Sturm und drang continues to rule the financial markets this morning, where bourses are reacting badly to signs that Russia is tightening its control over the Crimean Peninsula. Currency traders are engaged in a slow-moving flight to safety, bidding up the dollar, euro and yen as military forces set up border posts and prepare for a referendum on the contested region’s future.
Despite a relative paucity of major data releases planned for the week to come, investors are positioned cautiously – but we suspect that these concerns will be short-lived once again. The Soviet empire may be long dead, but mutually assured destruction still looms over geostrategic relations with the prickly superpower. The likelihood of a hot war remains extremely low, meaning that hedgers should see plenty of trading opportunities in the days ahead as sentiment rebounds once again.Â
However, it does reminds us of something Ambrose Bierce once said – “War is God’s way of teaching Americans geographyâ€. Traders now know where the Crimean Peninsula is…
A Surplus of Deficits:
The world’s two largest economies reported trade balance numbers over the last few days, and they are both in negative territory.Â
In the United States, increased energy production helped exports grow nicely, but imports grew even faster, widening the deficit to $39.1 billion in January.Â
In China, outbound shipments fell 18.1% year over year, shocking observers who had expected a modest surplus instead. This demolished sentiment globally, weighing on stock markets and crushing upside pressures across the commodity complex. Currencies like the Canadian dollar and the Aussie are distinctly on the defensive to start the week.
Again, this negativity may be forgotten in the coming days as observers consider the distorting effects of the lunar holiday and last year’s fake invoicing phenomena more soberly – but it does provide an interesting illustration of foreign exchange dynamics.Â
What is often forgotten is that when a country imports more goods and services than it exports, it is doing the opposite in currency terms. In other words – a country running a persistent trade deficit is effectively exporting its currency to the rest of the world.Â
This has long meant that global markets have been well supplied with dollars, devaluing the currency and helping  maintain its status as the lingua franca of international trade. As the US trade deficit has narrowed in last 18 months, proportionately fewer dollars have been exported – and their value has risen.Â
In China, the implications are more nuanced. When the country is running a trade surplus (as it has for decades), it is effectively importing currency from its trading partners. Because the conversion channel is tightly controlled and quantities are restricted, dollars and euros are brought to China, where they are translated into renminbi before circulating through the domestic economy. Over the years, this excess demand has put upward pressure on the external exchange rate, while simultaneously forcing policymakers to expand money supply at an astonishing pace.
However, when China runs a trade deficit, this pattern goes into reverse. Because capital controls heavily limit the renminbi’s utility offshore, importers are forced to purchase foreign currencies onshore – and downward pressure is exerted on the exchange rate.Â
This might help to explain the fall in the yuan that occurred over the past two weeks. The People’s Bank of China may have simply let market forces run their course, letting the currency weaken in line with changing fundamentals.Â
If so, two of the most important milestones in China’s long march toward sustainability have been achieved in a single week. Although Westerners have viewed these developments with alarm, the yuan’s recent weakness and the weekend default by Shanghai Chaori Solar Energy Science & Technology Company might be seen as positive indicators. Floating exchange rates and market-driven credit cycles are hallmarks of mature economies – signs that the Asian behemoth is finally making the transition toward longer term stability.Â
further reading:
Strong US employment figures reaffirm taper continuation
euro
