“Who will win the currency wars — the Americans or the Chinese?” asks risk expert and chairman at Intelligence Capital Limited, Avinash Persaud, at the CFA Institute Middle East Investment Conference. Currency wars, such as the “beggar-thy-neighbour” policies of the 1930s, might be thought of as domestic responses to domestic problems, but Persaud argues they are actually undeclared phoney wars on other countries with serious implications.
“Devaluation provides no long-term solution,” said Persaud. The same countries deploying the devaluation weapon also have the smallest manufacturing export sector and, when faced with difficulties, have elected to devalue. In contrast, the euro has forced countries to make decisions they have been deferring for too long. Decision makers on policy and their policies matter. “People on the sell side underestimate importance of policy and neglect the implications of policy,” he added.
Persaud believes we are facing an age of volatility. In this new age, currency management becomes more costly and more important to returns. “The strongest economies in the world are those with the lowest interest rates,” said Persaud, “What drives currency is not growth or interest rates; it is inflation.” He stated that the key policies that matter are those that contribute to low inflation and how inflation divides up the cake between creditors and debtors. Inflation is highly political, determining the allocation of wealth in a country.
Inflation and wealth distribution are determined by policymakers in each country and, in turn, determined by demographics. As an example, Persaud cited the dominant demographic in aging Japan: Japanese pensioners dependent on a fixed income are never going to vote for inflation. In contrast, in the United States, which has a much younger demographic profile, indebted mortgage holders would probably think a little inflation is a good thing. China, with its huge reserves of U.S. Treasuries, has a cylindrical demographic distribution because of the one-child policy. China will thus be inclined toward keeping things as they are, a mild anti-inflationary bias.
In order to navigate currency volatility, Persaud proposed three rules for success in foreign exchange trading (quite a significant condensation from the seven rules he proposed to us a year ago). The first rule is that policy matters. Persaud’s second rule is that in the long run, currencies are determined by inflation. Third, short-term and long-term drivers are different in that fundamental forces may be weak in the short term. Overlaying fundamentals is the investor’s appetite for risk. The currency market’s appetite for risk changes and moves the currency with it. Local interest rates may also have a bearing on appetite for currency risk.
In his concluding remarks, Persaud contended that there will be much greater currency volatility than in the past because of divergence of inflation and other policy. Holders of U.S. currency assets, such as the Chinese, risk importing inflation. Currencies are bonds, not equities, suggesting that inflation really matters to currencies. Countries are also now more heterogeneous than before, with half the world in recession and half the world not. Currencies are capable of being used as weapons and vulnerable to short-term investor risk appetites.
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