The Ultimate Manipulation

Currency manipulation becomes Currency misalignment Hands up if you remember when intervention in the FX market was a common monetary policy tool? Intervention is the most blatant currency manipulation weapon available to Central Banks.

There is a mountain of economics professor ‘jargon’ that surrounds intervention. The web is littered with explanations and articles. For the purposes of this article let’s simply agree that the best way for a country to deliberately use its monetary policy to affect the value of its currency is to buy or sell it.

Of course, there are plenty of examples of monetary policy affecting currency value. The latest and easiest to follow is the ultra-easy monetary policy adopted by Japan. President Trump recently lumped Japan with China and, bizarrely, Germany onto his list of currency manipulators.

Japan, the world’s third largest economy, suffers from very low inflation and needs to stave off deflation. It does this by several economic measures. The most transparent policy is low, even negative, interest rates. A by-product of this policy is a weakening of the currency as traders use interest rate differentials to value currencies.

In times of stress, leading to risk aversion, traders buy low yielding currencies like the JPY and CHF since the low inflation also preserves the value of the currency.

Why do countries deliberately weaken their currency? Well the main one is to be able to gain export market share. As a currency weakens, the competitiveness of its exports (either goods or services) increases (they become cheaper)

Greece and Cyprus both suffered severely during the financial crisis which started in 2008. If they had run their own currencies, they would have fallen dramatically due to fear over default for their domestic bonds. However, this fall in the currency would have eventually led to a recovery as the value of their exports became more competitive. They could even have unilaterally ‘devalued’ as is often seen when countries suffer a severe economic downturn.

So, why the history and economics lessons? Well, it’s quite simple.

A little mentioned news story this past Friday concerned a White House Official who commented that currency misalignment not manipulation was the term that most concerned the Administration.

It would be difficult to see a more blatant sop to the sensibilities of a country; whose leader just so happens to be visiting the U.S. this week.

President Trump as part of his election manifesto declared that he would label China as a currency manipulator on his first day in office. This would have entailed all kinds of fines and tariffs severely damaging the U.S./China relationship.

In typical fashion political ‘war of words’ have curiously not lead to any real action, and more than two months in, his minions have come up with a word that solves the issue, certainly for the layman.

Labelling currencies as being misaligned is, frankly, nonsense.

The foreign exchange market turns over approximately, $5.5 trillion a day. It is wholly unregulated with currencies rising or falling due to several economic or political factors.

These factors can, of course, include intervention but putting that aside for a moment, currencies are free to move in line with what the market believes their true value to be. So, to say the market is unaligned is simply invoking Purchasing Power Parity (PPP) as the method to which the true value of a currency is determined.

Simply put PPP is valuing a currency by using the value of a commodity or basket of commodities in, say the JPY and USD to agree on the exchange rate.

The best way to illustrate this is by way of the ‘Big Mac Index’. With McDonald’s setting the price of the famed two all beef patties, special sauce, lettuce cheese, pickles, onion, on a sesame seed bun sandwich the same worldwide, in relation to the buying power of the USD dollar, the index essentially shows the ‘true’ exchange rates worldwide, ie those that affect local buying power.

So, if a Big Mac is $2.50 in New York and Jpy 250 in Tokyo. The real exchange rate is Jpy 100 per dollar. The fact that the Jpy closed yesterday at 111.05 reflects other factors that drive currencies and determine the free float.

Trump: “Oh President Abe your currency is misaligned”

Abe: “Yes President Trump we are suffering low inflation and using low interest rates to try to encourage spending”

Trump: “The U.S. is suffering since your cheap exports provide better value for money than U.S. produced goods”

Abe: “Yes I know, but a weak currency is a by-product of a monetary policy designed to aid the Japanese economy not provide jobs for Americans!”

Trump “Yes I see that, but couldn’t you intervene to sell dollars and buy Yen to strengthen the currency.

Abe: “We could, but isn’t that manipulation?

Trump: “Only if its not in your interest to do so”

Abe: “Then, why would we do it”

Manipulation leads to misalignment, not the other way around.

Official intervention in the currency market has largely died out. It was last seen in 2012/13 when the G7 agreed to intervene to weaken the JPY to assist a country whose economy was reeling from the earthquake and Tsunami. Japan was subsequently criticised by the U.S. Treasury for unilaterally intervening again to weaken its currency further.

In conclusion, it is clearly in everyone's best interests to have a free-flowing FX market where prices are determined by genuine economic factors. Those factors may be engineered, however, as in Japan’s case. This must be seen to be a genuine attempt to stave off an event or crisis rather than an artificial attempt to gain market share.