Watch Out for Currency Wars

10/11/2010 1:30 pm EST

Focus: MARKETS

Axel Merk

President and Chief Investment Officer, Merk Investments, LLC

Axel Merk, president and chief investment officer of Merk Mutual Funds, and co-portfolio manager Kieran Osborne warn that competitive currency devaluations are a real danger.

Competitive currency devaluation appears to be the name of the game for many Treasury departments and central banks alike. It may also be a key driver of the recent strength in gold.

For many countries, the motivation to devalue the currency is to spur export growth. Devaluing a country’s currency is akin to providing a subsidy to the export sector, as it makes that country’s exports relatively cheaper.

The flip side is that for a high-growth developing economy, the combination of an undervalued currency and increased production and labor costs can cause substantial domestic inflationary pressures, as evidenced in China.

Moreover, devaluing a currency may lead to escalating international political strains, global criticism, and intensification of protectionist pressures, [such as] the US criticism leveled at China, culminating in the passing of legislation aimed at pushing up the value of the yuan.

We have long argued that China should allow its currency, the yuan or renminbi, to appreciate, as it may help alleviate much of China’s domestic inflationary pressure.

The Chinese are unlikely to allow the currency to float freely overnight, as even small moves to the currency affect many businesses throughout the Chinese economy; the process is likely to play out over many years. This hasn’t stopped US politicians from taking a swipe.

But it is unlikely that [many] of the jobs that already left as part of the outsourcing bubble that occurred throughout the last decade will return to the US. The US simply cannot compete on cost; these jobs are likely to migrate to lower-value-producing countries, like the Philippines, Vietnam, or Thailand.

[In fact,] with a continued weak consumer outlook in many western nations, it is quite likely that further competitive currency devaluations occur in the lower-value producing Asian nations.

Should we enter a period of competitive currency devaluations globally, the risks of trade wars may increase substantially, which could come with serious consequences for global markets.

Countries that run current account deficits, including the US, may be at the greatest risk should a global trade war play out, as these countries are reliant on foreign investors to finance their deficits. Should additional tariffs, capital controls, or sanctions take effect, the US may lose the trust of international investors, who may in turn pull funds out of its markets, putting pressure on the US dollar.

The last thing the global economy needs right now is anything that would hamper or derail economic growth. Brazil and Japan’s recent decisions to intervene in the currency markets follow a disturbing trend. If policy makers are not careful, present dynamics may precipitate a worldwide economic slowdown, brought about by protectionist pressures and exacerbated by political motivations globally.

Recent references to a “race to the bottom” and worldwide “currency wars” should not be taken lightly:  [Since] the global economic recovery remains on unsteady ground, the implications of another slowdown in growth could be disastrous.

Read more commentary from Axel Merk at the Merk Mutual Funds Web site here…

Related Articles on MARKETS