Bassanese: The Currency Wars Continue
As has been the case in Japan, the decision by the European Central Bank to ratchet up its monetary stimulus program will do little to improve the region’s ailing domestic demand outlook. The move is best seen as yet another round in the “global currency wars”, in which one economy tries to boost its own exports at the expense of others.
Note from a low of around $US1.20 in mid-2012, the value of the Euro has steadily risen over the past two years to a recent peak of almost $US1.40 earlier this year. European exporters were not happy, and together with strength in the US economy and added rounds of stimulus from the ECB, the Euro has since fallen back to under $US1.30.
Given respective trends in the European and US economies, the Euro seems destined to slide further - at least to the lows of recent years of around $US1.20. Indeed, a slump back below US$1 is not out of the question over the next year or so, taking the Euro down to the lows of earlier last decade.
As the ECB hopes, this should be at least one factor supporting the economy and easing the risk of deflation - but not because even lower interest rates and cashed up banks will generate a revival in borrowing and investing. Rather the support will come from raising import prices and making European export and import-competing sectors more competitive.
The ECB’s move, moreover, will again let European politicians off the hook, with pro-competitive supply side reform Europe most needs collecting dust in the too hard basket, as reliance is wrongly placed on the ECB ability to solve the economy’s entrenched unemployment problem.
The ECB can’t solve Europe’s economic problems. After all, European interest rates are already ridiculously low, and both borrowers and lenders have all the capacity they need to ramp up credit growth and kick start the economy if they so wish. Yet as we’ve seen in Australia, cheap funding can’t make banks lend or households and business borrow if the investment opportunities are simply not compelling. The only way the ECB’s action will work is by weakening the Euro and growing Europe’s trade exposed sectors at the expense of others – such as Australia.
Having had practically zero short-term interest rates for some time, Japan has also tried to boost its economy through US-style quantitative easing. But after a brief flurry of growth last year due to a step again (again!) in public spending, Japan’s economy remains as anaemic as always – though some exporters have managed to wrest some market share from Korean exporters in global markets.
Being a conscientious abstainer in the global currency war, Australia is once again caught in the cross fire.
The ECB’s decision is yet another kick in the guts for the Australian economy as it will keep the $A uncomfortably higher for longer – especially on a trade-weighted index basis. Note the Euro accounts for almost 10 per cent of Australia’s trade weighted exchange rate index – only a little less than the US dollar – while the Japanese Yen accounts for a further 13 per cent. The also under-valued Chinese renminbi accounts for a whopping 25 per cent.
At a time when spot iron ore prices are collapsing, the increasing disconnect between the $A and commodity prices risks being a major drag on the economy at a time when we desperately growth in non-mining sectors to offset the intensifying slump in mining investment.
Of course, we could also cut local interest rate further, but the Reserve Bank is now of the view this won’t do much to stimulate stubbornly cautious business investment and consumer spending – but rather goad investors into driving already frothy Sydney and Melbourne property even higher. Lest we encourage a potentially destabilising house price bubble, Australia needs a less overvalued currency to shore up its growth prospects in the coming year – and less talk of a “fiscal crisis” out of Canberra would also help.
Indeed, contrary to all the talk of the need to slash spending by the Abbott Government, a good chunk of Australia’s deficit problem now reflects the weak state of the economy – and a dash of fiscal stimulus might in fact be useful as we head into 2015.
That’s said, I won’t hold my breath over any change of tune from Canberra anytime soon.
David is one of Australia's leading economic and financial market analysts. His is Chief Economist with BetaShares, and an Economic Advisor to the National Institute for Economic and Industry Research (NIEIR). His has held former roles as senior commentator with The Australian Financial Review, Macquarie Bank interest rate strategist and Federal Treasury economist. He is also author of the online e-book, TheAustralian ETF Guide.