Davos Reveals Big Currency Challenges

On Wednesday, Russian Prime Minister Vladimir Putin stood before a smarting crowd in Davos, Switzerland and warned against the reliability of the US dollar (USD) as a reserve currency. Russian officials, and Mr Putin in particular, aren't always the most reliable economic soothsayers. Still, these comments were reflective of a general unease at this week's World Economic Forum.

Indeed, it seems everyone would like to figure out what is happening in foreign exchange markets. This past year saw an epic collapse for the pound sterling (GBP), mounting concerns about the viability of the euro, the staggering free fall of the Russian ruble, and the sharp appreciation of the Japanese yen (now at a 14 year high). In the United States, new Treasury Secretary Tim Geithner even challenged the dollar's exchange rate with the Chinese yuan, formerly a political taboo.

Such renewed focus on currencies is not surprising. With central banks the world over trying to breathe life into the domestic economies, monetary policy is having major forex implications. For managed and free-float currencies alike, the global crisis is giving economic ministers fits. Efforts to stimulate the economy often include interest rate cuts, which in turn make a currency less attractive for investors to hold and risk inflation. On the other hand, cheaper currencies lead to more competitive exports, a critical component of many developing economies.

Such cross-currents are weighing heavy in many foreign capitals. In Moscow, central bankers try to keep the ruble within some reasonable band of a weighted dollar-euro basket. Last week, however, the Russian currency depreciated about 1.4% every day, which dramatically widened this trading band. The weakening oil price and fears about the fundamentals of Russia's economy have only exacerbated the selling pressure. Over the last three weeks, central bankers have had to sell nearly $30 billion in foreign currency reserves to help prop up the ruble.

The situation is perhaps even worse in China. According to most reports, the country's GDP growth slowed to 6.8% in the fourth quarter of 2008. China needs to grow at around 8% to keep up with demographic realities and avoid social unrest. Even so, some analysts are concerned that the Chinese figure is overly optimistic. Some 60,000 factories have closed in China, and in November of last year, China's growth in electricity production was 8% below the 2007 level. Such figures seem to suggest a much more dire picture for the Chinese economy. Exports are falling rapidly, and there is no way for domestic demand to compensate for such a contraction.

In the US, hurtling jobless numbers and shrinking durable goods orders threaten the dollar. Still, the greenback has been the beneficiary of a continued flight to quality. Curiously, the dollar's rally has not had the predictable effect on gold prices, which are rising. In most cases, investors buy gold as a hedge against USD devaluation or inflation. The dollar is strengthening significantly against both the euro and the pound, and there is little concern of inflation in the short term (at one point TIPS were pricing in deflation). Consequently, it seems this dollar-gold relationship has broken down.

What does all this mean for forex markets? No doubt there are choppy waters ahead, and exchange rate volatility is likely to increase. News, to say nothing of rumor, about monetary policy developments will cause great swings in investor confidence. With all this turbulence, gold may find itself in another record ascent. In a potentially prescient move, the hedge fund Osmium Capital Management will allow its clients to denominate their holdings in gold.

On Thursday, Zimbabwe effectively abandoned its currency, as citizens may now use foreign-denominated notes alongside the Zimbabwean dollar. And so begins the dramatic process of an entire world trying to figure out the meaning of money.