Waging a currency war
The U.S. dollar has been on a tear this year, rising against the currencies of virtually all major developed economies. What we’re seeing around the world is intense - and in some cases, deliberate - devaluations. What’s going on and what are the investment implications?
One reason for the devaluations is that, when economic growth is weak - as it has been globally for five years - governments feel tremendous pressure to increase exports and reduce imports to restore growth. Often that means lowering the value of the currency so that products sent abroad are relatively less expensive and those coming into the country more so.
The European Central Bank, for example, wants to depress the euro to keep deflation at bay. The euro’s earlier strength drove down import prices, forcing domestic producers who compete with imports to slash their prices. As a result, consumer price inflation moved steadily toward zero. It was a mere 0.4 percent in October versus a year earlier.
The eurozone economy remains stagnant, with a third recession since 2007 a possibility. Unemployment is high. Youth unemployment tops 25 percent in many countries; it exceeds 50 percent in Spain and Greece. Meanwhile, consumer sentiment, which never recovered from the last recession, is again dropping.
In early June, the ECB responded by cutting its benchmark interest rate from 0.25 percent to 0.15 percent and introducing a penalty charge of 0.1 percent on reserves it holds for member banks. While these measures were more symbolic than substantive, the euro slid in reaction. In September, the ECB started to make up to 1 trillion euros ($1.24 trillion) in cheap, four-year loans available to member banks, provided they made more credit available to the private sector.
While the ECB will probably end up with outright quantitative easing in one form or another, keep in mind that QE is less effective in the euro area. Financing is concentrated in the banks, which account for 70 percent of corporate financing, not in bond markets as in the United States, where QE works its way into the economy rapidly. Also, weak eurozone banks are weighed down by bad loans, anemic profits and the need to raise capital to meet new regulatory requirements. In addition, there are 18 euro-area countries and, therefore, 18 separate bond markets for the ECB to consider.
On the other side of the globe, trashing the yen isn’t one of the three arrows in Japanese Prime Minister Shinzo Abe’s quiver for curbing deflation and reviving the economy. But it’s certainly part of his plan. It’s a natural consequence of the first arrow - massive quantitative easing by the Bank of Japan and the resulting explosion of the BOJ’s balance sheet. In anticipation, the dollar leaped against the yen when Abe was elected in 2012 and installed his own central bankers.
After flattening for a time, the yen has again risen sharply in recent weeks. The central bank is resolved to combat aggressively the deflationary expectations that are rampant in Japan after two decades of flat or falling prices.
Another goal of monetary easing and yen-cheapening is to spur exports, retard imports and reverse the growing foreign-trade deficit. Furthermore, a falling yen helps move prices toward the BOJ’s 2 percent inflation target by raising the cost of imported products.
The purpose of Abe’s second arrow, fiscal stimulus, is difficult to carry off in view of Japan’s already high government deficit and debt. This spring, he also introduced fiscal drag in the form of a sales-tax increase to 8 percent from 5 percent to pay down the government debt. The results - a jump in spending and GDP in the first quarter to beat the tax increase - were predictable.
But it’s been all downhill since, with a second-quarter annualized GDP decline of 7.3 percent followed by a 1.6 percent drop in the third, sending Japan into its fourth recession since 2008. In response, Abe put off a planned second hike in the sales tax and called for a snap election in December.
Because Japan has the lowest fertility rate among G-7 countries and no legal immigration (which typically attracts working-age people), Japan is suffering a population decline. As a result, a shrinking Japanese work force must provide for a growing number of retirees. It doesn’t help that the Japanese have the longest life expectancy among major countries.
Japan could address its problems with structural reforms, which is Abe’s third arrow. But such reforms are difficult in a country that, until the late 1800s, was immersed in feudalism. In feudalistic societies, women don’t work outside the home and a man owes lifetime allegiance to his feudal lord. Today, the Japanese norm is that women don’t work and men expect lifetime employment. Since companies are discouraged from firing, they don’t have room for new hires. In addition, efficiency-enhancing corporate takeovers are rare in Japan, another carry over from feudalism.
Still, the Abe government is discussing some less-disruptive structural reforms that could raise Japan’s growth potential. A cut in the top corporate tax rate to below 30 percent from above 35 percent, in line with the 29 percent average among developed nations, is one possibility. Also under consideration are “special economic zones” that would give companies the freedom to cut the red tape that constrains everything from hiring and firing to land ownership and management.
In any event, Abe is having trouble shooting his second and third arrows, fiscal stimulus and structural reforms. He will have to rely primarily on the first arrow, monetary stimulus, which will have a negative effect on the yen. Indeed, the BOJ said on Oct. 31 that it will accelerate its buying of government bonds by up to a third, while tripling purchases of exchange-traded funds and real-estate investment trusts.
Japan, like the eurozone, has clearly embarked on competitive devaluation aimed at spurring the economy and curtailing deflation. In part two of this series, I will look at the so-called commodity currencies and what’s driving their devaluations.
*The author, a Bloomberg View columnist, is president of A. Gary Shilling & Co., a consultancy in Springfield, New Jersey.
by A. Gary Shilling