SNB, Currency Wars, and the China Peg

The currency wars are back. It was, of course, the neutral Swiss who fired the latest salvo in this "conflict" by announcing a minimum exchange rate target vis-a-vis the euro. This amounts to quantitative easing a l'outrance: the Swiss National Bank will print Swiss francs as necessary to buy up foreign exchange to hit its target. Markets certainly took note.

The dramatic impact of the SNB's announcement refutes claims that monetary policy is currently impotent. Even in a liquidity trap, a sufficiently radical monetary shock will undoubtedly jolt an economy back towards growth. But, as if often the case, there is a fallacy of composition problem here: everybody cannot devalue at the same time—right? Buttonwood of The Economist makes the case:

It seems that all countries would like to see their currencies decline bar the Chinese who will only let the renminbi strengthen gradually. Some currencies must rise, however, and the Europeans may not be too happy to see the Swiss trying to drive the euro up, especially if the Fed opts for a third round of QE.

Hence, the evocatively dubbed "currency wars", i.e. competitive devaluations. However, Buttonwood's fear that this will lead to a destructive game of "beggar-thy-neighbor" leads to a puzzling historical analogy. Again, from The Economist:

It is all a bit reminiscent of the 1930s. When countries went off the gold standard, they gained a competitive march on their rivals, increasing the pressure for such countries to leave the standard as well. If one country devalued by 10%, the next might do so by 15%. QE may similarly begat more QE.

Isn't this an argument in favor of currency wars? After all, abandoning the gold standard was effectively a prerequisite for reversing the precipitous decline of the Great Depression. Insofar as combatting the economic crisis of the 1930s required a coordinated international response, competitive devaluation acted as an organic catalyst for such collective action by prodding one nation after another to pursue more expansionary monetary policy. This was the invisible hand on the macro level. As Ryan Avent points out, all the better if the ECB or the Fed respond today with their own currency interventions; the global economy might just get QE all the way down, to recovery.

But what of China? Indeed, their currency peg to the dollar short circuits this potentially mutually beneficial game of competitive devaluation, and turns it into a zero sum one. Due to its capital controls, foreign governments cannot respond in kind to the Chinese government's currency interventions. This amounts to "stealing" demand from overseas. Ryan Avent argues, however, that this does not need to end badly:

Central banks can still print money, taxing the foreign government's ability to sterilise until it relents, and in the meantime supporting the domestic economy. Alternatively, a government in this position can use the free loans provided by the intervening foreign government to directly stimulate the economy, through fiscal spending and investment.

Put simply: QE can make a peg either impractical due to the inflation it would inflict, or impossible due to the limitless foreign exchange that would be necessary to sterilize inflows. The surge in Chinese inflation after QE2 would seem to confirm this viewpoint—except for the fact that China did not ditch its peg. Indeed, a country that considers a currency peg an integral part of its growth strategy will only jettison it as a last resort. China would rather hike interest rates or increase reserve ratios—which are obviously contractionary policies both domestically and abroad—than appreciate its currency.

Clearly, not all currency pegs are created equal. Consider Switzerland's de facto peg. If the ECB decided to embark on its own bond-buying program to counteract the SNB, the Swiss would presumably respond by printing more francs and increasing their own bond-buying. The result: expansionary monetary policy for both the Eurozone and Switzerland. China's capital controls and rigid defense of its own peg subvert this calculus: the United States buys bonds, and China raises interest rates. Rather than both economies giving themselves an economic boost, China curtails its own growth —which obviously has negative spillover effects for the myriad economies that depend on Chinese demand.

Of course, a determined Federal Reserve could overcome these obstacles, much as the SNB just did. If the Fed announced that it would pursue open-ended QE until the real exchange rate between the dollar and the yuan hit (and stayed at) an explicit target more in line with perceived fundamentals, it would almost certainly force Chinese officials to reassess their stance. A credible threat would be sufficient. But this ignores the modus operandi of modern central banks: only the threat of imminent deflation spurs them to embrace unorthodox policies. As long as core inflation creeps along near 2%, they consider it mission accomplished. It would take another drastic leg down before the Fed would countenance approximating anything close to such a seemingly radical policy.

The natural bias towards timidity among central bankers—at least when it comes to trying to create inflation—is perhaps the most compelling argument in favor of a so-called currency war. It forces stimulative action. Still, capital controls can complicate the advantages of competitive devaluation; a positive sum currency war can devolve into a zero sum trade war. It is well within the power of central banks to forestall such a breakdown, but unfortunately far too many still seem obsessed with Don Quixote economics. It is a dangerous moment. Will the Fed and ECB notice?

The Road to Revolution in Beijing Runs Through Riyadh

Egypt is not Tunisia. Bahrain is not Eygpt. Saudi Arabia is not Bahrain. Such has been the tragicomic refrain from besieged capitals across the Arab world, as protests have put a lie to the illusion of stability that had seemingly prevailed (the same, of course, applies to the PIIGS and the Euro sovereign debt/banking crisis). These hollow protestations certainly belie the reality in the streets, but there is at least a hint of truth here: these are economically disparate societies. Yet none have been spared from unrest; not the rich (Oman and Bahrain), nor the poor (Yemen and Mauritania) nor the middle class (Tunisia and Egypt). Rather, the propaganda of the deed, swarms of unemployed youths, and -- yes -- food inflation have conspired to kindle revolutionary fervor across rich and poor country alike throughout the Arab world. But now the question becomes, will unrest spread beyond the Middle East or will this solely be remembered as the Arab 1989 (or 1848, depending on one's historical perspective)?

Which brings us to China. For the past twenty years, there's been something of a Western cottage industry endlessly predicting the imminent doom of the Chinese regime. And for twenty years, the reports of the CCP's demise have been greatly exaggerated. But at risk of succumbing to the same folly, this time really might be different. Indeed, the Chinese economy seems near a de Tocquevillian moment: doing (very) well, but not well enough. Thirty years of staggering growth have lifted untold millions out of poverty, but, as you would imagine, have also dramatically increased future expectations. And now there are legitimate concerns about a coming economic slowdown -- which Chinese authorities are keenly aware could prove fatal to their rule. 

 The Chinese government aggressively responded to the loss of export demand due to the financial crisis with a stimulus package that dwarfed any seen in the West, on a GDP-adjusted basis. This credit-driven growth, however, seems to have mainly contributed to an unsustainable property bubble. Ghost towns, empty office buildings, and off-balance sheet local government debt - it's all enough to make contrarian hedge funders perk up. To its credit, the Chinese government has tried both to gently deflate the bubble with higher reserve requirements and interest rate hikes, and to ameliorate the squeeze ordinary Chinese are feeling with an increased commitment to building affordable housing -- although none of these measures have yet been much effective.

Of course, the Chinese government is nothing if not vigilant when it comes to threats to its "harmonious" society. With soaring food inflation fueling simmering discontent over endemic corruption and abuses of power, the state was quick to shut down the copycat "Jasmine Revolution" Chinese web activists tried to organize several weeks ago. For Westerners quick to pounce on any evidence of discord in the Middle Kingdom -- including US ambassador Jon Huntsman, who conspicuously showed up at the pre-arranged protest site in Beijing -- the abortive demonstrations were certainly disappointing. The, perhaps unsatisfying, reality seems to be that there simply isn't widespread support for Tunisia-style protests in China. After a century of nearly unfathomable hardship, the Chinese people are loathe to force out a regime that, while undeniably corrupt, has delivered near miraculous growth and improvements in living standards. Put simply: despite indignation about abuses of authority, few are willing to risk killing the golden goose.

But that calculus changes with $200-a-barrel oil. The perturbations in the oil market due to the nascent civil war in Libya disrupting its supply reveals just how little spare capacity exists today. Libya only accounts for approximately two per cent of global production, but even asking the Saudis to dip into their (questioned) spare capacity to meet that shortfall stretches the market thin. Of course, Libya (and possibly Algeria) are only a sideshow to what a full-fledged revolution in Saudi Arabia would mean for oil prices. While it's certainly unclear whether protests will materialize in either Riyadh or Jeddah on the Saudis' scheduled "Day of Rage", it seems much more likely that its Eastern province will erupt. Like neighboring Bahrain, which itself has been gripped by demonstrations, Saudi Arabia's Eastern Province is home to an aggrieved, restive Shia majority -- and just so happens to be where its largest oil fields are located. Indeed, Saudi security forces have already clashed with protesters in the eastern city of Qatif, firing on them with rubber bullets a day ahead of the "Day of Rage". Prolonged unrest in the Eastern Province clearly has the potential to send oil prices parabolic, which in turn would torpedo the global economy.

The Chinese government would hardly be alone in being vulnerable to an unexpectedly bad economy due to an oil shock. The not-so-dirty secret of the Great Recession is that everywhere it has left in its wake the social preconditions for revolution: un-and-underemployed young men (in China, these are the so-called "ant tribe"). Regimes from Azerbaijan to Vietnam could very well be on the proverbial chopping block. Oil would be the revolutionary transmission mechanism, giving an economic push to already combustible milieux across the globe. The usual caveat that protests certainly do not guarantee a revolution is worth remembering; the shadow of Tiananmen and the simple truth that all revolutions come down to whether the army will fire on protesters casts a pall over any such discussion. Still, don't be surprised if a new line comes out of Beijing during the coming months: China is not Saudi Arabia.