Currency Wars: What Does It All Mean?

“Brazil to Buy Excess Dollars Amid Worldwide Currency War”

–Bloomberg, September 27, 2010

There was something about this headline that I found particularly disturbing this morning.  Upset that the soaring price of the Brazilian real is making the country’s exports uncompetitive, Brazil’s foreign minister made it clear that “Devaluing currencies artificially is a global strategy” and that Brazil is “not going to lose this game.”

Though I am not at all bullish on gold’s long-term prospects, I can certainly forgive the gold bugs for their enthusiasm when I read comments like that.

Currency devaluation is nothing new, of course. Debasing precious metal coins with base metals has been a practice of governments since the dawn of civilization. Today, the dirty work is done by central bank open market operations. Brazil’s strategy–which is the same employed by most governments–is to weaken its own currency by selling it to buy dollars (or other currencies).

There is nothing new under the sun here, of course. It was just the Brazilian finance minister’s bluntness that took me aback. Rarely do treasuries or central banks make their plans that cut and dry.

Brazil has a problem today that it would have loved to have had in the past.  Because of the country’s growth, attractive interest rates, and newfound stability international investors are flocking to the country.  Investor inflows and robust exports have sent the Brazilian currency soaring.   As a result, Brazil has had to limit the amount of foreign capital entering the country by instituting taxes on short-term inflows.

Brazil–and much of the rest of the developing world–appears to have its act together this time.  Developing countries are by and large following policies of macroeconomic stability and have largely escaped the debt crisis that is bogging down the developed world.  With some notable exceptions, they have also avoided the siren song of overt trade wars via high tariffs and restrictions.  Many analysts–myself included–feared that the meltdown and global recession would lead to a wave of protectionist sentiment, a la the Smoot-Hawley Tariff of 1930 that wreaked so much havoc on world trade at the beginning of the Great Depression. Perhaps humans are indeed capable of learning from history, because it appears that no such trade war will come to pass this time.  There were aberration–such as the “Buy American” provisions and their equivalents around the world–but nothing that upset the global applecart too badly.

Instead, we have the currency wars.  For now,  I consider this a benign threat.  But it is something that should be watched.  A true escalation of competitive currency devaluation could spiral into something bigger.  Investors currently flocking to emerging market bonds for their attractive yields should take this under consideration.

Charles Lewis Sizemore, CFA

Read the original story at H. S. Dent