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Currency Conflicts Heat Up

The easy-money, falling-dollar, rising-asset binary options trade was moving right along until China raised interest rates on Tuesday. This triggered a world-wide sell-off in stocks, commodities and currencies other than the dollar.

It was China’s first move since it cut rates in December 2008, during the depth of the global financial crisis. We’re surprised that China’s modest rate hike, by a quarter percentage point, was such a surprise. There clearly are excesses in the economy there that should be reined in, such as inflation, speculative lending and soaring real estate prices. And more rate hikes likely lie ahead.

The worry is that China’s economy will grow less rapidly, dampening demand for commodities and limiting overall global growth. But that seems unlikely. Yes, it’s true that on Wednesday, China announced that its economy slowed in the third quarter, rising at “only” a…9.6% annual rate! Year-over-year inflation was at 3.6%, with jumping food prices the main culprit. But the fact is that the Chinese government can’t afford to go too far in limiting growth because of the domestic problems that would cause. The likely goal is in the 8%-9% range. The stark reality is that, two years after the financial crisis, the industrialized economies of the U.S., Japan and much of Europe are still struggling, while most of the developing world, led by China and Brazil, are growing fast. Interest and inflation rates are very low in the first group, but they’re rising in the second. And money increasingly is flowing from the first group to the second.

China and other emerging-markets nations increasingly are attempting to manage rapid growth. One concern is that if, as expected, the Federal Reserve acts early next month to pump more money into the U.S. economy, much of it will find its way into those nations’ economies, creating more speculation, inflation and possibly asset bubbles.

As the Fed prints more dollars, it reduces the value of all the dollars already out there. This makes other assets more attractive, such as gold (the ultimate store of value) and other commodities; and the stocks and bonds of nations that have faster growth, lower debt and strong currencies.

The declining dollar is also a negative for other economies that are trying to keep down the value of their own currencies in order to make their exports more competitive on the world market. A weaker currency makes a nation’s exports more competitive. The currencies of Australia, Brazil and many others have been soaring as a result of the dollar?s fall.

China actually benefits from the weak dollar because Beijing continues to peg the value of its currency to the greenback. So the weakness in the renminbi, China’s currency, along with the dollar decline, has put pressure on other export-oriented economies. This is why the U.S. is not alone in trying to get China to let its currency appreciate.

Many faster-growth nations have boosted interest rates this year. But higher rates, while having a dampening impact on growth, also tend to attract more foreign capital. In recent weeks, central banks around the globe, including those of the Brazil, Japan, Indonesia, Taiwan, the Philippines, Thailand, Malaysia and Israel, have intervened in foreign exchange markets in attempts to weaken their own currencies, mostly in vain. Some countries have gone further, instituting forms of capital controls to reduce short-term outside investment. Brazil and South Korea lead the way here.

It’s hard to say exactly how and when all of this will end. But ongoing competitive currency debasement seems likely. This is good for gold. The bigger trend of global growth increasingly dominated by the emerging markets seems unlikely to stop any time soon. That’s good for commodities and emerging-markets assets. And rock-bottom interest rates here in the U.S. are good for financial assets in general.

Gold and commodities, in particular, have taken a hit this week. But those were markets looking for a reason to pull back after their big rallies.

It’s the same with the dollar, which had declined too far, too fast for now in anticipation of the Fed’s second round of quantitative easing expected in early November. After all, it seems illogical for the dollar to be declining against even the euro, at a time when protests over long-overdue austerity measures are gaining in number and force there, particular in France. Europe has many problems of its own.

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