the 1990s. Though it has allowed some appreciation in the reminbi in recent months, Beijing continues to assert its policy authority and has been able to hold its course in the face of massive pressure, most notably from Washington.
What does this mean for the other BRICs? As Martin Wolf of the Financial Times notes China’s build up in reserves stalls “the inevitable adjustment towards current account deficits in the emerging world,” which is now “being shifted on to countries that are both attractive to capital inflows and unwilling or unable to intervene in the currency markets on the needed scale.”
So will the needed consumption be found in the other BRICs, with the new flood of money? More than just short-term imbalances, Brazil and India are confronting the challenges of transitioning from emerging economies based largely on exports to ones with a greater focus on consumers. It is possible, but the transition could be risky. With central banks continuing to flood the market with money, there is the threat of a bubble inflating in these emerging economies.
Meanwhile, Russia seems intent to continue on its well-worn path of commodity-led growth. The result of this model, though, is a yawning gap between the uber-rich and everyone else. If the majority of Russians are still struggling to pay of life’s staples, there is only so much consumption that can be expected from the Land of Putin and Medvedev.
The question then is will a currency war actually be needed to address today’s economic issues?
Possibly. Diplomacy and negotiations could avert a race to the bottom—the issue was on the agenda of the last G20 meeting. However, China’s intransigence and U.S.’s continued weaknesses do not seem likely to change any time soon. The chances of any major breakthrough, therefore, are slim. Instead, the best that can be hoped for in the near term is the status quo. Should all sides bank of export led growth and devaluation then the outcome could be disastrous.
What is clear is that the world’s economic map is being fundamentally redrawn. The Great Game is on.