The European Union Has A Currency Problem

Authored by Milton Ezrati via NationalInterest.org,

Donald Trump, for all his rhetorical clumsiness and intellectual limitations, still sometimes makes a valid point. He does when he says that Germany is “very bad on trade.” However much Berlin claims innocence and good intentions, the fact remains that the euro heavily stacks the deck in favor of German exporters and against others, in Europe and further afield. It is surely no coincidence that the country’s trade has gone from about balance when the euro was created to a huge surplus amounting at last measure to over 8 percent of the economy—while at the same time every other major EU economy has fallen into deficit. Nor could an honest observer deny that the bias distorts economic structures in Europe and beyond, perhaps most especially in Germany, a point Berlin also seems to have missed.

The euro was supposed to help all who joined it. When it was introduced at the very end of the last century, the EU provided the world with white papers and policy briefings itemizing the common currency’s universal benefits. Politically, Europe, as a single entity with a single currency, could, they argued, at last stand as a peer to other powerful economies, such as the United States, Japan and China. The euro would also share the benefits of seigniorage more equally throughout the union. Because business holds currency, issuing nations get the benefit of acquiring real goods and services in return for the paper that the sellers hold. But since business prefers to hold the currencies of larger, stronger economies, it is these countries that tend to get the greatest benefit. The euro, its creators argued, would give seigniorage advantages to the union as a whole and not just its strongest members.

All, the EU argued further, would benefit from the increase in trade that would develop as people worried less over currency fluctuations. With little risk of a currency loss, interest rates would fall, giving especially smaller, weaker members the advantage of cheaper credit and encouraging more investment and economic development than would otherwise occur. Greater trade would also deepen economic integration, allow residents of the union to choose from a greater diversity of goods and services, and offer the more unified European economy greater resilience in the face of economic cycles, whether they had their origins internally or from abroad.

It was a pretty picture, but it did not quite work as planned. Instead of giving all greater general advantages, the common currency, it is now clear, locked in distorting and inequitable currency mispricings. These began with the enthusiasm in the run up to the currency union. High hopes for countries such as Greece, Spain, Portugal, and to a lesser extent Italy, had bid up the prices of their individual national currencies. In time, reality would have adjusted such overpricing back to levels better suited to each economy’s fundamental strengths and weaknesses. But the euro froze them in place, making permanent what otherwise would have been a temporary pressure. At the same time, Germany, which at the time was still suffering from the economic difficulties of its reunification, joined the common currency with a weak deutsche mark, locking in a rate, International Monetary Fund (IMF) data suggests, some 6 percent below levels consistent with German economic fundamentals.

Right from the start, then, the currency union divided the Eurozone into two classes of economies. Greece, Spain Portugal, Italy, and others became the consumers. Because the euro had locked in their overpriced currencies, populations in these countries had the sense that they had more global purchasing power than their economic fundamentals could support and consumed accordingly. At the same time, the currency overpricing put producers in these countries at a competitive disadvantage. Germany, having locked in a cheap currency position, faced the opposite mix. It became the producer for all Europe even as its own consumers, feeling a little poorer than they otherwise might have, remained cautious. Because Germans in this situation had every incentive to sustain production, while others did not, they made more productive investments, improving their economic fundamentals and so widening the gap between economic reality and the euro’s expression of it. Updated IMF data suggests that by 2016 Germany’s relative pricing edge had doubled to 12 percent.

These pricing biases have gone on to foster still more harm. The German economy has become increasingly export oriented, less responsive to its own consumers, more vulnerable to what happens abroad, and consequently more fragile. The distortions have also spilled outside Europe. By exacerbating the fiscal-financial problems of so many Eurozone members, they contributed to a general decline of the euro against the dollar, the yen, the yuan and other currencies. Accordingly, German industry’s pricing advantage has extended to the global marketplace, certainly compared to where matters would have stood if Germany had an independent currency that avoided the taint of Europe’s troubled economies. Japanese producers complain incessantly about how the strong yen has priced their products off global markets. American producers, which have seen the euro fall some 30 percent against the dollar during the past ten years, are hardly any better off. German industry makes no such complaints.

Berlin and the German media have pushed away any blame. They hotly deny that the country engineered matters in this way. This may be so. No one at the euro’s birth anticipated such a result, not even the Germans. But whether the advantage was planned or not, Berlin, it is clear, has certainly taken advantage of it and has taken steps to perpetuate it. Germany has, for instance, put some 671 billion euros ($752 billion) at risk, one quarter of its gross domestic product (GDP), to support Greece and other troubled nations on Europe’s periphery. It has also helped lasso the IMF into such lending. Berlin claims that all this money at risk reflects its commitment to the European experiment in union. That may indeed be so, but it is an awful lot of altruism. A more cynically inclined observer might suggest such extreme actions have an alternative motivation, that the Germans are desperate to prevent the unraveling of a structure that serves German industry well.

Whatever the truth of German motivations, Trump, it should be clear now, has a point. Germany is leveraging an unfair and distorting competitive advantage. More important everyone, except of course German industrialists, has an interest in unwinding this currency pricing bias. It is not apparent how Europe could do this. A harmonization of tax and spending policies might reduce some of the hardship imposed by these pricing biases but not remove the basic problem. A good first step might at least admit that such distortions exist and that an adjustment would provide relief. For non-German consumers, it might encourage restraint by demonstrating that the global purchasing power of their incomes is less than they had supposed. For German households, it would have the opposite effect. Finding a way to correct the imbalance would provide a lift to non-German production and in so doing lift the pressure of the fiscal-financial crisis under which Europe has labored now for almost ten years. In the process, it would save the German taxpayer from having to put so much money at risk to prop up a distorting system. If an adjustment would hurt German industry, it would also slow or perhaps reverse the underlying ill effects it is having on the structure of that important economy.

Trump Wins: G-20 Drops 'Anti-Protectionist, Free-Trade, & Climate-Change Funding' Commitment

After delays and hours of discussions amid tensions over "trade" comments between the United States and the rest of The G-20, it appears President Trump has "won". While China was "adamantly against" protectionism, the finance ministers end talks without renewing their long-standing commitment to free trade and rejection of protectionism after US opposition.

The world"s financial leaders are unlikely to endorse free trade and reject protectionism in their communique on Saturday because they have been unable to find a wording that would suit a more protectionist United States, G20 officials said.

This would break with a decade-old tradition among the finance ministers and central bankers of the world"s 20 top economies (G20), who over the years have repeatedly rejected protectionism and endorsed free trade.

But the new administration in the United States is considering trade measures to curb imports with a border tax and would not agree to repeat the formulations used by previous G20 communiques, clashing with China and Europe, the officials said.

"Unless there is a last minute miracle, there is no agreement on trade," one official, who declined to be named, told Reuters.  "This is not a good outcome of the meeting," a G20 delegate quoted Bundesbank President Jens Weidmann as saying.

In a partial face-saving move, as The FT details, G20 finance ministers meeting in the German resort town of Baden-Baden noted the importance of trade to the global economy, but dropped tougher language from last year that vowed to “resist all forms of protectionism”.

The new communique said: “We are working to strengthen the contribution of trade to our economies. We will strive to reduce excessive global imbalances, promote greater inclusiveness and fairness and reduce inequality in our pursuit of economic growth.”

The watered-down commitments on free trade reflected the anti-globalisation mood that Donald Trump has brought to Washington and came in the first G20 meetings between Steven Mnuchin, the new US Treasury Secretary, and his foreign counterparts.

US Treasury Secretary Mnuchin spoke to reporters after the meeting:

• *MNUCHIN: LOOKING FORWARD TO WORKING CLOSELY W/ G-20 COLLEAGUES


• *MNUCHIN: CONFIDENT U.S. CAN WORK CONSTRUCTIVELY WITH PARTNERS


• *MNUCHIN: U.S. BELIEVES IN FREE, BALANCED TRADE


• *MNUCHIN SAYS WILL LOOK AT TRADE SURPLUSES WITH VIEW TO CORRECT


• *MNUCHIN SAYS MULTILATERAL AGREEMENTS HAVE VERY IMPORTANT PLACE


• *MNUCHIN SAYS U.S. WANTS TO RE-EXAMINE TRADE DEALS INCL. NAFTA


• *MNUCHIN: U.S. BELIEVES IN APPROPRIATE REGULATION


• *MNUCHIN SAYS IMPORTANT BANKS CAN PROVIDE LIQUIDITY IN MARKETS

Reuters also points out another potential win for Trump as the communique will also drop a reference, used by the G20 last year, on the readiness to finance climate change as agreed in Paris in 2015 because of opposition from the United States and Saudi Arabia.

Trump has called global warming a "hoax" concocted by China to hurt U.S. industry and vowed to scrap the Paris climate accord aimed at curbing greenhouse gas emissions.

Trump"s administration on Thursday proposed a 31 percent cut to the Environmental Protection Agency"s budget as the White House seeks to eliminate climate change programs and trim initiatives to protect air and water quality.

Asked about climate change funding, Mick Mulvaney, Trump"s budget director, said on Thursday, "We consider that to be a waste of money."

The G20 do agree, however, to show continuity in their foreign exchange policies, using phrases from the past on foreign exchange markets.

As we noted earlier, needless to say, such an acrimonous end to the weekend"s summit would likely result in a surge in FX volatility when markets open for trading late on Sunday, reflecting the new state of global trade flux, in which the future of the US Dollar is completely unknown, and reflecting the emerging chaos over the future parameters of trade.
 

OECD Warns There Is A "Disconnect" Between Markets And The Global Economy

In a report released this morning by the Organisation for Economic Cooperation and Development titled "Will risks derail the modest recovery? Financial vulnerabilities and policy risks" the OECD warns the global economy may not be strong enough to withstand risks from increased trade barriers, overblown stock markets or potential currency volatility, and adds that the "disconnect between financial markets and fundamentals, potential market volatility, financial vulnerabilities and policy uncertainties could derail the modest recovery."

The OECD projects global GDP growth to pick up modestly to 3½ per cent in 2018, from just under 3% in 2016, boosted by fiscal initiatives in the major economies, a forecast which is broadly unchanged since November 2016 and notes that while confidence has improved, "consumption, investment, trade and productivity are far from strong, with growth slow by past norms and higher inequality."

Furthermore, the OECD notes that the pace of growth will remain well short of its average in the two decades before the financial crisis because of weak investment and productivity gains.

“We have acceleration but I’m concerned about this really soft foundation to the recovery,” OECD Chief Economist Catherine Mann said in a Bloomberg interview. “We still have this slow, sluggish productivity growth and persistent inequality. Put those together and it’s hard to see the robust consumption and investment profile you need to really get things going.”

Taking a cue from the IMF and central banks, the OECD launched a veiled attack at Trump"s proposed protectionist policies, and while the president was not named, the OECD highlighted concerns related to Trump administration policies, including his threats to impose tariffs on nations he deems to have an unfair advantage.

“We think the dynamic response to increased protectionism could be really quick, so we have a pretty significant downward bias on what it could mean for growth,” Mann said. “What we mean by that is the way businesses will respond by raising prices and cutting trade flows.”

Trump aside, however, key recurring core theme in the report is the OECD"s warning that there is a notable “disconnect” between equity valuations and the outlook for the real economy, with the market performance partly linked to anticipation of a Trump stimulus package, to wit: 

The positive assessment reflected in market valuations appears disconnected from real economy prospects. The interest-rate cycle turned in mid-2016 and rising divergence in interest rates between major economies heightens risks of exchange rate volatility. Vulnerabilities remain in some advanced economies from rapid house price increases. Risks to emerging market economies are high, including from higher corporate debt, rising non-performing loans and vulnerability to external shocks.

As Bloomberg notes, the OECD also highlighted potential exchange rate volatility from the shift in the interest-rate cycle. The U.S. Federal Reserve is forecast to increase interest rates next week in what may be the start of a series of hikes this year. In contrast, the European Central Bank is pressing on with its planned stimulus program through 2017. “Although risks may not materialize immediately, they remain a real possibility and a set of large shocks, possibly interacting with each other, would disrupt the recovery,” the OECD said.

Disconnects, volatility, financial vulnerabilities and policy uncertainty could derail the projected modest pick-up in growth. While immediate indicators of financial market stress have generally moderated compared with a year ago, underlying tensions have continued to rise. Although risks may not materialise immediately, they remain a real possibility and a set of large shocks, possibly interacting with each other, would disrupt the recovery.

Another warning: rising rates which could lead to "wider financial instability."

The recent interest rate rises have been associated with sizeable exchange rate movements, with the US dollar appreciating rapidly against the euro and yen, and a number of emerging market currencies have faced market pressures. Financial market expectations imply that a large divergence in short-term interest rates between the major advanced economies will open up in the coming years. This raises the risk of financial market tensions and volatility, notably in exchange rates, which could lead to wider financial instability.

The OECD also slams the world"s overrliance on monetary policy, which has not only led to exceptionally low rates, but also rising debt levels, and elevated asset prices.  In short central banks have created asset bubbles.

Significant financial vulnerabilities arise from the overreliance on monetary policy in recent years, which has led to an extended period of exceptionally low interest rates, rising debt levels in some countries, elevated asset prices and a search for yield. In advanced economies, some countries have experienced rapid house price increases in recent years, including Australia, Canada, Sweden and the United Kingdom. As past experience has shown, a rapid rise of house prices can be a precursor of an economic downturn. House price-to-rent ratios are at record highs in several countries and above long-term averages in many others. Although there has been a slower accumulation of household debt in recent years, mortgage-debt-to-income ratios remain high in many countries

Another major concern to the OECD are emerging markets, which are a source of "significant global financial vulnerabilities stem from emerging market economies, although the sources of potential vulnerability differ across economies." Of note here: China.

The rapid growth of private sector credit and the relatively high level of indebtedness by historic norms is a key risk in some countries, notably China, fuelled by favourable financial conditions amid low global interest rates. These high debt burdens, particularly of non-financial companies, leave economies more exposed to a rapid rise in interest rates or unfavourable demand developments. At the same time, a turning of the credit cycle is leading to a rise in non-performing loans, particularly for India and Russia, potentially exposing a misallocation of capital during the upswing and creating pressures on the banking system. In China, the high share of non-performing and “special-mention” loans reflects to a large extent borrowing by state-owned enterprises.

The OECD continues:

Many emerging market economies are also vulnerable to external shocks and currency mismatches. Sharp movements in foreign interest rates, rapid depreciations of the domestic currency, and or rising risk premia can induce financial stresses in countries with high levels of overseas borrowing or those with a mismatch between foreign currency denominated debts and export revenues. While exposure should take into account the position at the firm level and natural hedges and other factors, Brazil, Indonesia, Russia and Turkey have aggregate US dollar liabilities in excess of their estimated annual US dollar export revenues. While a number of factors make emerging market economies as a whole more resilient than during past episodes of rising interest rates in advanced economies, such as higher foreign exchange reserves and changes in the structure of foreign borrowing, exposures to global volatility are nevertheless high in many countries

A favorite topic of ours: the record low VIX which makes no sense in light of nre record high policy uncertainty. As the OECD wrties, uncertainties in many countries about future policy actions and the direction of politics are high. News-based measures indicate global policy uncertainty increased significantly in 2016, rising particularly sharply in some countries. Many countries have new governments, face elections this year, or rely on coalition or minority governments. More generally, falling trust in national governments and lower confidence by voters in the political systems of many countries can make it more difficult for governments to pursue and sustain the policy agenda required to achieve strong and inclusive growth. Rising inequality and growing concern about the fairness of society may also help to undermine trust and confidence in governments. These tensions lead to less predictable outcomes, including on progress in implementing policy reforms.

“Falling trust in national governments and lower confidence by voters in the political systems of many countries can make it more difficult for governments to pursue and sustain the policy agenda required to achieve strong and inclusive growth,” the OECD said.

There are many more warnings in the full report, but we are confident the market will do what it does best - ignore them - until the selling avalanche begins at which point the question will be "why did nobody warn us?"

Goldman Warns "China Remains A Key Risk", Sees Yuan Downside Accelerating

With Bitcoin at 3 year highs, China’s renewed efforts to curb declines in its currency are doing little to stop yuan bears who have sent forward devaluation expectations to record highs and options positioning to six-month lows. And judging by Goldman Sachs" outlook - a potential resurgence in Chinese growth fears early next year, but more broadly, a continued bumpy deceleration - things are not getting better anytime soon.

As Bloomberg notes, traders have turned increasingly negative amid tighter liquidity, sending bets for further losses soaring. The gap between forward contracts wagering on the offshore yuan a year from now versus its current level is heading for a record monthly jump...

Just as the extra cost for options to sell the currency against the dollar hit a six-month high relative to prices for contracts to buy.

The currency is facing a triple whammy of accelerating capital outflows, faster U.S. interest-rate increases and concerns over domestic financial markets as liquidity tightens. Strategists say its weakening, set to be the biggest this year in more than two decades, may accelerate as the government restores the annual quota for citizens to convert yuan holdings into foreign exchange. And Goldman Sachs warns, China remains a key risk to watch...

Where we stand now:

Broader concerns about China risk derailing global growth and markets proved somewhat short-lived. After the S&P 500 hit its low for the year on February 11, two days after we published, better economic data and a sense that the Fed would react to global concerns—confirmed by the dovish March FOMC meeting—helped improve market sentiment. Political events in the western hemisphere have since broadly taken center stage in global markets, leaving China concerns in the background. But the reality is that growth—on some level—did take a hit; for example, US GDP growth came in at an anemic 1.1% annualized in 1H2016, owing in part to weakness in the industrial sector and energy-related activity but largely due to tighter financial conditions primarily in the wake of China concerns. China growth itself also remained relatively weak in 1H as measured by the GS China Current Activity Indicator, which declined towards 4% in 1Q and began to climb slowly thereafter.

Stabilizing growth in China has helped push China to the background of investor concerns. In order to stabilize growth and meet official GDP targets, China’s policymakers continued to pursue an ambitious stimulus plan begun in early 2015 that entailed pausing fiscal reforms, sharply cutting interest rates, loosening housing policies, and increasing credit growth. The result: GDP growth looks set to meet the target of 6.5%-7% for 2016, and producer prices are rising after years of deflation.

But policies that re-ignited growth in the short-term just increase concern about the future, especially in terms of credit. We estimate that total credit growth adjusted for muni bond issuance accelerated from 13% yoy in 1Q15 to 17% yoy as of 2Q16, and to 20% yoy when including shadow lending not captured in official statistics. In short, the potential credit problems in China have not receded, and indeed have likely grown given the very fast pace of credit expansion.

Policymakers have taken note of these potentially destabilizing dynamics and have refocused on risk management; indeed, China’s recent Central Economic Work Conference to plan for next year’s economic policy included strong statements on controlling financial risks. Risk management measures employed in recent months include increasing short-term repo rates, reining in off-balance sheet exposures such as wealth management products, and rolling out measures to try to curb home price appreciation. Fiscal policy also seems likely to tighten at least slightly in coming months. But any tightening will likely prove short-lived given that meeting growth targets will remain critical in 2017—a year of leadership transition.

Our RMB view has also become more negative, presenting risk to the US dollar and S&P 500. When we published at the height of market anxiety around China, we were relatively constructive on the RMB, arguing that a large, one-off devaluation was unlikely and envisioning only a “mild” trade-weighted depreciation (against the CFETS basket, the CNY has depreciated 4.5% since then). But capital outflow pressures have remained, particularly in the context of US dollar strength. Despite the government’s official focus on a trade-weighted currency basket, higher $/CNY fixings are still a powerful signal that can easily re-ignite capital flight, as households and firms anticipate a faster pace of depreciation.

Indeed, the PBOC’s FX reserves fell US$69bn to US$3,052bn in November, the largest decline since January. The US election has reinforced these dynamics given the strengthening dollar and potential for trade frictions, motivating tighter restrictions on capital flows. Global markets have so far taken these developments in stride, but the risk of a repeat of related equity market volatility remains, which could impact the pace of Fed tightening and dollar strength.

What to look for in 2017 (and beyond):

A potential resurgence in Chinese growth fears early next year, but more broadly, a continued bumpy deceleration. We expect sequential GDP growth to decelerate into 1Q17 to c.5.5% annualized on recent tightening measures. But we expect a rapid pivot back to stimulus should the growth target look at risk, especially given next year’s leadership transition.

Continued concerns about China credit growth. Although policymakers have introduced tightening measures to reduce the risk of asset price bubbles, China’s reliance on credit growth, which undermines financial stability, remains a key risk.

RMB downside, posing potential risk to the stronger US dollar and global stock markets. We forecast a $/CNY fix of 7.00, 7.15 and 7.30 in 3, 6 and 12 months, respectively, and long $/CNY is one of our 2016 Top Trades. The pace of capital outflows and the evolution of the fix warrant monitoring; in our view, as long as the fix simply offsets dollar strength and capital outflows are contained, global risk appetite should hold up.

China remains a key risk to watch.