Thursday, 4 November 2010


Barely two years ago, even as the financial system was staring into abyss, there was an overwhelming desire from major countries to act in concert.  The fear of a global financial meltdown was too powerful a motivation that propelled the G20 towards a unanimous agreement for a coordinated policy action. This now seems like a distant memory as countries are pursuing their domestic goals as such fears have dissipated.

This is further accentuated by a divergence in economic outlook between the East & the West and the effects of policies pursued in some regions are having adverse impact on others.

In the West growth is faltering as the effects of fiscal stimulus fades. A double-dip is possible if there is a policy misstep, a further shock or a loss of confidence. With this backdrop, timing of policy tightening is the big fear for the Central Bankers’ in the West.

Basle 3 regulations imposes increased requirements for bank capital and liquidity.  The mood was “never waste a good crisis”. It seemingly assumes capital and funding will be available cheaply and in abundance to meet the new requirements.  The reality cannot be farther from this.  It will neither cheap nor will it be limitless.  Any increased cost of raising capital and liquidity by banks will be passed onto customers.  To the extend demand for capital and funding cannot be met banks will limit lending.  

Regulatory actions to appease the public now seems likely as politicians force draconian measures on banks, that will most likely lead them to shrink balance sheets and restrain lending.  This will herald a new credit crunch.  Although a global deal, the reality is the US never adopted its predecessor Basle 2 and some countries may implement different measures now. With change in political scene in the U.S. it remains to be seen whether some the measures may soften as high unemployment in the west continues to be the major political issue.

The monetary and fiscal policies pursued by the West is driving asset prices through the roof in Asia and is leading to the heightened risk of asset bubbles in most Asian markets.
Low interest rates, quantitative easing and loose fiscal policies in the west has encouraged the classic “carry trade” as money flows in search of higher returns to emerging economies. The combination of cheap money, one-way expectations, and the ability to borrow creates the environment in which asset price inflation occurs unabated  and bubbles are created, destabilising economies.

Hence in the west, interest rates will have to stay low to limit the pain. This will feed flows to the east, adding to bubbles and inflation across much of Asia. Thus, currency policy has come to centre-stage. Intervention by China and others to keep foreign exchange competitive for their exports is adding to trade tensions. Consequently, there is an increase in decibel levels around exchange controls, the fear of protectionism and talk of currency wars.

Intervening to stop a currency appreciating is easier than trying to stop one weakening. If a currency is overvalued and the markets decide to sell then it is just a matter of time before it falls. In contrast, governments and central banks can stop a currency appreciating.   

Thus it has become popular to consider exchange controls. Recently Brazil doubled the tax on bond inflows. Thailand re-introduced withholding tax for foreign investors. But if a country has been liberalising, controls may be less effective, being easier to circumvent. Also, any tax will have to be high enough to deter investors if they still think a country's prospects are good. Despite this, such controls are welcome, even if they just deter currency speculators.

In the near-term other measures may be needed. Hong Kong and Singapore have used specific measures to cap their property markets.

Some have opted for currency appreciation, although it has an adverse impact on export competitiveness. Thailand, Malaysia and Singapore, have allowed their currencies to strengthen. Although many Asian currencies are undervalued the big problem is the Chinese renminbi. Thus recent talk of currency wars needs to be kept in perspective.

An important thing to remember is that currency moves alone will not guarantee a stronger global growth. They are only part of the puzzle.  To rebalance the global economy there is a need for the west to save, the east to spend and currencies to adjust.

China, by keeping a strong economic growth, feels it is doing its bit. Hence it is unlikely to shift policy dramatically and as reiterated by them prefer gradualism. Ahead of the G20 meeting in Seoul next week it is always possible that there may be token moves  of appreciation. But may not be enough.

Across Asia, stronger currencies, higher interest rates and macro-prudential measures to curb asset prices with exchange controls to curb speculative inflows may all be needed. However, progress may be gradual. That is a big challenge.

In the west, fragile economies mean a failure to resolve the currency issue could lead to trade protectionism, led by the US. This is why global policy coordination is crucial.

Recent weeks have continued to see mixed data from around the world on the economic outlook. This has added to the air of uncertainty. In addition, uncertainty about future policy stances has increased.

What about Double-dip?

The biggest concern at the moment is - whether there will be a double-dip in the West. Across much of the emerging world, economic conditions are broadly stabilising.  In the West, however, there are enough uncertainties that could trigger a double dip:
§         an external shock e.g. sovereign default by one of the bigger euro zone countries;
§         rising food and commodity prices leading to domestic pressures;
§         a policy misstep;
§         or a loss of confidence.  

Any of these or a combination of these have the potential to derail the fragile economic recovery.  Deleveraging and the overhang of debt take time to work their way through an economy.

As the policy stimulus of the last year wears off, and as some of the Western banks that received aid face the need to roll over borrowings, it is important to be aware of downside risks.  
In the US, big corporates’ appear to be in far better shape than smaller ones, and although credit conditions for small firms appear to be past the worst, they are tough. The situation is the same in the UK. Hence, there is a need for both the Fed and the Bank of England not only to keep rates low, but to do more through quantitative easing. This is particularly so in the UK, where fiscal policy is to be tightened. The UK Comprehensive Spending Review is another reminder to the world of the challenges of unsustainable fiscal deficits facing governments in the West.

Europe has its own set of complexities. Should the European Central Bank (ECB)  tighten in response to the stronger growth in northern Europe – particularly Germany – or ease or stay accommodative to ease the pain in the south and the fringes. Any action will add to tensions. The likely concession may be that the ECB withdraw stimulus but hold off from interest rate hikes. None of this will prevent southern Europe, plus Ireland, from suffering a recession.  But in Germany, rising house prices are seen as an inflationary concern. This is the downside of a one-size-fits-all monetary policy.

Challenges faced by the emerging economies

The consequences of continued low US interest rates have taken its toll on some of the Middle East economies.  Due to the exchange rate peg to the USD in the Middle East, interest rates stayed far lower than where they needed to be for domestic reasons. This fed the boom there. Yet many emerging markets are not pegged to the USD and have chosen to intervene in their currencies.

The Asian economies have the ability to change set monetary and fiscal policy to suit domestic needs.  The lethal combination of cheap money, access to debt or ability to leverage, and one-way expectations is bad news. It fed asset bubbles in parts of the West. It now threatens to do likewise across emerging countries. Bubbles, of course, take time to develop.  The house prices in Tier 1 cities across Asia have all the hallmarks of a bubble. These countries have to act now before it is too late, as experience has shown that the bigger the bubble, the louder the thud!

Currencies do matter

This brings us the biggest topic currently in discussion – Currency Wars. China has started to allow its currency to appreciate gradually.  Yet from a domestic perspective, there may still be some unease about the possible impact on low-value-added exporters, many of which fear increased competition.  Within China, this will add to pressure for industry to move inland to take advantage of lower costs. But it still does not erase the fact that China's currency is cheaper than it should be.

China will, if not already, commence its diversification away from the dollar through its reserves management actions. They are investing increasing proportion of their new reserves into non-dollar assets.

Many countries would like to diversify into the Chinese yuan (CNY) itself. The growth of the offshore CNY (or CNH) market this summer in Hong Kong is perhaps a prelude to China paving the way for internationalisation of its currency in the future – not just for trade, but for more active use in investment and other decisions.

While it is necessary to view the issue of currency adjustment from all sides, the overwhelming view is that the Chinese currency needs to appreciate. Not only does this seem justified on domestic grounds for China, but it is also needed as part of global rebalancing. It would also take the pressure off of others who are intervening to keep their currencies competitive versus China’s.

But such arguments are not helped when the West engages in actively devaluing its currencies by pursuing policies such as “Quantitative Easing” (read printing money)! The latest is the Fed announcing a USD 600bn for QE2.

This crisis was triggered by a combination of factors: a failure to heed warning signs, particularly those associated with large deficits or cheap money; a systemic failure in the financial system itself; and an imbalanced global economy.

Restoring global balance requires a change in the behaviour of how countries operate.  The West (with the exception of Germany) needs to save more; East and Germany needs to spend more and the currencies be allowed to adjust to its NEER co-oefficient of 1 (Nominal effective exchange rate).

Germany manages to export considerably and has done so for some time because of the quality, not the price, of its goods. It should also recognised that China has made a huge contribution to the post-crisis recovery through its domestic policy boost, and through its impact on world trade.

Currency wars are a reflection of uncertain economic times. The fear is that unemployment in the West will remain stubbornly high. Protectionism is always a risk. There have been signs of this in the financial sector over the last couple of years, and the threat of trade protectionism is now resurfacing. How the currency war evolves will have a huge bearing on the global economic recovery.

QE2 is likely to raise the hackles for China and it is giving a legitimate concern for them as the impact this will be felt on the Chinese economy.

Overall, currency is needed not just to prevent a move towards a trade war, but also as part of the process of preventing bubbles across the emerging world. That is why domestic monetary policy such as appropriate interest rates, macro-prudential measures to curb domestic asset prices, and targeted exchange controls to curb speculative inflows may all be needed.

The imminent G20 summit in Seoul next week may not be the forum at which this issue will come to a head. France has put currencies, commodities and even capitalism itself, amongst the topics to be addressed in the G20 next year, when it holds the presidency.  

It remains to be seen whether this may yet blow out into an all out trade war and protectionist actions.  I hope not, as in that scenario every one would be a loser! Will wise heads agree to coordinated action in the coming weeks? Watch this space!

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