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Race to the Bottom - Outside View by Asad Dossani

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Race to the Bottom
Sep 28, 2010

As countries around the world aim to get their economies back on track, they are embarking on a variety of fiscal and monetary policies to stimulate growth. One of the biggest consensus ideas is that increasing exports will increase economic growth rates. Logic follows that to increase exports the home currency must weaken. A weaker currency means that your products become cheaper and more competitive relative to foreign countries.

The foreign exchange market is the largest and most liquid in the world. It is also a market where government intervention is rife, and exchange rates are largely a function of what governments say and do. Earlier this month, the Bank of Japan intervened directly in the FX market when it felt the yen was too high relative to dollar. As a result of the intervention, the yen fell 3% on the day.

More recently, the US Federal Reserve announced that it would be willing to pursue further stimulus measures through additional quantitative easing to aid the US economy. The dollar fell against all its major counterparts on that news. Notice that the Fed didn't have to physically intervene in currency markets, but was able move the markets through its words and actions.

An excellent example of a country that intervenes in currency markets to increase exports is China. The renminbi is pegged to the dollar, which keeps the currency artificially low, and improves the export capabilities of China. The US has continually put pressure on China to revalue its currency, but not much has actually happened.

Central banks around the world have one thing in common. They all want weaker currencies. They say and do things that will make their currency weaker. They directly or indirectly intervene in the foreign exchange market to achieve this.

Government intervention in currency markets usually results in long-term imbalances. Take China and the US as an example. As a result of China keeping its currency artificially low, it has build up a large trade surplus with the US. It has a massive supply of dollar reserves that mostly get invested in treasury bonds, rather than being used to import goods from the US. At some point, China's currency has to strengthen to correct this imbalance. The Americans will have to consume less, and the Chinese will need to consume more.

The consensus among politicians and central bankers is that exports are good and imports are bad. This is simply not true. We know that exports are good for a country because they create jobs and increase income. But imports are also good for a country. Imports reduce prices for consumers and lead to higher standards of living for the country as a whole. An ideal position for a country is to have its exports equal its imports, and not have large imbalances.

Neither the US nor China is in a good position when it comes to their trade imbalance. When China's currency does appreciate, US consumers will suffer because their imports will cost more. China will suffer because some jobs in its export industries will be lost. The period of adjustment will be painful on both sides, and this creates political obstacles to China's currency revaluation.

Central banks are now in a race to the bottom. They all want weaker currencies. We know this isn't possible, as one currency's fall must mean another's rise. Rhetoric for weak currencies is nothing more than a political gimmick - it plays to the general consensus' view that exports should be increased and imports reduced. In the long run, such a policy can create large imbalances and can ultimately harm an economy.

The global economy would be better off if central banks cooperated with one another rather than all of them trying to devalue their currencies. As a retail foreign exchange investor, what is important to remember is that currency movements are as much a result of government intervention as they are a result of underlying economic reality.

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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