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Hong Kong
CE Addresses Housing Affordability and Social Tension
October 15, 2010

By Denise Yam | Hong Kong

Chief Executive (CE) Donald Tsang delivered 6th Policy Address: Timed amid robust economic recovery and buoyant sentiment, the latest policy speech was dedicated to resolving social issues and answering discontent of the less privileged.

 In This Issue
Hong Kong
CE Addresses Housing Affordability and Social Tension
ASEAN
The ‘Impossible Trilemma': Buckling under the Liquidity Tide?
Russia
Russia: CBR Changes Imply Greater RUB Volatility
Global
QE-20
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 The Global Economics Team
 Joachim Fels
Joachim Fels is Morgan Stanley’s Chief Global Economist, based in London. He joined Morgan Stanley in 1996 to cover the German economy, became Co-Head of European Economics and the Firm’s first ECB watcher, and also built up the Currency Economics Team. Joachim then served as Morgan Stanley’s Chief Global Fixed Income Economist, Head of European Fixed Income Research, and more recently as Chief International Economist. Before joining Morgan Stanley, Joachim was an International Economist at Goldman Sachs from 1992-96 and a Research Associate at the Kiel Institute for the World Economy from 1987-92. He studied Economics at Kiel University, Saarbruecken University and the Bologna Center of the Johns Hopkins University’s School of Advanced International Studies (SAIS). The easiest way to follow Joachim’s thoughts on global macro issue is to subscribe to his weekly email Sunday Start.
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Property market the primary focus... Deteriorating housing affordability has topped headlines in the past 12 months following the sharp rebound and continued surge in property prices since early 2009, with measures aimed at cooling the market (and some capital outflows) bringing only a very limited and temporary correction in May this year. 

... addressing the supply of small and medium flats and assisting sandwich class home ownership... A quarter of today's speech addressed housing policy.  The government reiterated that sufficient land supply will be ensured, especially amid an upsurge in residential property prices, but that it will "refrain from participating in subsidized housing schemes as far as possible and minimize market intervention".  Several sites have been earmarked to become available, and 61,000 first-hand private residential units will come on the market in the next 3-4 years.  While the government once again rejected public demands to resume the Home Ownership Scheme (HOS) to help the ‘sandwich class' buy homes, it will instead introduce a new scheme of subsidized housing named My Home Purchase Plan (MHPP).  MHPP is a hybrid (rent-and-purchase) scheme which involves the provision of land to Hong Kong Housing Society to build "no-frills" flats for lease of up to five years (within which the rent will not be adjusted).  Tenants will receive a subsidy and the option to buy a flat (the flat they rent or any other flat).  Sites earmarked for the Plan will provide around 5,000 units.  However, we cannot expect relief to the property market any time soon, as the first 1,000 units under this new scheme will only be completed by 2014 (in Tsing Yi).

... and temporary exclusion of property as an asset class from the Capital Investment Entrant Scheme (CIES):  In response to concerns that purchases by foreign investors, especially those from Mainland China, have contributed to the upsurge in property prices in Hong Kong, the government has temporarily removed real estate from the eligible investment asset classes under the Capital Investment Entrant Scheme with effect from October 14.

But these measures should have limited impact on property prices: The surge in residential property prices has been concentrated in the luxury segment, attributable to short supply, foreign investor interest and easy monetary conditions, in our view.  The introduction of MHPP, with the first units only to become available in 2014, would have a limited impact on prices, in our view.  Meanwhile, CIES-related property investments accounted for only 1% of the total market turnover, and we believe that the new measure will unlikely discourage foreign investors from buying Hong Kong properties as they look for investment return rather than citizenship.

Measures to control "inflated buildings" unlikely to hurt property developers:  The government has also decided to cut back on concessions on green and amenity features in property developments, aimed at rectifying the recent trends in inflated floor areas in new developments.  The initial negative reaction in the equity market could be out of concern that this could hurt property developers' margins.  However, the existing land bank, which is large enough to last 4-5 years, is not affected by the latest announcement, while property developers will likely take into account the new rules and lower the price they are willing to pay in future land auctions.

Addressing the wealth gap: The CE also dedicated considerable time discussing the wealth gap and associated social tension and confrontation in Hong Kong, arising from vast economic restructuring under globalization and increasing integration with the Mainland.  The government continues to refrain from large-scale redistribution, but has promised increases in subsidies for students, the elderly and the underprivileged.  Worth noting is the introduction of a Work Incentive Transport Subsidy Scheme (HK$600 per month to eligible employees) to replace the existing Transport Support Scheme (limited to residents in four districts).  However, this raises our skepticism in relation to the pending setting of the minimum wage level.  It appears that, in the context of the "tripartite co-operation among the community, businesses and the government", the government is ready to shoulder part of the redistribution from businesses to the community through offering additional subsidies (hence lowering the level of minimum wage to be set).

Reiteration of initiatives for longer-term development: The latest Policy Address contained limited new initiatives in the context of Hong Kong's longer-term economic development, as the city economy's strategic positioning as China's service center is appropriately on track, in our view.  The CE reiterated initiatives and provided updates on infrastructure projects, the "six industries of advantage" and environment protection for sustainable development.  A key area of focus remains how Hong Kong will secure its position as the pilot offshore renminbi center, and its role in China's continued financial reform and internationalization of the renminbi.

Our lingering concerns for the economy amid cautious optimism: It is yet to be seen whether the latest policy initiatives will help to alleviate the challenges in housing and social tension.  Meanwhile, Hong Kong has had to cope with considerable volatility in monetary conditions and asset markets, which has resulted in undesirably large fluctuations in economic activity, or boom-bust economic cycles.  The recent gains in asset (equity as well as property) markets amid renewed expectations of further quantitative easing from developed markets has further heightened our concerns for excess volatility and instability ahead when conditions reverse.  Moreover, while the expansion of offshore renminbi financial services in Hong Kong represents significant opportunities for the economy over the medium term, the increasing circulation of renminbi could complicate monetary management in Hong Kong, with considerable implications on asset markets.  We therefore maintain a cautiously optimistic outlook for the Hong Kong economy.



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ASEAN
The ‘Impossible Trilemma': Buckling under the Liquidity Tide?
October 15, 2010

By Deyi Tan, Chetan Ahya, Shweta Singh | Singapore

Buckling under the Global Liquidity Tide?

As global economies become more intertwined with trade and capital market linkages, the effects of local monetary policymaking also become more globalised. Indeed, the global liquidity tide from DM is causing central banks elsewhere to feel its pressure. Reasonable market confidence has mobilized liquidity into markets with better growth fundamentals and macro balance sheets. These capital inflows have led to currency appreciation pressures. For some, such pressures have been compounded by central bankers undertaking policy rate normalization to ward off the risk of inflation. As a result, various policymakers have responded with measures to control the ‘valve' of capital inflows.

Cheating the ‘Impossible Trilemma'?

This is the ‘impossible trilemma'. With porous financial borders and policymakers running interest rate policies, currency movements often become a function of the other two. Yet, when the liquidity tide gets bigger, policymakers find themselves having to juggle between how much they want their currency to appreciate, how much control they want to retain over monetary policymaking and how open they want the capital account to remain. In ASEAN, policymakers try to have the best of all worlds by treading the middle ground. On the one hand, they dampen currency appreciation by accumulating FX reserves and selling local currency. On the other, they sterilize the liquidity build-up from the accumulation of FX reserves. This is to maintain the integrity of monetary policymaking and prevent excess liquidity from driving down domestic interest rates, leading to higher credit growth and further inflation pressures.

However, ‘cheating' the impossible trilemma via sterilization comes at a cost - directly via the yield costs of issuing open market operation (OMO) instruments and indirectly as FX reserves are typically parked in assets denominated in DM currencies which are depreciating. Moreover, usually, not all the inflows are sterilized, meaning that there is also a ‘cost' in terms of the liquidity leakage potentially causing inflation pressures. These costs look likely to get bigger if QE2 gets underway. Indeed, our US economists - Richard Berner and David Greenlaw (see US Economics: QE Coming - Slow Rise in Inflation Not Enough to Satisfy the Fed, October 1, 2010) - believe that the high jobless rate and a slow rise in inflation mean that officials will act to boost growth and inflation with additional large-scale asset in purchases.

Who's Facing the Greatest Trilemma Pressures?

ASEAN economies caught in a trilemma may have to sacrifice one of the corners of the ‘impossible trinity' to vent these pressures. The economy facing the greatest trilemma pressures is the one facing the strongest capital inflows, highest currency appreciation and highest sterilization costs from FX reserve accumulation. In our view, within ASEAN, Indonesia and, perhaps to a lesser extent, Thailand face greater trilemma pressures than Malaysia and Singapore.

(a) Who is seeing the strongest capital inflows?

The picture on this front is rather mixed. On a 4Q trailing sum basis, Thailand (4.8% of GDP) has the strongest capital/financial account. Meanwhile, Indonesia and Singapore's capital/financial account stand at 1.8% and 1.6% of GDP, respectively, and Malaysia stands at -6.2%. In terms of delta, the bigger turnaround in capital/financial account since 1Q09 was seen in Singapore and Malaysia, then Thailand and Indonesia.

(b) Who has seen greater currency appreciation?

We measure the extent of currency appreciation since April 2009, when foreign reserves in the last of the ASEAN economies started to turn around. Since April 2009, we note that Indonesia has seen the most appreciation whether in NEER, REER or against the USD. The Malaysia ringgit saw the second-largest appreciation, though most of this took place after early 2010. Meanwhile, the Singapore dollar and Thai baht saw a comparatively smaller degree of appreciation. When benchmarked to June 2008 before the Lehman event happened, we note that Indonesia and Malaysia also generally saw stronger appreciation than Singapore and Thailand on a NEER and REER basis.

(c) Who has the highest sterilization costs?

We estimate sterilization costs by making a few simplistic assumptions. First, we approximate the yield returns that the central banks will get from parking their FX reserves in foreign assets as the 1y UST bill. Second, we approximate the yield cost of issuing open market-operation (OMO) instruments to sterilize the liquidity build-up from FX reserve accumulation as the policy rate. Hence, sterilization costs would be a function of the extent of foreign reserve build-up, the degree of sterilization and the yield differential between the cost of issuing OMO instruments and the returns from parking reserves in foreign assets. Our exercise shows that although Indonesia did not see the largest increase in FX reserves since April 2009, and also had a lower sterilization ratio (22.4%) than Malaysia (86.5%) and Thailand (53.5%), the incremental net sterilization costs incurred are higher compared to Thailand and Malaysia. Indeed, the wide yield differential for Indonesia means that it is most costly for Indonesia to sterilize capital inflows, all else being equal. This may explain why the sterilization ratio is lowest in Indonesia and the ‘liquidity leakage' highest.

Overall, in ASEAN, we think that Indonesia and, perhaps to a lesser extent, Thailand face more trilemma pressures than Malaysia and Singapore, while Indonesia has seen the largest degree of appreciation and has the highest net sterilization costs. Meanwhile, in Thailand, capital inflows have been relatively strong and policymakers have so far chosen to cope with the liquidity inflows by allowing more FX reserve accumulation to soften currency appreciation. Sterilization costs have been incurred as a result, though lower than Indonesia, given the lower policy rate in Thailand. For Malaysia, we think that trilemma pressures are less significant, as its overall BoP position is the weakest in ASEAN. In Singapore, we argue that since policymakers have not tried to manage all three corners of the impossible trilemma simultaneously, trilemma pressures are hence lesser. Indeed, in Singapore, with policymakers operating a trade-weighted exchange rate within a designated policy band, independence of interest rate setting has always been sacrificed, and this is why domestic interest rates have been similarly depressed, in line with global interest rates.

If Something Has Got to Give - What Is it?

As liquidity flows increase, policymakers may have to sacrifice one corner of the impossible trinity for the other two or do a little of everything. Venting of the trilemma pressures could come via the following conduits:

1)         Controlling the capital account valve;

2)         Allowing greater currency appreciation; and/or

3)         Allowing FX reserve accumulation/liquidity build-up and delaying interest rate hikes, which may have subsequent inflation implications.

Below, we analyze what policymakers in ASEAN are likely to do:

Indonesia: In terms of controlling the capital flow valve, policymakers in June 2010 implemented measures to influence the tenure of foreign inflows, e.g., via a minimum 1-month holding period for SBI and going towards the issuance of longer-tenure 9M and 12M SBI bills. These measures are in a bid to reduce currency vulnerability should capital flows reverse. The fact that Indonesia is more domestic demand-oriented and sterilization cost is higher is probably the reason why the currency has been allowed to appreciate to a greater extent compared to other ASEAN countries so far. Possibly due to the higher sterilization costs of issuing OMO instruments, BI also announced that the minimum reserve requirement ratio will be raised from 5% to 8% with effect from November 2010 to help withdraw excess liquidity from the system.

If inflows were to rise further, we think that the scope for further currency appreciation could be limited in the near term, given the strong trailing appreciation so far. In our view, the risk is that policymakers will delay the policy rate normalization to manage trilemma pressures, given that foreign buying into Indonesia debt securities has been strong. Indeed, foreign ownership of SBI bills and government securities stand at 25.7% and 28.3%, respectively. A delay in policy rate normalization could give rise to higher inflation risks, especially as weather conditions continue to be bad. On capital controls, given that a significant portion of the economy is still unbanked, the need for foreign capital to fund investment and the need to further build up foreign reserves, policymakers cannot afford to shut their door to capital flows. In this regard, we think that draconian capital controls are unlikely. However, one possible measure may be to implement an SBI bill quota for foreign investors. SBI bills are issued to withdraw liquidity and foreign investors' ability to invest in these bills and take advantage of the rate arbitrage with the very objective of issuing such instruments in the first place.

Thailand: To manage the capital account, policymakers have been progressively implementing measures to increase the ease of capital outflows since a few years ago. These include raising the maximum limit of Thai residents' foreign currency deposits, raising the limit and expanding the scope for investment and lending abroad for Thai companies and increasing the limit for purchase of properties abroad among others. Policymakers have also just approved measures to remove the exemption of a 15% capital gains tax on fixed income investment by foreign investors. This will bring it in line with the 15% tax paid by the local investors. Capital outflows are also to be promoted by encouraging government bodies to expedite the disbursement of overseas investment and foreign currency purchases. As seen in the FX reserve build-up, the Bank of Thailand (BoT) has also intervened aggressively in the FX market to soften the currency appreciation.

If foreign inflows were to increase further, we think that measures to encourage more capital outflows may be announced. However, with a significant part of the BoP surplus being driven by the current account balance, such measures could see limited effectiveness on the currency. In this regard, we suspect that the currency is likely to see further appreciation pressures as the BoT continues with its policy rate normalization to bring the rate to 2.75% from 1.75% currently. Indeed, compared with Indonesia, the likelihood of a delay in monetary policy normalization to prevent rate arbitrage by investors is lower, as incremental sterilization costs are lower, given the narrower yield differentials and the BoT is relatively more hawkish. With the currency appreciation, policymakers have also begun to focus directly on helping businesses to cope with the stronger currency. Separately, an increase in reserve requirement to sterilize excess liquidity could also be an option to enhance the effectiveness of monetary policy. However, this measure does not seem popular with the policymakers. The minimum reserve requirement has been left unchanged at 6% for the past few years.

Singapore: Despite the strong capital inflows, we do not think that the Monetary Authority of Singapore (MAS) will take steps to tighten the exchange rate policy further. We expect the status quo of a gradual and modest appreciation stance to be maintained in this week's semi-annual October review. Indeed, although inflation pressures could stay more elevated compared to the historical average of 1.5-2.0%, it is driven by car and property prices and a further tinkering of the exchange rate policy is not the best tool to tackle such pressures, in our view. Moreover, the growth trajectory is likely to decelerate to a more normalized growth trend of 6.0-6.5%. If strong inflows were to continue, the liquidity build-up would persist and, in this regard, domestic interest rates would remain depressed. This may have ramifications on property markets, and we think the policymakers are likely to continue to resort to further sector-specific measures should property prices show too strong a pace of acceleration.

Malaysia: We think that trilemma pressures are less significant for Malaysia within ASEAN. If capital flows were to pick up further, we believe that policymakers are likely to allow more FX reserve accumulation to dampen the currency appreciation, as trailing appreciation has already been relatively strong. Indeed, this appears to be the case. While the pace of FX reserve accumulation has been relatively slow in the past few quarters, the central bank seems to have been intervening in the market recently to soften the currency appreciation and building up foreign reserves in September. Moreover, foreign reserve accumulation could be helpful because Malaysia's short-term external debt to foreign reserve ratio is at the higher end of the range within the AXJ region.



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Russia
Russia: CBR Changes Imply Greater RUB Volatility
October 15, 2010

By Alina Slyusarchuk, James Lord | London

The CBR's transition to inflation targeting accelerated. The parameters of its exchange rate policy were changed on October 13. The floating corridor was widened from 3 to 4 RUB with the new boundaries for the RUB/basket at 32.9 and 36.9, and the size of interventions shifting the boundaries of the floating band was lowered from US$700 million to US$650 million. The fixed ruble trading band of 26-41 RUB versus the basket was scrapped, which could eventually happen to the floating band as well. The removal of the band does not change anything about the fundamental outlook for RUB but implies greater volatility and wider ranges for the currency.  

We see three main reasons for the poor performance of the RUB in recent months, two of which we expect to persist over the remainder of the year:

First, the BoP deteriorated during 3Q, recording a relatively marginal surplus during July-September of US$8.7 billion. The current account surplus narrowed and there were moderate capital outflows of US$4.4 billion. Exports were contracting on average by 3.7%M (sa) during the last six months while import growth was strong. We expect the current account to continue narrowing over the remainder of the year, as import growth should stay strong. The main risk to this view is oil prices. The price of oil has been rising recently as expectations over further quantitative easing from the US Fed has boosted the price of risky assets, including commodities. An additional rise of around US$10/barrel adds a further US$30 billion (annually) to the C/A position and would offset much of the growth in imports that we have expected.

Another important dynamic that has led to RUB weakness is the amount of USD demand from local corporates and banks for the repayment of external debt. Instead of re-financing in USD, there has been a greater tendency to refinance local debt in RUB, partly because local rates are extremely low but also due to greater efforts to build a local corporate RUB curve. This dynamic has placed upward pressure on the USD/RUB exchange rate and, combined with some M&A flows and additional speculative pressure, caused ruble weakness. The CBR had tolerated most of the volatility, supporting it with only marginal FX intervention within the corridor (US$1.2 billion). The level of debt repayments for December is significantly higher, at nearly US$16 billion, with redemptions this quarter generally much higher than in any other quarter (at around US$30 billion). Note that in 1Q11, this source of USD demand will be much lower and should help to alleviate pressure on the RUB. Indeed, we would feel more comfortable recommending long RUB positions after this pipeline of redemptions had been cleared.

Finally, the level of real yields is very low in Russia, reducing the appeal to foreign investors from a carry perspective. Real RUB yields are among the lowest in the CEEMEA region. The weakness of the Russian economy over the summer months has prompted the CBR to adopt a fairly dovish tone, and the central bank appears to be looking through the recent increase in inflation. With inflation likely to rise further over the coming months, the level of real yields is likely to fall even further, given the dovish stance, which will keep the pressure on RUB. We would watch for the CBR to signal willingness to act to tackle rising inflation before recommending long RUB positions. We do not currently forecast an increase in the policy rate in Russia until 1Q11, which again argues for waiting until next year before becoming more bullish on RUB. Ulyukaev mentioned that the CBR could drain around RUB3-4 trillion of excess liquidity from the banking sector if it felt the need to. This is, of course, a huge quantity, at roughly 7% of GDP, though there was no mention of the time period over which the liquidity withdrawal would occur if at all. Clearly, if implemented over a multi-year time horizon, the impact on yields would be less significant.

Staying away from currency interventions, the CBR verbal interventions intensified on October 13. First Deputy Governor Ulyukaev commented that the budget deficit will be less than planned this year and the trade balance will stay in surplus in the following years, and he was positive on GDP growth in 2011. Finally, he commented that in the medium term the chances of RUB appreciation and depreciation are balanced. 

We stick to our end-2010 RUB basket forecast of 35.7. We expect the downside pressures on RUB to persist until the end of the year, with December being a particularly heavy month for foreign currency debt repayments. Looking ahead to next year though, there is scope for some recovery. Although we still expect the current account surplus to continue narrowing next year, the external debt repayments pipeline is much smaller. Moreover, we see an average Ural oil price of US$79/barrel. Our end-2011 RUB basket forecast is at 33.0.



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Global
QE-20
October 15, 2010

By Manoj Pradhan, Joachim Fels | London, Europe

The sustainability of recovery and growth in the US and the developed countries amid currency frictions around the world set the tense backdrop for the IMF-World Bank meetings in Washington, DC this weekend. Our main takeaways from these meetings were: i) the divide between emerging markets (EM) and developed markets (DM) is deepening, both economically and politically; ii) the consensus among attendees was that the US and Europe are likely to be the next Japan; and iii) in developed markets, monetary policy is the only show in town, as fiscal policy is maxed out.

The EM-DM divide is evident from the two-track nature of the global economic recovery, and the currency tensions under debate today are a direct corollary (see "No ‘Currency War'... Yet", The Global Monetary Analyst, October 6, 2010). Although the ECB is more reluctant to put its reflationary cards on the table, we doubt that the US is on the road to become the next Japan, given indications of aggressive action from monetary policymakers until such risks are eliminated. Part of that aggression is likely to produce additional QE in the near future. And even though the monetary transmission mechanism may be impaired in the US, there are fewer impediments to a weaker currency and to raising inflation expectations than many think.

But the global policy game would not end with QE2 from the Fed; indeed, it would only just be starting. It may be an unintended, or at least unspoken, element of QE2, but we expect EM economies to play their part, either by choosing to allow their economies to expand in response to capital inflows, or by choosing to let their currencies appreciate, or a bit of both. (And in the end, other DM economies may feel they have to join in too.) But from a US point of view, the precise mix of income effects versus price effects is not that material. In either case, the US economy is likely to gain through better export prospects.

Deepening EM-DM divide: On the economic front, despite the recovery over the past year, industrial output in the developed world remains below the peak levels of the prior cycle - consistent with our triple B recovery theme. By contrast, output in most EM countries has rebounded above prior peaks. More recently, Europe and the US have seen some loss of growth momentum. But China appears to be reaccelerating in 2H, after having achieved a soft landing in 1H.

Turning to politics, it became clear over the weekend that China won't give in to demands for a stronger revaluation of the renminbi, and will stick to its long-standing gradualist approach. We think the story going forward will be an increase in currency intervention by China and other EM countries in order to resist currency appreciation to varying degrees. This should lead to higher FX reserves, more domestic liquidity and higher asset prices in EM, as well as the return of capital controls in certain markets.

Will the US and Europe follow Japan into deflation? We take the other side on this debate: We think that inflation risks outweigh deflation risks precisely because policymakers dislike deflation far more than inflation. Monetary policymakers in the US and Europe reacted much more quickly and aggressively in the recent credit crisis than did the Bank of Japan in the 1990s. Despite the fact that the usual monetary transmission remains impaired, lower bond yields still have the ability to raise affordability and encourage a further round of mortgage refinancing. At the same time, numbers from the Senior Loan Officers Surveys show that the encouraging trend of greater willingness to lend by banks remains unaltered. According to our US team, a return to growth is likely to come from net exports, sustained consumer spending, lower mortgage expenses thanks to lower yields, and lingering fiscal stimulus.

Using a weaker dollar and inflation expectations: And even as the usual channels of monetary transmission are open to question, the Fed has the opportunity to take advantage of the two-track global recovery by weakening its currency or by raising inflation expectations, possibly simultaneously. An unintended or unspoken, but not unwelcome, consequence of more QE would be to keep up the pressure for incipient US dollar weakness for a significant period, much as QE has succeeded in keeping bond yields low for a long period of time. The infusion of money into the economy, along with the growth differential favouring the EM world, will encourage a continuation of capital inflows into those economies in search of yield.

The EM response: EM economies will likely respond in one of two ways. Economies with greater slack in their economies and less inflationary pressures will try to keep their currencies from appreciating, either through FX intervention or, to a lesser extent, via the use of capital controls. Intervention in FX markets will likely mean higher domestic liquidity (in the absence of tight credit controls like in China). In turn, the domestic economy is likely to expand and goods and risky asset prices are likely to be pushed higher. These EM economies should see a boom, and higher incomes, leading to an increase in the demand for US exports. Other EM economies, whose output gaps are too small for comfort or whose inflation is already a concern, could decide to let their currencies accelerate to a greater extent. Domestic expansion here would be more limited, so there would be not so much of an income effect; but US exports would still benefit again, this time from an improved price advantage thanks to EM currency appreciation.

Either way, the US wins. In a scenario of this kind, boosting demand in EM economies in order to kick-start flagging growth in DM economies is exactly what a textbook model of co-operative behaviour would have prescribed in the presence of asymmetric shocks. The only difference is that we currently do not have a co-operative framework, so this leaves the Fed, as the de facto monetary hegemon, to try to engineer such an outcome in a more strategic manner.

In the end, the success or failure of that strategy all boils down to the international response that we see in the coming weeks and months. Concerns of a ‘currency war' and a possible ‘trade war' raised by Brazil's Finance Minister Guido Mantega are, in our opinion, overdone since policymakers have not used any retaliation - yet. Rather, policymakers in fast-growing economies face rapid capital inflows and are rushing to keep their currencies from appreciating while trying to retain some monetary independence to keep their domestic economies from overheating. In other words, they are fighting the trilemma (see again No ‘Currency War'... Yet). But the risks of an escalation of currency tensions that lead to more serious developments cannot be glossed over. International economic history has many examples of international co-operation gone wrong. Surprisingly, not all failures of past international systems are harbingers of doom.

Two Stories of Currency Conflicts: The 1960s and the 1930s

Reserves, currency risks and the Triffin Paradox: The 1960s and now: The Bretton Woods System during the 1960s started off with the promise of co-operation. Capital controls played a central role in getting around the trilemma (a three-way trade-off between free flows of capital, fixed currency values and monetary independence) so that some degree of monetary independence could be achieved in participating countries. Still, conflict arose between short-term national interest and long-term global benefits for the ‘centre' country whose national currency was also the international reserve currency - the so-called Triffin Paradox. Faced with economic difficulties, the ‘centre' country might want to run current account surpluses, allowing surging exports to boost its domestic economy. At the same time, the non-centre countries would also like to run current account surpluses, but this would be in order to attract capital on the basis of which they would build a stockpile of reserve assets. Of course, these current account objectives could not simultaneously be met: the balance of payments within the system had to balance.

The scope for currency tensions at the present time can clearly be seen against the backdrop of the 1960s, with the US dollar still the pivotal reserve currency. With domestic demand not yet staging a sustainable recovery, DM economies - particularly the US - would very much like to get an external fillip to their domestic economy via exports and a current account surplus. At the same time, EM economies would like to buy some more self-insurance, given the run-down in reserves during the Great Recession and after looking at how EM economies with large reserves were more successful in warding off currency crashes and bank runs. And the scope for Triffin-style currency frictions is larger because the sheer size of the demand for reserves from EM economies simply dwarfs anything we saw in the 1960s.

Luckily for the present situation, the divergence between EM and DM growth means that EM economies are a natural destination for yield-seeking private capital flows. The impact of the Fed's next QE salvo could solve not just the need for the US to have enhanced exports, but also the desire of EM economies to build up their war chest of reserves; so, to the extent that the EM gross inward surge of private capital flows can: i) offset the gross reserve purchases of EMs, and ii) be wisely invested, a benign resolution of the global imbalance problem may yet emerge.

Devaluation, interest rates and inflation expectations: The 1930s and now: The experience of the 1960s may suggest a difficult road ahead. Ironically, it is experience from one of the most intense periods of currency battles from the 1930s that gives us more reason for optimism. In that tumultuous decade, the policy choices associated with the demise of the gold standard show that in some circumstances currency frictions can be a close substitute for global monetary co-operation, and can dramatically change the economic fortunes of countries trapped in a world of global deflation, high unemployment and near-zero interest rates.

The unravelling of the gold standard began in some periphery countries in 1928/29 but the key tipping points came between two and four years later when the two central players, the UK (1931) and the US (1933), left the gold standard. By the mid-1930s, the remaining adherents to the gold standard had shrunk to just a handful of countries in the so-called gold bloc: France, Belgium, Luxembourg, the Netherlands, Italy, Poland and Switzerland. What effect did this divergence in policy choices have? In the countries that freed themselves from the gold anchor, monetary policy expansion was made possible, interest rates fell, currencies weakened against gold, economies grew, and unemployment shrank; in the gold bloc, money was tight, currencies appreciated and recovery retarded, sealing a divergence in fortunes within the developed core economies. Importantly, for the countries that left the gold standard, a co-ordinated monetary policy expansion was enabled which was not beggar-thy-neighbour among these deviating countries, even if it did make life more difficult for those in the gold bloc.

If the 1930s are a guide, then QE-20 will have greatest traction in countries where further appreciation pressure is strongly resisted and the monetary spigots are opened, willingly if not enthusiastically. This group of QE-friendly countries will most closely resemble the ‘off gold' group of the 1930s with shared reflation, some heterogenous outcomes, but moderately stable exchange rates against each other. Conversely, countries unwilling to play the QE-20 game will resemble the 1930s gold bloc, with strong currencies but weaker economies. In aggregate, global recovery will be stronger the smaller is this group.

Inflation expectations remain key: An argument against drawing parallels from the 1930s is that DM economies have no room to cut interest rates, so that a devaluation-like move aiming to mimic the departures from gold would have practically no upside today.  But the interest rate channel in the 1930s should not be overstated. Influential research in economic history argues that the departure from gold was instrumental as a ‘regime change' signaling device, and succeeded in jolting inflation expectations upwards from very depressed levels. In the same way, inflation expectations are key today. Deflation is a source of concern in DM economies as they try to avoid a Japan-style outcome. The transmission mechanism that will prevent deflation involves DM economies exporting their expansionary monetary policy to EM. In turn, DM economies will re-import higher inflation through higher commodity and import prices aided by weaker currencies, helping the DM economies to work their way through their debt overhang problems.

Non-negligible risks: The complicated interactions we have discussed are certainly not without risk. Aggressive easing by the Fed could be met by aggressive action by EM economies in an attempt to weaken their currencies. Such a deterioration in global cooperation could lead us down the path to currency wars, or worse, trade wars. A less cheery lesson from the 1930s is that countries that found currency devaluation less palatable were more inclined to adopt protectionist policies.

A further risk is that pushing QE into EM economies through capital inflows risks stoking asset price bubbles. When the wave of EM ‘savings glut' funding washed up on the shores of DM economies, it was invested unwisely, producing the global financial crisis. Recycling the flow back to the EMs could risk a developing country boom-bust cycle as so often seen over the last 200 years. The steps taken in the last 10 years by EM countries to solidify their macroeconomic and financial stability may have diminished these risks, but a large financial inflow could still pose problems.

QExport: For now, the net benefits of pushing QE into the EM bloc are high. Faced with sand in the gears of its usual monetary policy channels, and non-existent fiscal policy support, the Fed would welcome external help via a weaker dollar and higher inflation expectations. It seems that the latest item to be outsourced by the US economy might well be its monetary transmission mechanism.

The US might wish a currency conflict had not started, but if it is forced to fight when backed into a deflationary corner, it has "infinite ammunition" giving it a supreme advantage on this battlefield (Wolf, Financial Times, October 12, 2010). In itself, this plan of battle has favourable portents for global growth. But the downside risk is obvious too: should war escalate into other theatres like trade, this may end up as a war nobody will win.

We acknowledge the contribution of Alan Taylor to this report.



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