« Currency war », return of protectionism: threats and opportunities!

An analytical report by Jacques Tebeka, Head of Diversified Multi management at Edmond de Rothschild Investment Managers

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At the height of the recent crisis, memories of the Great Depression in 1929 triggered a vigorous government response. Coordinated interest rate cuts and Keynesian stimulus programmes were introduced in many countries to avoid making the same mistakes as in 1929. Back then, US unemployment surged to close to 20%. The current approach has been to adopt quantitative easing policies which have led to interest rates of almost zero in most developed countries including the US.

In this low interest rate environment, further measures have been taken to curb deflationary risk. With varying degrees of enthusiasm, developed economies have thrown themselves into quantitative easing, in other words central bank buying of government bonds financed by printing money. On financial markets, this policy boosts financial assets, causes the currency to depreciate and raises expectations of inflation, thereby reducing real rates and stimulating the economy by bolstering the wealth effect, exports and demand.

The US was the first to introduce this policy. Japan intervened on its currency market to stop the Yen appreciating and is now mulling quantitative easing measures. The Bank of England is also seriously thinking about adding to the GBP 200bn already spent in this way. And lastly, the ECB, no doubt due to the debt crisis in countries like Greece, Portugal, Ireland and Spain, has been forced to introduce a government bond purchase programme for member states. At the same time, the continuing appreciation in the euro could jeopardise Europe’s fragile recovery.

A policy which targets currency depreciation is necessarily a zero sum game: what one side wins is lost by the other side; hence, current concerns over a “currency war”. The US seems more determined to apply this policy as the collective memory was scarred by the 1929 crisis and the subsequent period of deflation. Other central banks, willingly or not, are expected to introduce similar measures. It is difficult to predict exactly what effects this will have on exchange rates between developed countries but volatility will almost certainly be high. The EUR/USD rate, for example, has seen wide swings, falling from 1.43 at the beginning of the year to 1.20 before rebounding to 1.43.


Emerging countries, and China above all, have a development model that is based on exports and facilitated by an undervalued currency. This has resulted in their central banks stockpiling reserves. The Economist calculates that 2/3 of the USD 8.4 trillion in reserves are held by emerging countries.

But today, these economies cannot maintain capital mobility, a stable exchange rate and an autonomous monetary policy at one and the same time. If they try to stop their currency appreciating, they will lose control of their monetary policy, fuelling inflationary pressure and running the risk of creating a bubble in their financial assets. The other solutions are also tricky: it would be difficult to clamp down on capital mobility after encouraging it for several decades and allowing the currency to rise would have a negative impact on exports.

And so the announcement of further quantitative easing in the US has reinforced pressure on emerging countries. Not all have reacted in the same way. China, in particular, is trying to maintain its model based on fixed exchange rates and an undervalued RMB/USD rate. Other Asian countries like Indonesia, Malaysia, Thailand and South Korea have allowed their currencies to appreciate significantly. Brazil saw its currency appreciate sharply in 2009 before imposing taxes on capital inflows. In all these countries, foreign currency reserves, monetary aggregates and inflationary pressures are increasing significantly.


All financial markets stand to gain from this situation. Quite simply, after driving investors away from money market funds, the FED is using the same technique on long-dated bonds. In the search for yield, investors will have to turn to riskier asset classes and that will mean higher volatility.

Clearly, emerging markets represent a choice target for yield-hungry investors. The potential for stronger, more robust growth, higher interest rates, and strong pressure for emerging currencies to rise are just some of the reasons why investors are tempted.

The emerging country theme and its associated currency risk is one of our diversified multi management team’s top conviction plays and it is an increasingly large percentage of our allocation funds. Emerging debt denominated in local currency currently represents around 30% of our bond allocation – compared to 10% one year ago- and emerging equities account for 20% of our equity allocation in the Saint-Honoré Allocation Rendement, Saint-Honoré Allocation Patrimoine and SaintHonoré Allocation Dynamique funds

Multi management allows investors to pick the best specialists in specific market segments and invest in precise themes like emerging debt or equity. These markets are serviced by a broad and varied fund manager universe across more than 800 funds. In these famously volatile segments, fund performance is often unstable over time. Multi management is an efficient way of reducing performance volatility.

The Saint-Honoré Allocation fund range is a privileged solution for investors wishing to invest in current growth themes, allowing them to benefit from opportunities arising from the changing macroeconomic environment. As the currency war returns to centre stage, exposure to emerging market and exchange rate risk is a core them in our portfolios.

Jacques Tebeka November 2010

Article also available in : English EN | français FR




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