The Global Economy
Monthly letter from Swedbank’s Economic Research Department
by Cecilia Hermansson 19 October 2010
Econo...
The Global Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 7 • 19 October 2010
2
US...
The Global Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 7 • 19 October 2010
3
wa...
The Global Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 7 • 19 October 2010
4
Th...
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The Global Economy - No. 7/2010

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  1. 1. The Global Economy Monthly letter from Swedbank’s Economic Research Department by Cecilia Hermansson 19 October 2010 Economic Research Department, Swedbank AB (publ), SE-105 34 Stockholm, tel +46-8-5859 7740 E-mail: ek.sekr@swedbank.se Internet: www.swedbank.com Responsible publisher: Cecilia Hermansson, +46-8- 5859 7720, Magnus Alvesson, +46-8-5859 3341, Jörgen Kennemar, +46-8-5859 7730, ISSN 1103-4897 Currency tensions put the global recovery at risk • Even though the US economy is no longer shrinking, the recovery is taking time. There is a risk that unemployment could rise even further, and inflation remains uncomfortably low. The Federal Reserve is expected to begin another quantitative easing in November. The dollar is already weakening. • Currency tensions are growing and will overshadow everything else at the G20 summit in Seoul in November. A US quantitative easing could create bubbles in emerging economies when capital seeks out higher returns. China's currency reserves are growing, and in its attempts to spread currency risks it is buying yen and won, which are pushing the values of these currencies higher. Japan has already reacted to the US monetary easing and started intervene to prevent the yen from getting too high. Other countries are following suit. Currency tensions are growing, and Brazilian finance Minister Guido Mantega has talked about a currency war. • It is reasonable that countries with large current account deficits should have a weaker currency, while those with surpluses have to accept a stronger currency. Compared to exchange rates before the financial crisis in 2007, few currencies have appreciated against the dollar. The lack of economic tools in developed countries’ arsenal and an excessively mercantilist stance in several emerging countries are driving these currency tensions. The risk is that they could lead to protectionism and a vicious cycle of deflation and weak growth. It is still possible to prevent this from happening. US: No quick fix On September 20 it was announced that the US recession had ended in June 2009, i.e., the economy was no longer shrinking. The committee appointed by the National Bureau of Economic Research (NBER) to determine when the US goes in and out of recessions reported that this recession had been unusually long – 18 months – making it the longest since World War II. In our last monthly letter we mentioned it was important not to draw any hasty conclusions about the US economy. Labour, housing and credit markets had not shown any signs of a turnaround. What the NBER said, however, is that the economy isn't getting any worse. It is still hard to see any improvement on the horizon, especially since unemployment is expected to continue to rise before eventually tailing off. One reason is that states are coming under increasing financial pressure and more of their employees will have to be laid off. The private sector doesn't seem able to add many jobs either, as small and midsize companies struggle with weak domestic demand. The National Association of Business Economics (NABE) issued a new forecast at its annual meeting last weekend in Denver. It expects GDP to grow by 2.6% this year and next, a significant downward revision from May of this year, when it forecast 3.2% for both years. (Compare Swedbank’s forecasts from April and September of 2.8% and 2.2% for 2010 and 2011). In addition to lower GDP growth, the NABE economists now have a more pessimistic outlook on unemployment, and inflation is projected to be lower than before. They are not concerned, though, that the US will enter a period of deflation. On the contrary, they are more worried about inflation. Still, neither deflation more inflation are their biggest concerns. Instead it is weak growth and the job market – especially the federal debt situation – that keep them awake at night. Like other market analysts, they do not expect the Federal Reserve to raise interest rates until late next year.
  2. 2. The Global Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 7 • 19 October 2010 2 US unemployment (% of labour force) and core inflation (annual change) 1958-2010 Source: Reuters EcoWin 60 65 70 75 80 85 90 95 00 05 10 Percent 0.0 2.5 5.0 7.5 10.0 12.5 15.0 Annual Core Inflation Unemployment The political situation is complicating efforts in the US to implement effective economic policies. President Obama’s proposed $50 billion fiscal stimulus to improve infrastructure and the business climate has not yet been passed by Congress. Many US economists are complaining that the political situation threatens the recovery, as companies and households are feeling uncertain which way the country will go in terms of taxes, spending and economic policies in general. The healthcare reform could be taken up again by Congress if the Republicans decide to repeal the law if they win a Congressional majority in November (which many people expect). This means that the ball rests in the court of the US central bank, the Federal Reserve. In Jackson Hole in August, Fed Chairman Ben Bernanke signalled that inflation was below the Fed's comfort zone. Since then core inflation (excluding energy and food) has continued to fall, to 0.89, its lowest level since 1961. Since the benchmark interest rate has already been cut to zero, the only thing left for the Fed to do is crank up the printing presses again to buy bonds. Its first quantitative easing (QE) in March focused on mortgage bonds, and to a lesser extent treasuries. The financial market is expecting a new period of QE beginning in November that will focus more on government bond purchases. The goal is to further reduce interest rates and raise inflation expectations. In the wake of this anticipated measure the dollar has already begun to weaken. Even though the US administration frequently says it prefers a strong dollar, it isn’t complaining when it knows that a weaker currency will stimulate exports. The question is how US monetary policy affects the rest of the world and in what ways the response from other countries will impact the US. China in particular is a key. Irritation is growing over how the Chinese have dragged their feet in letting the yuan appreciate. The House of Representatives has passed legislation imposing a duty on Chinese goods. (The Senate has yet to take up the measure and the president hasn't taken action either.) US rhetoric is heating up. Just last week Nobel prize- winning economist Paul Krugman accused China of stealing American jobs. G20 summit in Seoul: Currencies dominate the agenda The G20 summit on November 11-12 in Seoul will bring together political leaders, finance ministers and central bank governors as well as a number of international bodies such as the IMF and the World Bank. The agenda was supposed to centre on financial sector regulation, but the currency tensions in recent months could now overshadow everything else on the agenda. The risk is that if these tensions worsen, protectionism and a trade war won’t be far behind, undermining the global recovery. In addition, there is the risk that deflation and weak growth in the West will follow when global imbalances are no longer shrinking. Economic policies were coordinated at a previous G20 summit in connection with the financial crisis and global recession. Now that economic weapons are no longer working normally – fiscal policy has to be tightened due to escalating debts in many developed countries, at the same time that monetary policy has already been made expansive and there isn’t much ammunition left – many countries are trying to prevent their currencies from appreciating against the dollar. It is reasonable that countries with large current account deficits switch from a growth model driven by domestic demand, large imports and low savings to more export-driven growth. A weaker dollar therefore makes sense to reduce imbalances and in the US case to strengthen growth, reduce unemployment and avoid deflation. In China, where the current account surplus is again growing after having fallen to about 6% of GDP last year, and currency reserves rose by 35% on an annual basis during the second quarter to $2.65 billion, it is instead reasonable that the currency, the yuan, be allowed to appreciate against the dollar. This is after China kept its exchange rate closely tied to the dollar during the crisis until last summer, when a slight appreciation
  3. 3. The Global Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 7 • 19 October 2010 3 was allowed. There is, of course, great disappointment in the US and among many emerging economies that compete with Chinese products over the slow pace. Japan: Nominal and real effective exchange rates (and 30-year trends) Source: Reuters EcoWin 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 Index 40 50 60 70 80 90 100 110 120 130 140 150 160 Nominal Effective Exchange Rate Index Real Effective Exchange Rate Index The upcoming quantitative easing (QE) in the US has already set in motion a wave of activity in other countries. At the same time China’s actions also make other countries want to stop the rapid appreciation of their currencies. China’s burgeoning foreign reserves have to be invested, and to avoid becoming overly dependent on the dollar China is also buying yen, won and euro (e.g. Greek government bonds) to reduce the share of dollars in its reserves, which are estimated at 65%. Last spring, when China bought the yen, it rose, and it is now at a high level in nominal terms (though not yet in real terms, since Japan has deflation). Even though China sold the yen in August, there are analysts who feel that yen purchases in the UK at the same time were the work of the Chinese trying to be less transparent about what their currency portfolio really looked like. When the financial crisis began in fall 2007, a number of currencies weakened against the dollar as investors sought out safe harbours and had to restore their balance sheets. Since early 2009, when the crisis eased, most of these currencies have risen, and in several cases they are now back at the levels from before the crisis (in nominal terms). The Japanese yen and the Swiss franc have appreciated strongly since the crisis. Both countries have intervened, but have not been successful in their unilateral efforts. Expectations are that these currencies will continue to rise in value. It is not unreasonable that countries with large current account surpluses such as Japan, Germany and Sweden allow their currencies to appreciate. This is happening all over Europe, but Japan must also accept a stronger yen and instead do more with structural reforms. Various currencies’ nominal values compared with the US dollar 2003-2010 (Index 9 Aug 2007 = 100) Source: Reuters EcoWin 03 04 05 06 07 08 09 10 60 70 80 90 100 110 120 130 140 150 160 170 180 190 Yen Euro Korean Won Brazilean Real Swedish Krona Yuan Swiss Franc If China accepted a faster appreciation, it would also give other emerging economies’ currencies some breathing room. An excessive appreciation should be avoided, however, so that China's economic development isn't threatened in terms of its export industry and employment. It is in China’s interest, however, to allow the yuan to appreciate, since it would facilitate an easier transition to a growth model driven by domestic demand at the same time that any inflation problems can be better controlled. At the same time the US quantitative easing complicates the picture, since it is driving capital to countries offering higher returns, i.e., emerging economies. There is a risk that the capital inflows now “hurting” these countries could lead to new bubbles, overheating and instability. Representatives of South Korea, for example, claim that the main reason for their attempts to prevent the won from appreciating is to counter volatility. As indicated in the diagram above, the won is still weaker than when the crisis broke out in 2007. Every country is trying to export its way out of the crisis for a lack of better economic tools. Some are trying to prevent their currencies from becoming too strong (South Korea, Japan). Some are trying to directly or indirectly weaken their currency (US). Others are doing little to influence their currency (Eurozone).
  4. 4. The Global Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 7 • 19 October 2010 4 This works for certain countries in the Eurozone (Germany), while the PIIGS countries (Portugal, Ireland, Italy, Greece and Spain) will have a tougher time pushing their economies in the right direction again now that they are weaker competitively. This means more emphasis on internal devaluations through lower wages and prices in order to compete. In the diagram below you can see how Ireland's competitive strength has been sapped in the last decade, which can be compared to Germany's, where the real effective exchange rate has remained stable for much of the decade. Japan's improved competitiveness is mainly the result of the long period of deflation it has endured, which has brought its cost level down. Even after the recent appreciation, the yen hasn’t returned to the 2000 level. Real effective exchange rate according to BIS for a number of countries, where the index on 1 January 2000 = 100 Source: Reuters EcoWin 00 01 02 03 04 05 06 07 08 09 10 Index2000-01-01=100 60 70 80 90 100 110 120 130 140 China Euro Zone Germany Japan US Ireland The world has two currency unions: 1) Essentially an involuntary union between China and the US 2) Another, more voluntary union among euro countries. Both currency unions face problems. The US has to carefully consider how much difference an additional QE will actually make in stimulating the economy, i.e., provided the costs exceed the benefits nationally and globally. The risk with raising inflation expectations is that it can be hard to adjust them downward later and the country could instead face problems with inflation, a weak dollar and higher interest rates. There is also the risk of negative global effects that excessive capital inflows could cause in emerging countries. China should consider whether it wouldn't benefit from a faster appreciation of the yuan from a national perspective and in order to take greater global responsibility. The Eurozone and the European Central Bank have to carefully consider the risks of having certain countries in the Eurozone under excessive deflationary pressure, which could spread to the rest of the region. During the 2000’s the euro accounted for a larger share of currency adjustments than the dollar, for example. It is reasonable that structural reforms now become the principal economic tool in developed countries, but it is unreasonable to complicate the process more than necessary by accepting a considerably stronger euro when the region as a whole isn’t reporting any major imbalances. It is important this time to look beyond averages and instead focus on countries with large surpluses (Germany) and those with large deficits (e.g., Spain). It is still too early at this point to discuss whether the ECB should raise its benchmark interest rate. The euro isn’t in the same league as the yuan, where China’s leaders intentionally let the currency be undervalued, since the euro’s value is determined by the financial markets. The Eurozone can hardly be blamed for jeopardising stability at the global level. On the other hand, is important that the euro’s currency union address the problems there, to create new rules that work better and avoid new periods of divergence and imbalances within the union. A crisis for the euro countries of the kind we have seen certainly should make it easier to come up with such rules. It is a question of survival! Cecilia Hermansson Swedbank Economic Research Department SE-105 34 Stockholm, Sweden Phone +46-8-5859 7740 ek.sekr@swedbank.se www.swedbank.se Legally responsible publisher Cecilia Hermansson, +46-88-5859 7720 Magnus Alvesson, +46-8-5859 3341 Jörgen Kennemar, +46-8-5859 7730 Swedbank’s monthly The Global Economy newsletter is published as a service to our customers. We believe that we have used reliable sources and methods in the preparation of the analyses reported in this publication. However, we cannot guarantee the accuracy or completeness of the report and cannot be held responsible for any error or omission in the underlying material or its use. Readers are encouraged to base any (investment) decisions on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages, direct or indirect, owing to any errors or omissions in Swedbank’s monthly The Global Economy newsletter.

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