Euro Bearing the Indirect Brunt of Currency Warfare

January 31, 2013

When excessive inflation poses a larger risk than deficient economic growth, strengthening currencies are coveted to promote price stability and low interest rates.  This is not one of those times, and besides short- and long-term interest rates are already too low, many would argue.  History demonstrates, however, that unilateral efforts by policymakers to depreciate their currencies tend to be self-defeating.  This form of trade protectionism invites retaliation and ultimately depresses two-way commerce and GDP around the world.  To avoid such a trap, governments use an honor system with peer pressure that is formally laid down as semi-binding code in joint statements that are issued from time to time.  At last June’s summit of Group of Twenty leaders held in Los Cabos, Mexico, attendees pledged the following:

We reaffirm our commitment to move more rapidly toward market-determined exchange rate systems and exchange rate flexibility to reflect underlying fundamentals, avoid persistent exchange rate misalignments, and refrain from competitive devaluation of currencies.

G20 finance ministers and central bank heads have scheduled a meeting in Moscow on February 14-16, where part of the agenda will be devoted to recent Japanese policy on the yen and whether such violates the spirit, if not the letter, of the above code.  My view is that the policy of the Prime Minister Abe’s government, while provocative, lies within proper boundaries and that Japan will emerge from that meeting without the label of either an explicit or implicit currency manipulator.  The marketplace long ago ceased delivering a yen exchange value that conformed to the greatly changed Japanese economic fundamentals.  Against the dollar, the yen is currently 50% stronger than its average value in 1987-89.  But in contrast, real GDP expanded 5.1% per year in that span versus 0.6% per year over the last fifteen years.  The current account was strongly in surplus then but now hovers near zero.  Japan had enviable public finances then but has since run up massive public debt.  Satisfactory inflation below 2% then has been transformed to stubborn deflation during the past decade.  At the end of 1989, the yield on 10-year Japanese sovereign debt was 5.72%, roughly five percentage points higher than now, and the Nikkei-225 stock index was at 38,916, 250% above its present level.  There was talk at the end of the 1980s that Japan would overtake the U.S. economy.  Japan’s aura is totally different these days, as analysts wonder how its standard of living can be maintained in the face of very poor demographics.  If Japan’s present value in 1987-19 accurately embodied a 137 per dollar exchange rate, there’s little way that a sub-100 value can be appropriate now.

In an effort to weaken the yen and overcome deflation since December, Japanese officials have verbally criticized its strength, expanded quantitative easing, and approved fiscal stimulus, but in fact they have done less than a situation of recession with continuing deflation warranted.  There are many actions the Bank of Japan could have taken to promote positive inflation but still did not do, and the government failed authorize outright sales of yen against other currencies in the open market. From 79.04 per dollar on November 9, the dollar rose through the 90 yen threshold by January 17 but the trend has flattened more recently. 

Japan’s yen campaign has indirectly buoyed demand for the euro.  The common European currency has risen almost 24% against the yen and outpaced the dollar by 7% since it was worth JPY 100.4  and $1.2690 on November 9.  A slew of possible catastrophes greatly influenced investor behavior in 2012.  There was the fear that the European Economic and Monetary Union was on the brink of a break up.  Market players didn’t know if the U.S. fiscal cliff in 2013 would be averted or at least blunted, and Japan was feared likely to never shake the deflation monkey even as fiscal debt sailed beyond 200% of GDP. 

More hope exists now in each of these risk areas, but the degree of improvement is not uniform.  Greater confidence exists that the euro’s integrity can and will be preserved than in the likelihood of ending Japanese deflation or in U.S. politicians acting responsibly to fix America’s long-term fiscal problem without prematurely removing near-term support for the sub-normal economic expansion.  Japan’s proactive yen policy has produced depreciation against the dollar but even more so against the euro.  The upcoming G20 meeting in Moscow is more likely to deter yen demand against the dollar than versus the euro.  Investors will take notice that ECB officials haven’t objected to the euro’s rise against the dollar or yen.  An orderly further rise in the euro will help reestablish general confidence in the monetary union and put downward pressure on import prices and therefore inflation, which is still running above the ECB target.

Copyright 2013, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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