March 1st, 2016

Exchange rates: a race to the bottom

by Enrico Colombatto Trying to predict how exchange rates will […]

Team AEC

Trying to predict how exchange rates will evolve during the rest of the year is a futile exercise. For different reasons, the world’s major central banks are all doing their best to weaken their own currencies.

Summary

In the United States, the Federal Reserve is having second thoughts about resetting its monetary stance to neutral, fearing that anything less than reckless Keynesianism might choke an underperforming economy. The European Central Bank is making no secret that its policy is to kick the can down the road, propping up banks’ overloaded balance sheets and mountainous piles of public debt. Meanwhile, the Chinese hope to cushion their slowing economy by letting the yuan slide and boosting exports.

In the end, volatile exchange rates will show just how mischievous central banking can be and how much uncertainty policymakers can create. Market operators will try to anticipate the next steps, but will not necessarily do what the policymakers want them to. The threat is that governments may try to legislate people into behaving according to plan. If that happens, the next step may be attempts to regulate the movement of capital.

It is now apparent that over the past decade, central bankers have done a pretty bad job. By injecting huge amounts of liquidity into the system, they have kept alive bad banks, failed to ignite growth, caused major distortions (low interest rates and stock-market bubbles are the tip of the iceberg) and allowed governments to accumulate large debts. The world is not on the verge of catastrophe, but the illusion of damage control afforded by easy money and cheap debt service leading to even easier money and bigger fiscal imbalances will cost us dearly.

Guessing game

Policymakers worldwide do not seem to be following a strategy. It is therefore not surprising that one of the characteristic features of the current situation is uncertainty. True, most observers have realized that the different versions of quantitative easing have been largely ineffective, when not counterproductive. Yet they are at a loss to guess what might happen if QE were discontinued and monetary neutrality became the name of the game.

As a result, markets follow each word pronounced by the world’s leading central bankers with deep apprehension. Exchange rate forecasts diverge in all directions, wreaking havoc on the strategic decisions of companies and entrepreneurs. This gives us many possible scenarios to work with.

Under normal circumstances and absent monetary intervention, the price of a free-floating currency should reflect the competitive position of the producers in the issuing country. For example, before the introduction of the euro, the strength of the deutsche mark was heavily dependent on German producers’ increasingly high productivity (relative to the rest of world). Regrettably, market operators today believe that the speed and direction of monetary policy is more important in valuing currencies. They have resigned themselves to taking decisions by guessing what policymakers might do next.

Within this context, future exchange rate developments will be dominated by the interaction of three scenarios: 1) how the Fed reacts to the disappointing performance of the American economy, 2) to what extent the Chinese authorities make use of the yuan to revive the manufacturing sector, and 3) the perceived risk that the European Monetary Union will unravel. The one thing traders are certain about is what the European Central Bank will do: keep on providing easy money, regardless of the consequences for capital markets, savings and public debt.

Dollar scenario

As to the first scenario, the Fed is well aware of the distortions created by an expansionary monetary policy, but it is still persuaded that easy money remains necessary to spur satisfactory growth. Unless gross domestic product expands by at least 2.5 percent on an annual basis (the current rate is about 2 percent and weakening), U.S. interest rates will stay put.

Since most investors had been expecting a gradual tightening of monetary policy during 2016, slower growth will induce them to revise their expectations and sell dollars. If that happens, the greenback will depreciate, regardless of what happens in the rest of the world. This tendency was already palpable in early February and may continue through the year.

The dollar thus appears headed for considerable volatility, especially if the next few months’ data on the real economy send out mixed signals and are subject to numerous revisions and corrections. The volatility will only intensify if Fed Chair Janet Yellen hesitates and appears vulnerable to market or political pressures in an election year. In that case, the dollar could lose its safe-haven status.

In the medium term, the chances that robust GDP growth will underpin a strong dollar are modest. The U.S. recovery reached its peak in early 2015 and then lost momentum. As a result, Ms. Yellen’s resolve to put an end to easy credit also weakened. It is difficult to say how far the dollar could fall, but a 5-percent depreciation by June is not out of the question. This will be good news for many dollar-denominated debtors. European leaders hoping for a weak euro to enhance exports will not be pleased, however.

Beijing’s aims

The second scenario concerns the Chinese economy and Beijing’s intentions regarding the yuan. From the political viewpoint, China needs a relatively strong currency to honor its new status at the International Monetary Fund. The government has made no secret of its ambition for the renminbi to play a bigger role in global financial markets, possibly becoming the reference currency for international trade in Southeast Asia. Russia already accepts yuan in payment for its oil exports.

Moreover, Beijing must counteract massive outflows of private capital (some $100 billion in January 2016 alone) which are damaging the country’s international image and growth prospects. Yet the authorities might be tempted to continue their rather generous credit policy to support exporters, attract foreign investors and provide much-needed liquidity to key industries, such as construction and banking.

Predictions are difficult, since the final decision will be a matter of politics. A look at the recent past suggests that the Chinese have failed to agree on a clear road map for economic reform. Consequently, they may be inclined to act as if a weakening yuan actually enhances their role on the international stage. It may be the case that developing countries now prioritized by China’s foreign policy prefer to deal with a relatively weak currency, which would impose less restraint on their own fiscal policies and possibly lighten yuan-denominated debts to be paid in the future.

Euro’s fate

The third crucial variable is the future of the euro, and possibly of the European Union itself. The concern here is less the single currency’s exchange rate than its future existence. The euro can survive only if its member economies perform similarly, or are elastic enough to absorb the imbalances. However, several key countries – including euro heavyweights France, Italy and Spain – have failed to enact the reforms needed to gain such flexibility.

Hence, two different outcomes are possible. Either the unreformed countries agree to give up some sovereignty and accept a Greek-style restructuring program designed in Brussels, or they will end up dropping out of the euro. Since the next candidate to follow Greece is a large economy, Italy, the resultant crash would be devastating and probably seal the end of the eurozone as we know it today.

Deadly mix

Over the next few months, currencies will track modest growth in North America and Europe, rising economic tensions in China and the increasing despair of policymakers. The U.S. Fed will likely respond by sticking to its Keynesian guns, even if they are firing blanks. Central bankers in China and the euro area will agree to ignore economic common sense and do the politically expedient in hopes of avoiding or delaying the worst. These behavioral patterns will interact in unpredictable ways, making chaos the only credible scenario.

The climate of rising uncertainty will do more than stifle growth. It will also stoke the temptation to force investors to do what policymakers want. There has already been some saber rattling over the possible introduction of controls over capital movements.

Our leaders should really know better. A mix of irresponsible monetary policy in the 1920s and trade and capital controls throughout the 1930s gave us first the Great Depression, and then contributed to unleashing a world war.

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