Who Will Win The Currency Wars?

分散投資就是啦 !

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As debate about potential currency wars heats up, commentators including myself have called out the likely losers, the Japanese yen and South Korean won being high on most lists. Much less discussed has been which countries will win from the currency wars. After all, the currency market is a zero-sum game - as one currency declines, another must go up. In this issue, I'm going to suggest that Singapore and to a lesser extent, Thailand and Malaysia, will be relative winners. And I'm also going to explain why some supposed currency safe havens - including Australia, China, Canada, Switzerland and Norway - are unlikely to perform as well.

Now I know that some will point to gold being money and the ultimate winner of the race to the currency bottom. I too am a gold bull and suggest the metal should be a core component of any investment portfolio. Having written about gold on previous occasions though, today the focus will be on currencies.

The wars are just beginning 

In early January I wrote the following in a newsletter called Sayonara To The Yen:
"The yen could collapse. Anyone for 200, perhaps 300, yen to the dollar? ... The impact from any Japanese financial crisis will go well beyond Japan though. After all, Japan is the world's third largest economy, accounting for 8.3% of global GDP. Its banks finance a lot of business both in Asia and elsewhere. Japan is also a major exporter competing with South Korea and Taiwan on high-end electronics, auto and industrial goods.

Think about the potential impact on South Korea for a moment. Exports account for 52% of GDP there ... South Korea and other countries won't allow their exporters to become totally uncompetitive against their Japanese counterparts though. They'll join the fight to trash their currencies in order to help their exporters."

Since then, the yen has tanked. I had thought there'd be some short-term respite in February but that hasn't been the case. The reason is that the Bank of Japan Governor, Masaaki Shirakawa, has announced that he will resign on March 19, three weeks before this term was due to end. This means Japanese Prime Minister Shinzo Abe will be able to appoint a new Governor that is more in line with his inflationist policies. Simply put, money printing is on the way sooner than markets thought and the yen has got pummelled further.

Just as important has been the reaction to yen weakening. Many countries have voiced their concerns. Those concerns are intensifying, particularly in Europe given continued euro strength. European Central Bank President Mario Draghi has signalled policymakers are worried the euro's advance could dampen inflation and hamper an economic recovery. France has been a particularly vocal critic of the rising euro.

The broader issue is simple: the developed world has too much debt and to reduce this debt, they want to create inflation and depreciate the value of their currencies (thereby reducing the value of the debt). It's not going to be able to grow its way out of the debt or cut spending enough to make the debt more manageable.

Which currencies won't win 

The losers from currency wars are relatively easy to identify, with the Japanese yen, South Korean won and British sterling being high up on the list. Less easy to identify are those currencies that will prove safe havens. There are a number of currently perceived safe havens that could prove anything but.

Let's start with the commodity currencies. Depreciating currencies mean tangible assets such as commodities should perform reasonably well. Those currencies largely dependent on commodities should also outperform. On a long-term basis (five years) though, the current commodities bull market is likely to end. The safe haven status of the Australian dollar, Canadian loonie and Norwegian krone will be under threat.

Let's turn to the Australian dollar or Aussie as it's commonly known. On a long-term basis, the Aussie is extremely risky. Australia has benefited from a three decade property boom and 12-year commodities boom. The problem is that the property boom is unwinding as highly indebted consumers pay down their debt and worry about job security as unemployment rises. When the commodity boom ends too, there will be nothing to fill the gap.

Australia has been poorly governed over the past decade, leaving few globally competitive industries other than mining. That might be ok if the country's balance sheet was in good shape. Unfortunately though, even during boom times, Australia has consistently run budget and trade deficits. In sum, long-term investors should stay away from the Aussie. As an Australian resident, I hope I'm wrong though!

The Canadian loonie suffers similar afflictions. I regularly visit Canada as my wife is Canadian. On my last visit in July 2012, I was surprised to read of an east-west divide developing in the country. The mining-intensive west was enjoying good times while the more manufacturing-exposed east was not doing as well. The reason that I was surprised was that it was exactly the same issue being faced in Australia.

Like Australia, Canada too has a property bubble propelled by too-easy bank lending standards that's left people with way too much debt. The one big difference with Australia though is the significant reliance on trade with the U.S.. If you're bullish on American prospects, the loonie may hold up even with deflating mining and property bubbles. I'm not optimistic on a U.S. recovery and so the loonie could be in as much trouble as the Aussie.

Many sophisticated investors have a preference for the Norwegian krone. This is understandable given Norway's rock-solid balance sheet. But I am less optimistic given the country's reliance on oil and trade with Europe. Also, it appears to this author that the currency is currently both over-owned and over-valued.

Finally to a currency not commodity-exposed, the Swiss franc. Historically, the franc has proved the ultimate safe haven currency. Switzerland has had impeccable economic credentials, with high savings rates, low taxes, minimal debt and flourishing exports.
But over the past four years, the country has gone mad. It's printed so much money that foreign exchange reserves having gone up 7x, now equivalent to 70% of the country's GDP. All of this to keep its exporters competitive of course. But it's likely to set the country back for decades. And the franc too.

The problem with the yuan 

Many argue that the Chinese yuan is undervalued and will inevitably appreciate in future. Particularly as other countries seek to become more competitive by devaluing their own currencies. But I couldn't disagree more with this assessment.

To understand why, let's take a step back. One of the most overlooked recent global developments has been slowing foreign exchange (forex) reserves in China. Forex reserves are simply foreign currency and bonds held by monetary authorities. Historically, China has had strong growth as there's been overwhelming demand for the yuan. To prevent rapid yuan appreciation and help its exporters, China has printed loads of money and invested that money abroad, primarily in U.S. Treasuries. Buying these Treasuries has kept U.S. rates low and American consumers have been happy to buy cheap Chinese goods.

But forex reserves in China are now stalling as more people are getting their money out of the country. Many brokers claim this development is cyclical, that China has been going through a rough patch and people are being cautious by getting their money out. But what if it's structural? Perhaps the Chinese themselves see their currency and assets as overvalued, with better value found elsewhere? It's hard not to see at least an element of that.

Also, without forex reserve growth, China doesn't need to print money to buy overseas assets. In fact, it may end up having to do the opposite, buying yuan to maintain the exchange rate peg to the U.S. dollar. This would be deflationary for both China and the rest of the world.

The upshot is that if China's economy deteriorates and authorities are forced to choose between maintaining the exchange rate peg or foregoing it to depreciate their currency, which are they going to choose? My bet's on the latter.

As for the argument that internationalising the yuan would result in yuan appreciation, it's hard to see the logic of this either. If more Chinese have the choice to get their money out of the country (which is illegal now), won't they go ahead and do it? So put me in the camp that thinks the yuan is overvalued rather than the other way around.

Singapore is (already) the new Switzerland 

As a former Portfolio Manager and sell-side analyst, I covered the gaming sector across Asia and subsequently visited the Singapore casinos on a regular basis. What amazed me then was the meticulous planning that went into developing the casinos and tourism in Singapore more broadly. With the casino and tourism numbers, targets were exceeded on almost every count.

The meticulous planning of Singapore is part of the reason why it's been a phenomenal success story over the past 55 years. You just have to look at the country that it split from, Malaysia, to realise how successful Singapore has been.

Singapore is now the world's third-richest in terms of GDP (power purchasing parity) per capita. It also boasts one of the best balance sheets with a large current account surplus (exports minus imports and transfer payments), balanced fiscal budget, high savings rates and zero foreign debt. Not bad for a country with no natural resources and a small population.

One question mark has always been over the country's high public debt, at an estimated 110% of GDP in 2012. But almost all of this debt is in the form of Singapore government bonds and the main holder is the Central Provident Fund (CPF) Board. The CPF is a pension fund that's primarily used to fund public housing. It dates back to Singapore's beginnings when the country needed money, not knowing whether it would survive. In other words, it's all government money - the government owes itself and no-one else.

The unique thing about Singapore is that it manages it currency against a basket of currencies. This gives it flexibility. And most importantly, Singapore has refused to engage in the stupidity of quantitative easing (QE) with which the rest of the world is currently enthralled.

All right, you're probably saying - Singapore's in a strong position but is that going to continue and will the currency rise? The short answer to both is yes.
Recently, the government released a population white paper, detailing its long-term thinking on population policies (meticulous planning again). It's a critical issue given the country has one of the world's lowest birth rates.

The government is projecting the population to reach 5.8-6 million by 2020 and 6.5-6.9 million by 2030, from 5.3 million. To achieve that target, it would mean slowing growth in foreign workers (close to 40% of the population), to around 2.6% per annum from close to 7% currently. With labour force growth moderating to 1-2% per year to 2020, the government is estimating an average 3-5% GDP growth through the rest of the decade.

There's little doubt that the government is treading a fine line on the population issue. The local population is agitated at the growing wealth of foreigners, increasing inequality, crowded populace etc. This has been reflected at recent election polls. But the government and its people also realise they need foreign workers to maintain economic growth. Remember that GDP growth equals population growth plus by productivity growth.

All of this means that you can expect a tighter labour market and higher wages going forward. And this will put upward pressure on inflation and the currency.

What then are the risks? Well, Singapore is reliant on exports and if there is another global economic downturn, its economy would be impacted. Also, there's been talk that the government may seek to slow the growth in currency appreciation. That may happen though note that it doesn't mean it will pursue a policy of currency devaluation.

 

Other candidates 

 

For wont of space, I'll very briefly mention two other currencies poised to outperform: namely the Thai baht and Malaysian ringgit. Both are reasonably solid currencies, though not to the same extent as the Singapore dollar. I quite like the baht as a long-term bet as:

• Thailand is potentially emerging from a long period of stagnation.
• It would be a primary beneficiary of a comeback of neighbouring Myanmar.
• It's building a low-cost industrial base to match and perhaps beat China.
• The country's showing clear signs of political maturity given the peaceful transition to the latest government.

Malaysia is higher risk given its commodities exposure, budget deficit and political uncertainty with elections approaching. Hopefully the next government can implement badly-needed reforms and kick-start the economy. Perhaps the recent impressive growth of Asean neighbours including the Philippines, Indonesia and Thailand, will spur it into action.