G4+CHF can fight the currency wars longer and more aggressively than small G10 and EM countries can. However, as Citi's Steven Englander notes, it also takes a lot of depreciation to crowd in a meaningful amount of net exports. His bottom line, GBP, CHF and JPY have a lot further to depreciate. In principle, the USD can easily fall into this category as well, but right now the USD debate is focused on Fed policy – were it to become clear that balance sheet expansion will end well beyond end-2013, the USD would fall into the category of currency war ‘winners’ as well. Critically, though, the reality of currency wars is that policymakers do not use FX as cyclical stimulus because of its effectiveness; they use it because they have hit a wall with respect to the effectiveness of fiscal and monetary policies, and are unwilling to bite the structural policy bullet. The following seven points will be on every policymakers' mind - or should be.
Via Steven Englander, Citi: “Do you only know how to play? Or can you shoot as well?”
Policymakers who are indifferent to the consequences of depreciation or balance sheet expansion are likely to win the currency wars. They can stay the course with respect to liquidity expansion, a run-up in domestic asset prices and CPI inflation to a greater degree than policymakers with more orthodox policy preferences and less damaged economies. Countries that are more constrained because of concerns about domestic asset markets or inflation can ‘play’, but it is much harder for them to ‘shoot’.
Currency war winners typically have economies that face headwinds from excess government or private sector debt and that have been unresponsive to conventional monetary and fiscal tools, so it is hardly a sign of strength. However, it does give their policymakers a degree of credibility with respect to their policy stance.
(The quote above is from Sergio Leone’s “Once Upon a Time in the West”.)
Consider:
1) Countries with deflation can stimulate for longer than countries where rising inflation rapidly becomes a policy issue.
If your price level is falling as in Japan or Switzerland, the vulnerability to inflation just isn’t there. So your credibility in voicing indifference to, or desire for, a weaker currency is pretty high. If you are afraid that a weaker currency or m liquidity provision will lead to higher inflation, you will be unwilling to stay in the game. At a minimum you will have to balance any competitive advantage against the domestic negatives.
2) Being poor puts you in a more vulnerable position
Food and commodity prices will respond quicker than services or high value added products to any global liquidity surge. Food and commodities are a bigger share of EM consumer baskets than DM consumer baskets, so the first wave of any inflationary pressures will be felt more acutely in countries that are food and commodity intensive. DM consumption and production is service intensive, which tends to be more inertial with respect inflationary pressures.
3) Caring about inflation puts you at a disadvantage
EM countries and G10 countries with an orthodox policy framework seem more attached to inflation targets than are G10 countries. There is relatively little discussion of alternative policy frameworks, temporarily breaching long established inflation norms, nominal GDP targeting or any of other heterodox policies that are under discussion. If you care about inflation more or less in real time, you have to tighten sooner than if you see room to overshoot.
For example, nominal GDP targeting has been discussed in academic circles for forty years or longer. It has been discussed in policy circles for almost as long, but was a complete nonstarter when a nominal GDP target would mean tightening. Now that nominal GDP is far below targets in much of the G4, it is gaining traction on the view that it allows you to be bad in the short term without compromising long-term credibility. In practice the asymmetry in the willingness to adopt it as a policy target means that investors will view it as indicating willingness to overshoot long-term inflation targets in the short term, while giving a somewhat less than binding promise to adhere to them in the long term. Such a loss of credibility may not be unwelcome, If it is accompanied by aggressive CB balance sheet expansion, it achieves the goal of a weaker currency.
When central bankers in the same speech discuss: i) disappointing economic outcomes; ii) the need to for net exports to grow significantly; and 3) revising the policy framework, the odds are that the revised policy framework will be more rather than less expansionary and give at least a wink and nod to measure that will will weaken the currency significantly.
4) Caring about domestic asset price inflation puts you at a disadvantage
The Fed is encouraging, or at a minimum, extremely tolerant of domestic asset price inflation. Ask yourself whether they would like the S&P at 1600 and housing prices 20% higher. Japan and the UK are seen as moving in the same direction. The logic is that domestic asset price inflation will make households feel wealthier and encourage spending.
A 20% run-up in home prices will be much less welcome in Canada, Australia or China, and many other countries where asset prices are already high relative to activity and income. Even in countries where CPI inflation is low, there is concern that liquidity and low real interest rates are bidding up home prices and consumer borrowing. Unlike in their G4 counterparts, policymakers in these countries have to be mindful that excessive domestic asset market exuberance may carry negative long-term consequences. We saw in 2008 that currencies move quickly when the shock is big enough, while balance sheet adjustment takes places slowly and painfully.
5) If the central bank is in the pocket of the Treasury, policymakers do not fear a backing up of rates
This is another ‘make me virtuous but not too fast’ situation. If your central bank is financing a large portion of your deficit, you are not afraid of rates backing up. In fact the more the CB protests that this is monetary policy, rather than monetization, the more committed it is to keeping rates from backing up. The CB’s involved all argue for long term fiscal consolidation, but in practice they worry more about the risk of abrupt short-term fiscal tightening than about the absence of long term tightening. So rates can stay low and unsustainable fiscal paths remain in place for a long period. And if investors don’t like this policy combination … they can always sell the currency.
6) Setting a currency line in the sand is risky for countries with attractive countries
Policymakers with attractive currencies, such as AUD, CAD or high quality EM find the Swiss nuclear-option less attractive than at first glance. If the RBA were to decide that 0.95 was the AUD ceiling, they would soon discover that there was a lot of willingness to sell USD, GBP, EUR and JPY and buy RBA. Australian reserves would shoot up and the portfolio would consist of currencies that the global private and official sectors want to dump. In addition the portfolio yield would be essentially zero, so they would be in a significant negative carry situation.
If they thought these currencies were good investment, they could just go out and buy them, but if they accumulate them as a result of pegging their currency, it is hard to argue that the accumulation is voluntary. This has been China’s and other major reserve managers’ downside to their intervention versus the USD. At a certain point your reserves portfolio becomes big enough and bad enough to be an issue, even if competitiveness was the highest priority originally.
7) Currency has become a clear policy target
Think of recent comments from UK, Swiss and Japanese policymakers. The openness with which the BoE, SNB and Japanese government now discuss the need to get an immediate boost from the export sector is striking. One can correctly argue that currency manipulation applies to many EM countries in greater or lesser degree, but few EM or small G10 countries have been as explicit as UK, CHF and JPY policymakers in their desire to make higher exports and immediate driver o a cyclical rebound. It is very unusual for G10 policymakers to lean on a weaker currency as the cyclical ticket out of a downturn. This is a big policy shift, given the effort to put in place rules of the game that all major G10 and EM countries signed on to.
The Table below shows how we see considerations 1) - 7) as they apply to the G4+CHF. We indicate where we think the issue conveys a significant advantage in the currency war with ‘*’. In a couple of cases we use a question mark to indicate that we are unsure of how important the issue is.
Right now we see JPY, CHF and GBP as most likely to fall because of these considerations. USD may fall as well, given the equivalence that many global investors see between QE and outright currency manipulation, but they have been overtaken by smaller countries with bigger FX emphases. The most likely outcome still seems that the USD falls against currencies that have a normal policy framework. Were the Fed to decide that it needed an unambiguous dose of balance sheet expansion, it is likely that the USD would fall, but it is a secondary ‘currency warrior’ now that investors are debating when the Fed will halt currency expansion.
We include the EUR, but sovereign risk still seems to be the biggest driver. It is unclear now whether the ECB will keep expanding its balance sheet, and the inflation commitment looks stronger.
Note also that the more closed you are as an economy the harder it is get leverage from a weaker currency. So reliance by the US and euro zone on competitive depreciation would be unlikely to work. This might apply to JPY as well, but the Nikkei/JPY link gives currency depreciation a bit more leverage in stimulating activity (well at least in making Japanese feel richer, even as they get poorer).
For the sake of comparison we would invite readers to assess themselves how Australia, Canada, Norway, Sweden and major EM countries would far in our table. There are very few countries that would get as many ‘*’s as GBP, CHF and JPY -- or, for that matter, USD.
Finally, as an endnote we reiterate the other reality of currency wars. Policymakers do not use FX as cyclical stimulus because of its effectiveness. They use it because they have hit a wall with respect to the effectiveness of fiscal and monetary policies, and are unwilling to bite the structural policy bullet. In advanced economies the boost from a weaker currency is much less than advertized in Econ 101, with exporters often taking the higher margin in the hand than the higher export volume in the bush. So if currencies are going to stimulate growth they have to move a long way.
Taking our two propositions together we end up with the G4+CHF being better able to engage in currencies wars, even while needing big depreciations to generate any significant impact. Hence the surprise will be how much depreciation it takes for competitive devaluation to work, not how little.