THE spring assessments are in. As expected, the global economic situation is less buoyant than predicted.
The IMF’s (International Monetary Fund) April’15 World Economic Outlook and its companion, the Global Financial Stability Report pointed to some healing.
But not enough to bring about a less risky global economy in the face of a continuing environment dominated by wild cards such as the likes of Russia, Brazil & Greece, not to mention the chaotic Middle-East and Ukraine.
Two of their conclusions bear repeating: (i) the world economy is expected in 2015 to be much less dynamic, even flat (at 3.5%) – but (the good news) it’s less divergent (US growth being trimmed to 3.1% from 3.6%; while eurozone’s GDP will rise 1.5% from 1.2% previously); and (ii) financial risks have since evolved to become more exposed to the lesser regulated shadow-banking segments, including hedge funds and asset management.
In all, the global economy remains tentative and turbulent, even fragile – indeed, more risky.
Europe’s growth remains too slow for its own good. The United States is still a lead locomotive but it did hit a soft-patch in the first quarter. It is just not creating jobs fast enough (hiring this March being weakest since December 2013).
IMF downgraded the growth outlook for most emerging economies, including China, Brazil & Russia.
World Bank also cut its growth forecasts for developing East Asia and Pacific to 6.7% in 2015 and 2016 each, down from nearly 7% in 2014 and previous (October 2014) forecast of 6.9% for 2015 and 6.8% in 2016.
It warned of “significant risks” emanating from global uncertainties, including strengthening of the US dollar and higher US interest rates to come, despite the widespread impact of lower oil and commodity prices.
Stealth currency war
It has become clear that the global economy needs to grow faster and create more jobs that don’t come at the expense of others. After all, part of the current US slowdown can be traced to the sharp US dollar appreciation over the past year in a stealth currency war despite a better balancing of world demand.
It is also clear that over-reliance on currency depreciation to boost domestic economies and exports will exacerbate global tensions over exchange rates. Fair enough, overall, recent currency shifts can be helpful in the short-run, as they support struggling economies such as the eurozone and Japan, but their broader impact creates both winners & losers.
And, losers can be expected to retaliate with “beggar-thy-neighbour” measures that can only prove counter-productive – indeed, it’s a zero-sum game.
Why is the US dollar so strong? The US Dollar Index, which tracks US dollar performance against six of its main counterparts, rose by about 25% from its May 6, 2014 low because: (i) US growth pace is expected to outgrow its major trading partners, and (ii) US Fed will raise interest rates in the face of easy money in Europe, Japan and China.
In other words, the United States has since shown to have far stronger demand relative to its potential to grow, than the eurozone, Japan and China. This has led the Fed’s chair Yellen to warn that US dollar strength have had a “notable drag” on the US economy, making her run out of “patience” – thus allowing the Fed to start the process of raising interest rates (interpretation: the currency war is on!).
History: The US dollar’s last two surges did lead to significant disruptions. In 1985, US & its allies banded together under the Plaza Accord to drive the US dollar down after the strong dollar led to an outburst of US protectionist measures. Then in late 1990s, the rising US dollar triggered a world-wide crisis that devastated the economies of Thailand, South Korea, Indonesia, Malaysia, Russia & Brazil.
While the current US dollar advance isn’t as large, nevertheless, studies have shown that it’s already enough to knock off between 0.5-0.75 percentage point from annual US growth. Globally, policymakers in Europe and Japan have turned a blind eye to the fall in exchange rates in the hope they’ll boost growth and act against deflation.
Indeed, they are relying on a weaker exchange rate to reinforce easy monetary policies and boost foreign demand and import prices. Deutsche Bank has estimated that recent euro-depreciation could raise eurozone GDP growth by 0.3 percentage point this year and 0.5 percentage point in 2016.
As for Japan, the bank estimates that a 10% fall in the yen’s value would bolster growth by 0.2 percentage point over two years.
So, its 30% drop since mid-2012 should get Japan out of deflation. Finland, Ireland, Germany and the Netherlands are also best positioned to benefit from US dollar’s strength. Less happy are many emerging economies which previously complained that the weak US dollar was injecting unwanted speculative capital into their fragile systems. Now, the currency’s rebound brings down commodity prices, raises the cost of servicing US dollar denominated debt, and often provokes currency volatility.
Why is the euro so weak?
The euro, which traded at US dollar1.60 in 2008 and more recently, at as high as US dollar1.39 in March 2014, hit its lowest level in nearly 12 years touching US dollar1.056 on March 11, 2015 (down 13% so far in 2015). The US dollar has risen 28% against the euro since May’14.
This slide towards parity with the US dollar (not seen since 2002) underscores the broad ripples from the European Central Bank’s (ECB) bond buying program that started on March 9 in the face of dim economic prospects bordering on deflation.
By printing money to give to the banks selling it bonds, the ECB deliberately drives down the euro’s value. Similarly, government 10-year bond yields have since tumbled, hitting record lows in Germany. Also in France & Italy. German yields hit an all-time low of 0.20% on March 11.
Today, it’s 0.078%. Two-year bonds yield a negative 0.257%. This clearly reflects a supply-demand imbalance, with too much cash chasing too few safe assets. I am told that, on average, an interest rate is cut somewhere in the world once every three days. Indeed, the euro’s slide (as well as the yen’s) has re-ignited talk of a currency war.
The ongoing bazooka bond-buying programme, or quantitative easing (QE) that ECB and the Bank of Japan (BoJ) have initiated – so-called bazooka because of their sheer size – has transformed the nature of world liquidity flows.
First tried in Japan in 2001 to combat deflation (but failed), the US Fed started using it in 2008 in response to the financial crisis & pull the US economy out of the Great Recession. Japan again used QE with better success in 2013 and ECB joined the party in March 2015 with a 1-trillion-euro bazooka. Clearly, QE can (and does): (a) improve market liquidity; (b) promote investments, hence stimulate growth; and (c) bring down money yields so funds will flow out to seek higher returns, thus pushing down the currency value – which is not unwelcome since this favours exports; hence more growth.
But depreciating its currency is never a stated policy objective. In reality, however, it’s “so loud” the whole world hears it. Led by Brazil, emerging nations had charged that the US QE fired the first “currency war” shot because the weak US dollar unfairly brought down their exports. Today, the complaints are directed at Europe and Japan. Like it or not, a weak currency boosts exports, and contributes to a wider economic recovery and create jobs.
The trouble is, it’s a zero-sum game. Someone always loses.
Euro-US dollar parity?
As I see it, the US dollar will remain strong for a while longer.
Two elements persist over the market. First, there’s a large pent-up demand for US dollar because foreign sovereign and non-US corporate borrowers “owe” some US dollar nine trillion in US currency denominated “debt” according to the Bank of International Settlements (BIS) – the world’s central banks’ bank.
Technically, the world is “structurally short” the US dollar, since much of this debt needs to be repaid over the next years. Second, US dollar share of world reserves (US dollar12 trillion today) fell to 60% in 2011 from 73% a decade earlier. It’s now 63%. Indications are that central banks are accumulating US dollar reserves again – so there’s still room to move up.
Above all, the US economy’s outlook continues to be good relative to Europe, Japan, China and India. Sure, Europe has improved but not enough: negative interest rates, high unemployment and ECB’s QE will exert a steady downward pressure on the euro. So, continuing US dollar demand for reserves cover, for higher returns, and for short covering and growing liquidity needs will send yield-hungry capital to the US and push the US dollar up.
Indeed, US dollar strength is beyond cyclical growth. I sense a euro-US dollar parity to be a good possibility within the next 3-6 months. Indeed, a further 5% advance to 95 US cents for each euro by year-end remains within reasonable bounds. This view is shared by many, including Bank of America, Deutsche Bank and Goldman Sachs.
It’s a calculated bet.
What, then, are we to do?
The rising US dollar is working to redistribute whatever growth there is more evenly throughout the global economy. This erodes US competitiveness, but oil and commodity prices are also down.
Today, the United States and the UK can borrow for 30 years at 2.4% and 2.6% respectively, which simply means at near zero cost after adjusting for inflation. On the flip side, Europe and Japan are gaining an edge through their weakening currencies. China and India are also net gainers.
But many emerging nations which tie their currencies to US dollar, produce commodities, boast high payments deficits and carry a heavy US dollar debt load, feel increasingly threatened. The BIS prefers to talk of “easing-begets-easing” (instead of the crude, currency war); even so, the message is loud and clear.
Growth has slackened all over.
The weak currency option remains attractive as nations threaten further easing (latest being UK, Sweden, Denmark, India & China).
It’s just a matter of time before the US Fed raises interest rates in the face of negative yields in Europe and Japan.
The US dollar has long borne the brunt of other currencies’ weakness. This means in practice allowing these countries to export their deflation to the US, which has been strong enough to cope with this “drag” on its growth.
No doubt, world markets are getting more twitchy to further bouts of US dollar strength. The worry is the more US dollar gains, the more markets get unsettled following massive injections of easy money. So far, the outcome has been reasonably constructive. I worry when the “sweet spot” is over.
Already, the dollar’s surge has reduced growth in emerging markets.
Malaysia, Turkey and Indonesia are most at risk. Brazil and South Africa are close behind. China and India will probably fare a little better. Indeed, I wonder if continuing QE has gone too far. Renewed G-20 support for the soft-option (continuing easy money) – essentially backing currency depreciation to promote growth, underscores the concern I have about the world being stuck in IMF Lagarde’s “new mediocre” anaemic growth-path.
It marks an implicit acknowledgement of the big powers’ hypocritical failure to enact structural overhauls (which they had insisted emerging nations must do whenever they faltered), preferring to rely on easy short-term stimuli instead. Greece’s worsening crisis is darkening the outlook. For sure, emerging economies are getting increasingly worried their economies could get whisked in the process.
Former banker, Tan Sri Lin See-Yan is a Harvard-educated economist and a British chartered scientist who speaks, writes and consults on economic and financial issues. Feedback is most welcome; email: email@example.com.