- Last week, China responded to the recent rally in the international value of its currency by resorting to measures it last used during the global financial crisis.
- That’s bringing back focus on the prospect of a currency war, where countries try to weaken their currencies to boost exports.
- But it’s never a good thing if a country’s currency weakens by too much: just look at Turkey, whose currency has plummeted this year.
✍️ Connecting The Dots
Just a few years ago, the US was accusing China of intentionally weakening its currency in order to make the country’s exports more competitive. But earlier last week, the Chinese yuan hit its strongest level in three years relative to the US dollar.
So how did that happen? Well, first, the yuan’s strength reflects the Chinese economy’s strong and early rebound from the pandemic. Second, Chinese government bonds offer a yield that’s multiple times higher than the yields found on other safe government bonds, like those in the US, the UK, and Japan. That’s attracted international investors to the yuan-denominated bonds, pushing up China’s currency.
But China now thinks the yuan’s rally has gone too far, making its exports more expensive and therefore less attractive overseas. The country responded last week by resorting to measures it last used during the global financial crisis: it told local banks they need to hold more foreign currencies in reserve, which should make it harder to buy the yuan using those currencies and help stem the yuan’s rise.
Turkey, meanwhile, should be looking at ways to halt its currency’s plunge: the Turkish lira fell to a new record low relative to the US dollar earlier last week, after the country’s president (again) pressured the central bank to cut interest rates. See, Turkey’s central bank has been hiking interest rates to discourage spending and cool off the country’s overheated economy. But the country’s president holds the pretty unorthodox view that lower interest rates will actually lead to lower inflation.
Investors, for their part, don’t seem to agree: they sold the lira after his latest intervention at the central bank. That’s in part because it should, in theory, be completely independent of politics, and in part because the lower interest rates he wants would make the lira less attractive.
1. China has a couple of balancing acts on its hands.
On the one hand, a strengthening yuan will help China’s resource-hungry growth ambitions by making commodities – whose prices are on the rise – cheaper in the country’s currency. But on the other, a higher yuan means Chinese exports – which matter a lot to the country’s economy – will become less attractive overseas. Meanwhile, China’s trying to make the yuan more globally acceptable by allowing it to move according to market forces, rather than via its own tinkering. But as last week showed, the government doesn’t have much patience when those market forces involve one-way rallies…
2.The lira saga highlights the risks of investing in emerging markets.
Turkey is considered an emerging market, and EM investments come with a big unknown: currency risk. That is, even if your underlying stock and bond investments rise in value, you could end up losing money if the country’s currency plummets. Plus, what affects one EM generally affects them all, which is why many EM currencies fell in value during Turkey’s 2018 currency crisis.
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