The “Currency War” Will Push Oil Even Higher
As Kerri Shannon, associate editor of Money Morning, said last Wednesday, an international conflict among currency valuations is already underway.
With the preponderance of dollar-denominated holdings around the globe, a declining dollar is something other countries will need to respond to.
The key to a nation’s position in all of this remains dependent upon the condition of its trade balance. Those who desire (or need) to increase exports want to reduce the foreign exchange value of their home currencies.
This is the primary reason why, from a production standpoint at least, a declining dollar has been a good thing for the U.S. economy. It results in more exporting of American products abroad, because they are now less expensive. The problems, however, are accentuated by dozens of countries attempting to do the same thing.
This resulting "currency war" will have a direct impact on oil pricing – a profitable one… for investors, anyway.
The focus here remains on the yuan…
China Won’t Be Changing Its Currency Position Anytime Soon
Many Western countries believe China’s currency is significantly undervalued relative to the dollar and the euro. That helps Chinese exports (a driver of the Chinese economy). But it takes market share away from other countries.
This weekend, as many anticipated, the International Monetary Fund (IMF) meetings in Washington failed to entice a Chinese currency revaluation.
The issue has been deferred to two upcoming G20 sessions in South Korea, bringing together the 19 leading industrial countries and the European Union. G20 finance ministers and central bank leaders will meet on October 22nd and 23rd in Gyeongju, while heads of state gather on November 11th and 12th in capital city Seoul.
While IMF Managing Director Dominique Strauss-Kahnabout achieving some progress by the time of the Seoul meeting, there will need to be some heavy lifting for that to happen. Media hype aside, there exists a genuine possibility for an expanded currency war in the near future. This will pit what many in the West see as an overly-supported Chinese yuan against the preponderant international holdings denominated in U.S. dollars.
With the ending, in June, of an almost two-year peg of the Chinese currency to the dollar, the yuan has appreciated a bit more than 2% against the American currency. China is facing advancing pressure from Washington and much of the West to allow the yuan to rise more quickly against major trading currencies.
In fact, last week, the yuan rose to its highest value against the dollar since 1993. Nonetheless, Washington sees this as far too slow to assist in rapidly increasing U.S. exports.
Beijing responds that the dislocation from any more rapid change would create direct financial problems for the nation.
There is also the opinion, according to People’s Bank of China Governor Zhou Xiaochuan, that a faster appreciation of the yuan would not bring balance to the world economy, anyway.
China also does not want to increase its buying of dollars, given the greenback’s deteriorating exchange power against other major trading currencies (euros, yen, pounds sterling, even Swiss francs). One persistent concern among Chinese economists is that the government has allowed the yuan to appreciate more than 20% in the past five years, and increasing that rate any more would have unsavory consequences for the domestic economic and financial outlook.
Allowing the yuan to increase in value would make exports from China more expensive. And it is the trade balance that provides the basis for much of this discussion. Under what Chinese leadership is now referring to as a "normal" gradual increase, they say they intend to reduce the country’s trade surplus to less than 4% of GDP by 2015. The equivalent figure was 5.8% last year and 11% in 2007.
Beijing also points out that a more rapid appreciation of its currency would create significant domestic dislocation. The drain on Chinese foreign exchange holdings would also adversely impact development. However, given the size of those holdings (well in excess of $2 trillion), that problem will not hit right away.
On the other hand, the adverse impact of a fall in exports will be felt immediately.
China, therefore, will not be changing its currency valuation position anytime soon, regardless of how much global pressure develops. And that means reactive policy changes in a number of other countries. As trade deficits result or grow worse elsewhere, those governments will be hard-pressed to introduce more expansive capital controls with first the yuan, and then the weakening dollar, regarded as the primary targets. Indications are that the pressure will not be particularly effective, at least short-term, against either currency.
But all of this will have a more immediate impact on one of our primary concerns – oil pricing.
Expect the Run-Up in Crude to Accelerate
The relationship begins with something well known to all watchers of commodity markets. The fundamental basis for this is the use of dollars for virtually all global oil trades. As the value of the dollar declines relative to other major currencies – all other things being equal – the effective pricing of oil consignments increase.
However, in the current climate, the capital restrictions placed upon trade by countries in response to the currency valuation problem will act to further accelerate pricing.
This has a primary impact regardless of the local currency, since the oil is traded in dollars. An offset might be possible if euro and dollar polices would be balanced – that is, if the capital changes could offset. Unfortunately, Western Europe is facing the same export concerns as the U.S., with a greater impact on employment. Some coordination will be expected, but the euro will still rise relative to the dollar.
That means the differential will remain between NYMEX prices in New York and ICE (forward Brent) prices in London. Brent pricing (which reflects sales in Europe and elsewhere outside of North America) will continue to be higher than NYMEX, even though both are denominated in dollars and both will be moving higher.
But the policy decisions reflecting the euro will have a premium effect on London ICE pricing in dollars. That will also serve to raise NYMEX pricing as policy decisions on the other side of the Atlantic are introduced to compensate. The resulting situation will add to the very volatility I have been telling you will increase the trading value of shares in the oil sector.
Here’s the decisive point to remember in all of this: It is far more difficult to coordinate currency practices when the corresponding domestic economic objectives are at cross-purposes.
That is the case now – both Washington and Brussels need to improve exports, and that can’t be accomplished with the dollar and the euro needing to move in the same direction. Achieving agreements on regulatory matters, such as the recent Basel accords, is another matter entirely. That is far more doable.
Oil, itself, has acquired a position as an asset in the market. When the valuating pressures resulting are augmented by the kinds of currency value revisions expected, the combination will intensify the upward movement of those prices.