The continued deterioration in global economic data and mixed figures in the US have probably tempered the US Fed’s plan to hike its policy interest rate this year. The Fed is now likely to increase rates two to three times this year instead of four times. This is not because the US is about to enter recession. It isn’t. There is far too much earning power in the US economy. It is because, having more or less achieved its employment target, the Fed is focused on inflation and there won’t be enough of that for four hikes. So the path of ‘normalization’ in monetary policy will flatten.
That will still leave the global divergence of monetary policy as the key currency driver. It looks like Mario Draghi has girded his loins to take on the ‘further-action naysayers’ at the German Bundesbank. In March, expect €10 billion to €15 billion a month added to the asset purchase programme; a further extension of the duration of the plan; a possible broadening of its scope; and a cut in the deposit rate of 10 basis points to -40bp.
The ECB action follows the decision of the Bank of Japan in February to introduce a negative interest-rate policy. The BoJ action and the promise of more on negative interest rates means the BoJ has no tolerance for a deflationary strengthening of the yen. What the BoJ has done so far is quantitatively very marginal, but psychologically very material. It makes the weakening yen trajectory more certain and more likely to happen earlier.
As I argued last month, I expect the Chinese monetary authorities to allow the yuan to depreciate by up to 15% this year, despite talk by People’s Bank governor Zhou Xiaochuan that capital flight from China was exaggerated and mainly the result of legitimate purchases of overseas assets by Chinese firms. It’s true that China is a surplus savings economy offering low returns to its own investors. This creates a natural tendency for capital to migrate to areas of higher return outside China.
But there are reasons for low Chinese domestic returns on investment. Interest rates are kept artificially low by government diktat so the banks can channel surplus savings into low-return investments in local government and infrastructure. The use of the banks as the proxy of stimulatory fiscal programmes (since the 1998 Asian crisis) added more to the bad assets and bad loans at the core of China’s economy.
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Today, the stock of bad assets and misallocated savings is substantially greater than GDP. It manifests itself most visibly (but not exhaustively) in overcapacity in state owned enterprises. SOEs are now in debt deflation with a 5% to 10% gap between falling output prices and cost of debt. Capacity utilization is around 60% in most heavy industry. Industrial (not just SOE) profits continue to fall.
So there is every reason for capital to exit China. Interest rates cannot be raised to stop it doing so, because it would make corporate debt deflation worse. The cure is to reform the SOEs and other bad assets and heft productivity, to make China a higher investment-return environment. But that is not going to happen any time soon. Politics, bureaucratic paralysis and lack of vision at the senior political level will stop that outcome.
The effect of renminbi devaluation will continue to encourage capital to flow into Japan for now. A more disorderly renminbi decline would make the yen even stronger. But a strong yen will add to deflationary pressure in Japan. And that means the BoJ will have to print more and cut rates even further. That will be the real turning point in the yen.
The BoJ will continue to try to achieve the impossible and government policies will fail to refresh Japan as a production platform, ultimately raising the issue of sovereign debt sustainability, which the BoJ will solve by buying it all. But the result will be capital fight (as domestic returns will be nonexistent). So bang goes the yen.
And with the yen and the Chinese yuan weakening sharply over this year, most Asian currencies will follow them down, as well as the currencies of commodity-exporting emerging economies like Brazil, South Africa and Russia and those with substantial corporate-sector dollar debts like Turkey.
The winner in all this will be the dollar.