16th July 2010 by Shaun Richards
As equity markets have calmed down a little since their gyrations of late June and early July exchange rates have taken centre stage. These have not achieved the same amount of publicity as they did a month ago which in some respects is revealing. You see the weakening of economic figures coming out of the United States has led to her currency falling. Putting this another way the Euro as an exchange rate has rallied quite considerably against the US dollar. This has many implications but I notice that many news media and newspapers have effectively ignored this rally, I guess it does not fit the story they want to tell. Back on the 7th June this exchange rate fell to as low as 1.19 but yesterday it rallied 0.02 to above 1.29. You’d think a rally of nearly 8.5% would be news. Indeed a rally in the US dollar of this amount would have been but not in the Euro it would appear.
Effective Exchange Rates
One way of looking at a currencies position overall is to look at an effective exchange rate which is an attempt to calculate a theoretical exchange rate which represents a countries trading pattern weighted to the currencies of the countries it trades with.
The Euro has had an interesting pattern since it began. It fell to 80.96 back in October 2000 and its high has been 115.8 on the 18th December 2008 and its average has been 100.10 since its inception in 1993.
If we look at what has happened in recent years we can see that the strength of 2008/09 was a factor in the problems of the euro zone in 2010. For the weaker peripheral countries such as Greece, Ireland Portugal and Spain the currency strength contributed to a competitiveness problem. Now if we look at the recent fall in the Euro which started on the 26th October 2009 at 115.17 and hit a low of 99.86 on the 8th June 2010 one can see that it should have helped with this problem. If look at the figures over the past year we have seen the Euro on this basis fall by 8.1%. The rally since the 8th June has taken us back up to 102.6.
The Economic Impact of this
The first thought I had when looking at these numbers was that they put the recent fall in the Euro into context. If you look at its recent fall it only just fell below its average since inception. So some of the screaming headlines look at little overdone as 99.86 is only just below 100.1 which is its lifetime average. Indeed some of the railing at speculators by Europe’s politicians looks rather over-done too.
The actual fall in the Euro exchange rate would have been a benefit to the euro zone at a time it needed it as her exports should have become more price competitive just as a time when price competitiveness was and indeed is a problem. Just when the euro zone desperately needs some economic growth to help with its fiscal deficits the Euro was doing its best to help. I always thought many of the headlines and indeed statements from Europe’s politicians and officials to be curious as the “wolf pack” were in fact in this instance helping Europe adjust. I notice that Wolfgang Munchau in the FT once called the leaders of the euro zone financial illiterates well in this instance they deserve that title in my view. As Germany was most likely to be the nation that benefits from such a move and the peripherals less likely to do so then the “internal problems of the euro zone would have been exacerbated but this is likely to have been a small price to pay for the euro zone growing more quickly overall.
Actually the rally in the Euro’s exchange rate that has taken place recently is not as unfavourable as you might think. If you look at the numbers I have quoted above you see that the rally against the US dollar (8.5%) is much larger than the general rally (2.7%). As many commodity prices are priced in US dollars this means that the rally will be anti-inflationary whilst only have a small impact on competitiveness.
The Japanese Yen
One country that can seem almost obsessive about exchange rates is Japan. The reason for them being more talked about there is simply because Japan is such a large exporter. Also if you look at her economy and see her struggle to increase her internal consumption over the past twenty years then you can see that Japanese hopes for the future depend on exports.I have written several articles on her problems with domestic consumption and its corollary of disinflation and at times deflation.
Here the pattern is not the same as for the Euro the Yen has been strengthening against the US dollar since the 18th June 2007 when the US dollar bought 124.16 Yen whereas it only buys 87 right now. Japan’s exporters have had a difficult time dealing with this and the recent general fall in the US dollar will not help. For many countries a rise against the US dollar has the impact of reducing inflationary pressure but remember Japan is mired in disinflation so she is the one place in the world that will not welcome this. So exchange rate movements since the middle of 2007 have been something of a curse for Japan. On an effective exchange rate basis Japan did get some relief in early 2009 when her currency fell including for a few months against the US dollar but unfortunately for her the more recent trend is up.
Japan and her consumption tax
Recent weeks have produced something which to my mind is slightly curious from Japan. The new government of Nakato Kan established an early priority of reducing Japan’s fiscal deficit and its (enormous) national debt. This is welcome news although it is a massive task as her national debt is over 200% of her Gross Domestic Product and is only sustainable at all because Japan is a nation of savers. If she was like the UK for example the bubble would have burst long ago.
Mr Kan’s Democratic Party of Japan (DPJ)government called for increasing taxes in the run up to the July 11 upper-house elections as part of his effort to reduce the fiscal deficit which is not usually a good strategy to seduce voters! However it was at least a welcome contrast to the recent UK election where political parties dodged the subject. He argued that more tax revenues could bolster social welfare programmes, in turn helping to lift Japan out of its prolonged economic malaise and boosting living standards. Old Liberal Democrat Party policies such as massive public works and deregulation have failed, he felt, leaving the nation saddled with vast public debts which he planned to try to control.
Sadly this honest approach did not work well with the electors and the election was something of a set-back for Mr.Kan. However his plan for a consumption tax has found a supporter in the International Monetary Fund. It feels that Japan should start raising its consumption tax from 5 per cent next year to help restore its fiscal position. It has called for a gradual rise to 15% “over several years”.
If you read my previous articles on Japan you will see that a constant theme and problem in Japans economic history has been a lack of domestic demand. Those at the Bank of Japan have probably pulled their hair out so many times in frustration at their inability to influence this that they may well have none left. So a plan to tax consumption is at best very curious. I cannot help but feel that a hike is likely to further suppress weak domestic demand and run the danger of plunging the economy back into recession. If we look for a guide from the past then a rise in the rate from 3 per cent to 5 per cent in 1997 was quickly followed by a harsh downturn.
So if this is a cunning plan I fear that it is likely to be a “cunning plan” of the sort constructed by Baldrick in Blackadder. For those who wonder why I supported a rise in a consumption tax in the UK but do not in Japan it is quite simple. We are natural consumers and are more likely to shrug it off. This is not the first time that I have accused the IMF of having a rigid “playlist” or a one size fits all policy. I am afraid the one size does not always fit all.
The battered UK sterling has managed quite a decent rally recently. I was personally grateful for this as I got just under 1.20 when I bought some Euros for my holiday a fortnight ago which compared with 1.10 last year. Although the 1.50 of 3 years ago has long gone! After falling below 1.10 in March we rose to a high of nearly 1.23 at the end of June,although we have since slipped back to 1.19 as the Euro has strengthened in July. Against the US dollar after a low of 1.43 on the 18th May we have now rallied to just above 1.54.
Some may remember the stir in the press and other news media when we went below 1.50 which has not been repeated as we have gone above it. Rather one-sided you may feel and you would be right.
The recent rally in sterling is likely to have a weakening influence on our balance of payments. This is not in itself particularly helpful as it will impact on our economic growth just as we badly need some. However the move so far has been relatively small (for a small open economy anyway…).
However there is a much more helpful effect. As many commodity prices are denominated in US dollars then the rally against the US dollar will help to reduce our inflationary tendencies which have been a problem throughout 2010. Indeed as our Monetary Policy Committee continues to fail to take action on this front it would appear that this particular rally may well turn out to be rather beneficial and be the best hope of an improvement we have. There is a further irony in this as Mr.Posen who is a member of this committee has given speeches recently which have suggested that the MPC feels that our exchange rate is less of an influence on inflation and the UK economy than the Bank of England has suggested in the past. But these days the Bank of England seems to undergo intellectual contortions rather regularly in what I consider to be an unhealthy fashion.
In the area of exchange rates the the euro zones politicians did deserve Wolfgang Munchaus description of “financial illiterates” as they attacked what were favourable exchange rate moves.
The IMF is again applying policies for a pre-set playlist. If you look at it another way you could say that it operates with something of a similarity to a cult.
Seeing Japan also began to take up the austerity banner provokes a line of thought that has troubled me over the past few weeks. Whilst austerity individually is a good thing for many countries the world is running quite a risk with so many trying it at the same time.