The End of Currency Wars?
by Richard Clarida, PIMCO
- International capital is flowing to countries with good growth prospects and to countries with central banks confident enough to raise interest rates.
- Certain nations are placing controls on capital or intervening in currency markets with an eye to maintaining economic competitiveness.
- We see central banks in the U.S. and the U.K. winding down monetary stimulus that has exacerbated the situation. Also, we see potential for emerging market currencies to appreciate, and that may give developed nations a boost.
Nations generally benefit when their currency valuation is low enough to assist domestic industry, making their exports cheap and imports expensive. But when a trading partner intervenes in currency markets to enforce a low valuation, then international tension may arise.
In the fourth of a series of Q&A articles accompanying the recent release of PIMCO's Secular Outlook, portfolio manager Richard Clarida discusses PIMCO’s outlook on currencies and argues that global currency tensions may ease in the years ahead.
Q. Could you discuss efforts some nations appear to be taking to direct the exchange value of their currencies to favor domestic industry? Is this a source of long-term global tension (previously some media reports spoke of “currency war”)?
Clarida: Taking a step back, our secular outlook for the next three to five years is for a two-speed global recovery with emerging markets (EM) leading the way. One natural consequence is that international capital is flowing to countries with good growth prospects and also to countries with central banks that have the confidence to raise interest rates. Much of the focus, rightly, has been on emerging markets, but developed nations such as Australia, Canada and Norway have been hiking interest rates, and their commodity producers are benefiting from booming emerging growth.
Some countries are resisting the upward pressure that these capital flows are putting on their exchange rates. They are placing controls on capital or intervening significantly in currency markets with an eye to maintaining economic competitiveness. We do see this dynamic as a source of long-term global tension, but we believe it is a tension that most likely will be manageable. For example, we see central banks in the U.S. and the U.K. winding down monetary stimulus that has exacerbated the situation; rate hikes could be on the horizon in 2012.
Q. Could you elaborate on how PIMCO sees this issue playing out?
Clarida: If indeed emerging economies are to continue to be centers of global growth, then at some point we believe they will move toward more of a local-demand-driven economic model and away from an export-reliant model. We see currency adjustment as part of that rebalancing.
Let me explain this dynamic. Think of an emerging economy with very rapid productivity growth – the amount of goods and services it can produce each year is expanding. If this hypothetical country relies on export demand, it requires a relatively weak exchange rate to absorb more and more supply. If this country fears export demand is tapering off, it may shift focus and begin nurturing domestic demand – selling local goods to local customers. But if goods and services shift to domestic demand that creates scarcity on the global market and prices rise. So to maintain domestic demand the emerging nation allows its currency to appreciate, which enables domestic consumers to compete globally. Theoretically, this eases global tensions and gives developed nations a boost: since their currencies are relatively cheaper their exports become more competitive.
Q. What does PIMCO mean when it speaks of a trilemma dilemma?
Clarida: The trilemma is a fundamental concept in international finance developed by Nobel laureate economist Robert Mundell, and the basic idea is that for any national economy operating in a broader global economy, there are three desirable outcomes. National leaders want an independent monetary policy that suits domestic circumstances. They want to benefit from the free flow of capital, especially capital inflows directed toward economic investment. And they want a stable exchange rate.
This trio is called a trilemma because theory and experience suggest at most a nation can only achieve two of those objectives. Thus, international policy making is always about trading off the desirability of exchange rate stability, monetary independence and capital flows. The U.S., for example, has had an independent central bank and certainly benefits from an open capital market reflected in our current account deficit – we borrow from the rest of the world. But the dollar fluctuates not only with U.S. events but also with global ones. China, on the other hand, has a very stable exchange rate because they manage it, and their central bank has some leeway to influence domestic interest rates. But China has restricted capital mobility.
Q. Is the U.S. dollar slipping as the world’s reserve currency? Which currency or currencies will dominate global commerce in the years ahead?
Clarida: The dollar’s preeminence dates to the end of World War II with the Bretton Woods global agreement on monetary management. That formal system unwound in the early ‘70s, but the dollar has continued to serve as the global reserve currency. But note that the share of dollars in global central bank portfolios has been declining slowly for the last eight to 10 years. According to the International Monetary Fund, about 60% to 65% of global reserves held by emerging nations are in the form of dollars, down from about 70% a decade ago.
In our baseline case we do not see the dollar being supplanted as the global reserve currency in the next three to five years. If foreign central banks were to decide that they did not want to hold dollars as a reserve, they would have to hold some other currency. And right now there is not a single viable alternative to the dollar. Aside from the 60% that I mentioned earlier, global reserves include about 30% in euros and the rest is mixed. Given current circumstances in Europe, we would not expect the euro to supplant the dollar.
I should point out that although there are privileges that accrue to the provider of the global reserve currency such as cheaper access to global funds, there are also obligations. In periods of financial turmoil or geopolitical turmoil, we tend to see the dollar become more volatile and to appreciate sharply in the flight-to-quality trade. I suspect there are not many policymakers in the world that would like that loss of control and certainty about their currency valuation.
Q. How should investors approach currency investing both in terms of hedging and seeking investment returns? What are the opportunities and risks?
Clarida: At PIMCO, we like to separate in our own minds an investment decision on a security with a separate decision on whether we want to take the related currency bet. In today’s markets, investors are generally able to hedge currency exposure.
Also, certain PIMCO strategies may invest directly in currencies. Broadly, our approach to investing in currencies is to think of them as a way to express our macro views about opportunities in a number of countries.
With our New Normal worldview of headwinds to growth in developed markets and tailwinds in emerging markets, we now generally look at emerging market and G-10 currencies simultaneously and with the same analytical framework. As I discussed earlier, we anticipate EM policymakers will allow their currencies to appreciate in the years ahead as they nurture domestic consumption. And in contrast to the ‘80s and ‘90s, in recent years EM currencies have been less volatile than G-10 currencies. Thus, EM currencies can be attractive opportunities.
Of course, as with any financial investment, there are risks to investing in currencies. The primary risk, in our view, is that there are periods in which volatility spikes and in which there are potentially significant drops in a currency’s relative valuation. There is a saying in the foreign currency markets that currency trades work until they don’t. And so certainly anyone thinking of investing in currencies should also consider if portfolio managers are appropriately factoring in such tail risk. That is certainly a focus at PIMCO.
Thank you, Rich.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Concentration of assets in one or a few countries (or a particular area) and currencies will subject a portfolio to greater risk than if the assets were not geographically concentrated.
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