Imported Deflation and a New Currency War?
The lowest euro area CPI print in four years has not spurred investors to reconsider the outlook for this week's ECB meeting. Most recognize the ECB is likely to shrug off today's preliminary report.
It is not clean, in the sense of the base effect of lower oil prices and that distortions caused by Easter (last year Good Friday was on March 29, so holidays were booked in March, which exaggerate the drop as such booking will be concentrated in April this year). Some economists are forecasting that this will be the trough in euro area CPI.
The Wall Street Journal asks, "Is Abenomics pushing Europe toward deflation?" The reporter answers in the affirmative: "...Deflation pressures in the euro zone are also being driven by the monetary policy elsewhere, not least in Japan."
This sounds reasonable. The yen has depreciated by about 29% against the euro since the start of November 2012, when it become clear that Abe would likely be given a second try as Japan's Prime Minister. To attribute much of the disinflationary (if not deflation) headwinds in Europe to Japan is an exaggeration.
First, the bulk of the yen's weakness occurred before the end of H1 2013. Since then the yen has depreciated about 9% against the euro. Headline euro area CPI was 1.6% in June and July 2013. It now stands at just less than a third of that. If with unpredictable lags and lead times, there does not look to be much of a smoking gun here.
Second, and more importantly, the euro area does not trade that much with Japan, making the impact of the currency fluctuations less significant. According to the ECB, Japan's exports account for about 3.2% of the euro area imports. On a trade-weighed basis, looking at the euro area's largest trading partners, the yen's weight is about 7%.
Third, when the ECB hiked rates with inflation above 4.0%, the euro was trading near JPY170. This month it has averaged about JPY141.50. This is to suggest, that knowing where the euro-yen cross is trading does not allow one to forecast euro area CPI.
Fourth, the Wall Street Journal argues that the rise in the euro drives down imported prices within the euro area and makes euro area producers less competitive. This is true in theory, but not in fact. On a trade-weighted basis, the euro has risen less than 2% since the beginning of H2 13. The 6, 12 and 24 month average merchandise exports have converged between 155-158 bln euros a month.
Lastly, we note that those countries that are experiencing outright deflation in the euro area, like Greece and Spain, do not trade more with Japan than say Germany and France. Attributing the euro area's low inflation to Abenomics distracts investors and policy makers from the real culprit, which is primarily home grown.
Indeed this report and others in the traditional and social media space play up renewed currency wars. The depreciation of the Chinese yuan, some suggest, is to boost exports and arrest the economic slowdown. Other see the recent agreements that allow the UK and Germany to clear and settle yuan transactions as another attempt to undermine the role of the dollar.
The dollar has appreciated about 3.2% against the yuan since the multi-year low was set in mid-January just below CNY6.04. This was of course sanctioned by the PBOC. However, the goal was not to boost exports, but squeeze out the speculative excesses in the financial sector. Studies suggest that the value-added being done by Chinese workers, or yuan-denominated incurred in the production process ranges from about 12% to 20%. That means that the minor adjustment in the bilateral exchange rate is unlikely to have any impact on trade flows.
China did reach preliminary understandings with Germany and the UK to clear and settle yuan transactions. The permission that China granted is itself predicated on the restrictions the PRC has imposed on the yuan. Given the increasing importance of the yuan, this is the only way countries can participate directly. German and UK memorandums of understanding with China says nothing about the US or the role of the dollar in the world economy.
Separately, the BIS head of its banking department opined over the weekend that the dollar's share of reserves could fall 10%-15% in the coming years, without threatening its role as the world's primary reserve currency. Peter Zoellner also suggested that the role of the yuan would continue to grow (it is after all presently all but inconsequential as a reserve asset), but did not anticipate it replacing the dollar over the next couple of decades.
The economic literature is littered with forecasts of the dollar's demise as a reserve currency. As recently as 2008, for example, prominent economists Harvard's Jeff Frankel and the University of Wisconsin's Menzi Chinn suggested the euro could overtake the dollar as the world's primary reserve currency by 2015.
While the dollar's share of world reserves may indeed decline in the coming years, it is hardly a foregone conclusion. Indeed outside of the run-up to EMU, when the dollar's share of reserves rose to around 70%, the dollar's share of global reserves appears fairly steady. That is probably the best guess of what is going to happen in the coming years.
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