A Lesson from Twenty Years Ago

George Soros spoke on currency exchange again after the famous battle on the Bank of England. This is what he started in an essay in October 2010 on China's currency policy:

The prevailing exchange rate system is lopsided. China has essentially pegged its currency to the dollar while most other currencies fluctuate more or less freely. China has a two-tier system in which the capital account is strictly controlled; most other currencies don’t distinguish between current and capital accounts. This makes the Chinese currency chronically undervalued and assures China of a persistent large trade surplus.

Most importantly, this arrangement allows the Chinese government to skim off a significant slice from the value of Chinese exports without interfering with the incentives that make people work so hard and make their labor so productive. It has the same effect as taxation but it works much better.

This has been the secret of China’s success. It gives China the upper hand in its dealings with other countries because the government has discretion over the use of the surplus. And it protected China from the financial crisis, which shook the developed world to its core. For China the crisis was an extraneous event that was experienced mainly as a temporary decline in exports.

Most investors trade on common instruments, equity, credit, currency, and commodity. Soros and his right-hand man Druckenmiller traded against a government. This is definitely audacious as governments seem have unlimited resources. Well, they would read and found traces that a country has their weakness. Soros seems back to game he and Druckenmiller fought 20 years ago. A back view on the history appears great similarity between then and when he commented on Chinese currency. For him, he is probably doing the same thing 20 years ago. But at any sense, to bet against a country needs courage and knowledge and many other things.

Let's take a look at historical situation in 1992 and reasons they started the sterling bet. From there, there is a great similarity in China's economy and the rest of the world today.

After the Berlin Wall collapsed, it was expected German government would have large deficit to sustain many East Germans flooded into the West for better social life. Commonly, budget deficit could fuel inflation so that German currency would be weakened. It did dip after the Wall down. But after the dip, what would happen? Soros' team thought the German government would tighten monetary policy because of strong economy due to large reconstruction spending. The German central bank would raise interest rate to curb inflation. That would make German currency stronger. This logic was debatable back then because not many foresaw higher interest rate in Germany. They were reading a country before anyone else understand the situation, including the Germans. It was proved that the deutsche mark did rally after the unification.

A higher interest rate caused problems weaker European countries, representing by Italy and England. Their currency needed to be devalued because people would sell them and buy the deutsche mark. Europe currencies were regulated by an exchange-rate mechanism(ERM) to ensure all currencies were at equilibrium rate. This ERM worked well for a decade but started show constraints after the Berlin Wall fell down. Britain didn't want to see their currency devalued because of political commitment on ERM. They didn't want to raise interest rate to match to German's either because of weak economy. They were stuck at this situation. On the other hand, Italy devalued their lira so that they avoided a similar ambush on sterling.

Understanding that the British government was in a difficult situation, Soros' team figured that if they sold sterling in the market, the British central bank would buy them. However, their research showed that the British central bank didn't have enough reserve to sustain this fight. So they sold billions of pounds. This is also an audacious plan because first, the calculation had to be accurate, and second, no other countries would intervene. Magically or logically, it turned out just like they planned. The bank of England surrendered after a few days buying.

There are many open questions on the trade if we think carefully. However, this is what we know so far.

The analogue of Germany and England is China and the US nowadays. China is running at a GDP of nine plus and US is relative far behind. However, other than keep raising bank reserves, Chinese government didn't increase interest rate. Common understanding is that they eventually have to do that. They don't want to do that now is because they want to have some sorts of stress tests using bank reserves to see if their bubble real estate market would collapse. That provides time to investors so that they can buy into China. The other reason China will raise interest rate is inflation.

To counter rising pressure on Chinese currency, the government would buy US dollar or issue more currency. The later is unlikely. They have massive US dollar reserve. So this seems impossible. However, not much can be lost: strong liquidity in the US would continue for a while so that it would increase buying costs. As long as there are enough US dollar supplies, this pressure will be there. There seems not much to loose. The only thing is a trigger, a trigger that realizes this logic.