New world order and currency wars

IN 1944, delegates from 44 countries came together to create a post-war economic order. They created a framework to foster international economic cooperation by encouraging currency exchange stability and promoting global trade.

Asian countries did not enter this post-war order until the second half of the century, perhaps most notably characterised by Deng Xiaoping opening China to the West in 1978. But when these economies came onto the scene, a potent force was unleased into the global economy. Favourable demographics and agrarian-based economies were transformed by industrialisation and mercantilist trade policies, leading to rapid growth for many Asian countries.

Asia was the primary beneficiary of globalisation, especially given the tolerance for one-sided trade practices shown by the major developed countries during that period. With Asia's rise, nearly a billion people in the region were lifted out of poverty.

The multilateralism represented by that 1944 agreement is now at risk. So, too, are the economic miracles witnessed in the second half of the last century. Populism has swept the globe, leaving no region untouched. With it has come a shift to more inward-focused, nationalistic leanings. Global cooperation has been overshadowed by scepticism and animosity. Multilateral trade agreements are being replaced by trade wars. The framework that lifted Asia out of poverty is in jeopardy.

Unfortunately the first shots have been fired in a currency war. This can be seen in the US-China and the Japan-South Korea currency tensions. It is unclear whether Singapore, where net trade is 300 per cent of its GDP, can avoid inadvertent damage. But there are winners, too. Vietnam has seen massive influx of new business as tariffs have hit China trade. The US is theoretically less vulnerable to currency wars because it has the advantages of a reference currency, higher real interest rates and trade as a smaller percentage of GDP.

Risk to the global economy

One of the most tempting responses to threats to its global trade is for a country to weaken its currency. The barriers to such an action are low, and a weak currency can, in the short term, make exports more competitive and protect domestic businesses by raising the cost of imports. But such an action is ultimately shortsighted because other countries will follow suit. A currency war's biggest impact may be financial market turmoil rather than direct damage from the currency war itself.

That's not to say there are not lasting negative consequences. By weakening their currency, countries increase inflation and decrease the purchasing power of their populations, constraining monetary policy. For countries with below-target inflation, this makes currency devaluations all the more tempting. But high savings rates produced by many Asian countries could be drained, leading to deficits.

In addition, debt-to-GDP in large economies has already grown from 45 per cent in 2001 to 76 per cent today, sapping fiscal firepower.

Uncertainty and unpredictability

Against the present backdrop of slowing global growth, with the US the only major economy doing well and Brexit looming, a currency war now would further limit central banks' ability to cut rates, pump liquidity into their economies, and stimulate growth at a critical juncture.

Beyond monetary policy, currency wars create uncertainty and unpredictability. Planning is difficult, business capital expenditure and foreign direct investment slows, capital flows to the sidelines, and "deglobalisation" aggravates economic inefficiencies. Increases in the cost of imports typically run ahead of wages, causing consumers to reduce consumption. All these effects put further pressure on economic growth at a time of vulnerability.

For example, with Chinese fundamentals deteriorating, a weaker currency will require greater amounts of monetary and fiscal stimulus to accelerate growth. At the same time, currency devaluations increase domestic outflows. To combat this, the Chinese government would need to either draw from its foreign exchange reserves, constrict offshore renminbi liquidity or tighten capital controls, any of which make managing domestic RMB liquidity more difficult. Finding the right balance is tricky, and failure risks triggering an uncontrolled run on the RMB.

How a currency war can be expected to play through securities markets is a topic of keen interest for global investors. One expected effect is a flight to quality and liquidity. The yen, euro (absent Brexit), Swiss franc, US dollar and gold will be beneficiaries. What is essentially happening in a currency war is that foreign governments impose quantitative easing on their trade counterparties which would fall today on massive central bank stimulus already under way.

Developed country equity markets should suffer, as perceived risk and uncertainty rise at the same time that economic growth is under pressure. With its dual influences of increasing inflation and retarding economic growth, a currency war risks unleashing stagflation, a demon which has proven anathema to equity markets. Within equities, yield and value stocks can be expected to hold their value somewhat better than growth stocks.

Ironically, risky credit in developed markets, which should be hit as capital moves to safer havens, could actually rally. This is because today's zero-bound rates on sovereign debt mean their yields have limited room to fall (30 per cent of traded bonds globally have negative yields today). At the same time, capital crowding into these markets could cause spreads on risky credit to contract. This would create an inversion where the normal positive correlation between equities and risky credit reverses.

Emerging markets will be particularly vulnerable to currency turmoil, especially those with large amounts of dollar-denominated debt or countries heavily dependent on imports of dollarbased commodities. FDI and access to capital can dry up just as economic growth comes under pressure, subjecting smaller economies to substantial fundamental challenges. These emerging economies risk being collateral damage in a currency war among major countries.

Finally, the premium for illiquidity and complexity will expand. This means substantial outperformance could be available for investors willing to move capital into private investments while crowds run the other way. These investments are often premised on highly specific operating improvements at the individual asset level. As a result, correlations of investment returns in private assets with global economies and stock markets should decouple in this scenario, which opens the opportunity for farsighted investors to capture substantial alpha.

Taking the high road

Responding to deglobalisation and decreasing global trade with managed currency regimes - that was yesterday's policy. At best, it leads to a temporarily larger share of a shrinking pie.

Transforming the economy and developing the middle class by converting savings to consumption is a better path to securing prosperity for the region.