"Sorry , Partners ..... you'll have to fend for yourselves on this one ."

Tuesday 10th November 2015

 

"Sorry , Partners ..... you'll have to fend for yourselves on this one ."

Ref: "Europe's Quiet Currency War Besets Nations Losing Inflation Grip" , Bloomberg Markets

 

Back in August, China's move to set the value of its currency marginally lower and allow its rate to be more directly influenced by the market was met by some (particularly in the US) with vehement accusations of competitive devaluation, and was portrayed as just the start of a currency war. Such accusations have proved unfounded, but there is a currency war going on. It has attracted much less attention on a global level but having many of the characteristics of a civil war it could end up as a particularly nasty one.

The Eurozone comprises 19 nations, which leaves a further 9 EU members which are not included in the single currency bloc but they will undoubtedly be feeling that their own monetary policy is being dictated by Mario Draghi and the ECB. The 1.1trn euro bond-buying programme (QE) initiated in January has flooded the euro-area with cheap cash and pushed investment flows into neighbouring countries. In the first quarter alone, total portfolio investments held by euro-area residents in the other 9 EU nations rose by 9%, to 2.05 trn euros.

Obviously such capital flow boosts the currency of the receiving countries and thus stymies their own desperate attempts to hit inflation targets. The ECB may give lip-service to appreciating the problems it is causing to fellow EU members, but its mandate is to look after the Eurozone and it knows it is playing a zero-sum game ..... in other words, if it implements increasingly easy policies that engineer a weaker euro, by definition other currencies will have to increase in value.

The ECB repeatedly states that it does not target its exchange rate .... true or not , it does not deny that a weaker currency helps to revive the economy and inflation by boosting exports and pushing up import prices. On a trade-weighted basis, the euro has fallen about 7% this year and significantly the unfortunate "beneficiaries" include Sweden's Krona, Poland's Zloty, the Czech Republic's Koruna and Hungary's Forint. For the purposes of this conversation and because of its many trade deals, we could probably also include the Swiss Franc, even though Switzerland is not part of the EU.

 Almost without exception, these countries and others have determined that boosting inflation is their primary objective and therefore in face of likely further easing by the ECB they may be forced to implement further easing measures themselves (to keep a lid on their currency), even if such measures would be entirely inappropriate if one had other priorities in mind.

 For example :

The Swiss real-estate market is viewed as decidedly overinflated (just one example of the kind of asset bubble that can occur with money so cheap for so long), and yet SNB President Thomas Jordan has said that the deposit rate could fall further from its current rate of MINUS 0.75%.

Swedish property prices are also booming and the economy is growing twice as fast as the euro area, but with little scope to cut interest rates even further or to buy more government bonds, their only option may be to intervene in the currency markets  --  a policy fraught with dangers if conducted in the long-term. Much the same could be said of Denmark.

And what about the Czechs ? With forecasted GDP for 2015 at 4.7%, they are struggling to hold down the Koruna even though rates have been at 0.05% for three years.

And the exception ? (yes, there is one) ..... Poland.

Most interestingly, the strategy of the National Bank of Poland led by former IMF official Marek Belka for combatting the difficulties in hitting inflation targets is ..... to ignore those targets completely. The NBP has refused to cut rates to nothing or below, or to embark on expensive bond-buying programmes, pointing out that the economy is still trucking along nicely despite a prolonged period of deflation.

The world will be watching closely to see how this experiment pans out in the longer term. It certainly goes against most current economic thinking but raises the question as to whether such a narrow focus on consumer price gains or falls really is the best measure of success in growing economies.

As Anatoli Annenkov of Soc Gen points out, competitive devaluations used to be about getting more growth  --  now they're about getting inflation even if it has nothing to do with the underlying economy. He's right, and it sounds more and more strange the longer you think about it.