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What does the European Troika think it will accomplish this time in China?

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economy_1Nov. 20, 2009 (Erwan Mahe) Of course, everyone thinks they know, since the three officials in question, Mr Trichet (ECB Chairman), Mr Almunia (European Commission on Economic Affaires) and Mr Juncker (President of the European Council of Finance Ministers), have expressed their views on the matter many times in the past few weeks.

The eurozone must contend with the Beggar Thy Neighbour policies of its main trading partners, United States, the United Kingdom and China, which have their own processes distinct to their countries.

And I am leaving aside for the moment the 15% to 20% depreciation in the currencies of peripheral European countries since March.

The United Kingdom.

The Pound Sterling has depreciated by over 20% against the euro since the beginning of the subprime crisis.

The UK was hit harder than its trading partners by the collapse of its banks, with RBS shedding 98% of its capitalisation in two years (!) and Lloyds losing 94%. Only the government's decision to take capital stakes in these banks saved them from going under, while the government flat-out nationalised other institutions (Northern Rock, Bradford & Bingley) or forced them to merge (HBOS).

Given the weight of the financial sector in the British economy (the services sector represents 73% of GDP, due to the City's magnitude), investors immediately sensed the danger to the British currency and the magnitude of the measures authorities would have to take.

Indeed, British officials (government + BoE) reacted strongly. They were the first to purposely let their currency slide, as recently confirmed by Mr King during his latest monetary policy statement.

The UK economy is facing a prolonged period of balance sheet adjustment.

The fall in the exchange rate over the past two years will help to smooth that process.

The considerable stimulus from the past easing of monetary and fiscal policy and the depreciation of sterling should lead to a recovery in economic activity.

However, while the UK would obviously see any improvement in its trade balance resulting from the Pound's depreciation as a bonus, given the heavy weighting of services in the economy, the main interest, as Mr King acknowledged, is that is its usefulness in the struggle against deflation:

The outlook for inflation is again highly uncertain, with risks in either direction.

He immediately added that:

Inflation is, on balance, more likely to be below the target than above it

In any case, given the importance of the soundness/survival of the British banking system to the eurozone, given the tight links between our financial institutions, few voices have been raised on this side of the Channel for the time being to denounce a currency devaluation that is more monetarist than competitive.


The United States.

The US situation is a bit different from that in the UK. Aside from the fact that the struggle against deflation cannot be ignored, given the Fed's dual mandate requiring it to look after both prices, with an implied target fairly close to the ECB's  (+1.50-2%), and jobs. This has led to the dollar variable being employed in an even sneakier way.

The US is above all much more dependent on foreign trade than the UK, and still has substantial manufacturing capacity, which implies that any depreciation of its currency can result in the flow of purchases moving toward US-made products. The slow improvement in its trade balance is bringing immediate positive relief to GDP.

As such, the US balance of payments deficit has been cut in half, as the average monthly deficit has fallen from $60bn during 2005-2008 to $30bn in 2009.

Fed officials are not in the least worried about the inflationist impact of the dollar's depreciation, despite regular proclamations by US officials in defense of a "strong dollar", and sheepishly accepted by European officials .

As Dallas Fed chief and self-described super hawk, Mr Fisher, so forcefully stated in an interview with MNS yesterday:

In terms of its inflationary input, unless it becomes disorderly, a depreciating dollar -- a gradually depreciating dollar -- doesn't necessarily add an enormous inflation impulse.

Ten percent of the value of a Barbie Doll priced at retail comes from Chin. The rest of it is all added on through the distribution system, merchandising and margin.  So you would have to have an enormous move in that currency to inflate the price of Barbie Dolls.

So it is not necessarily true that a depreciating dollar leads to significant inflation impulses here.

Our duty is as the Federal Bank of the United States, and we have said publicly that interest rates are going to be low for an extended period of time.

Inflation is obviously not the issue; there is so much excess capacity out there.

There’s no velocity (in money) right now

Frankly, I have never seen such an explicit statement on the matter from a Fed board member, not labelled a dove (like our dear Janet Yellen), which probably explains why certain highly reputed investors, such as Mr Paulson (‘to invest $250m in new gold fund’) continue to bet on the debasing of currencies by taking refuge in "solid" assets (gold, oil and even food stuffs of late!).

Having said that, Mr Fisher's case of the Chinese Barbie doll is a really bad example, because, if there is one thing the United States has been unable to do -- regardless of Geithner's and Obama's visit to the Middle Kingdom, is to free the greenback from the peg with the currency of China, which is doing everything in its power to accompany the Americans as they travel down the path of "benign neglect".

As it is, America's trade deficit with China, which had shrunk from a peak of $28bn in September 2008 to $14bn in February 2009, thanks to a $15bn reduction in imports (to $19bn), has since surged back to $22bn, with imports of $28bn!

These imports are, however, of a fairly seasonal nature, as US wholesalers usually stock up for the late-year holiday sales. As such, this deficit (and imports) could contract sharply in the coming months, like every year, especially if the high-consuming American household begins to return to his spend-free ways.

On the subject of bilateral relations, I strongly recommend this excellent op-ed piece by Martin Wolfe: ‘What Obama should have said’.


The Middle Kingdom has become the most enthusiastic supporter of Adam Smith (which makes for a quite a road travelled for the descendants of Mao's "Long March"), as they have become totally enthralled with aggressive mercantilism, which is fairly logical at this stage of their economic development, like the Empire of the Rising Sun was earlier following the Meiji revolution of 1868.

For the most avid readers, check out this very complete 27-page text (‘La période mercantiliste’) describing this phenomenon, starting with Spanish mercantilism (bullion) and ending with modern commercial mercantilism.

Despite prevailing opinion on the matter, in this who-loses-wins game where Chinese current account surpluses are almost always systemically reinvested in US treasuries, the country in the greatest difficulty is not necessarily the one we might believe.

Indeed, if the Chinese were to reduce their purchases of US treasuries and if the dollar were to depreciate further leading to a hike in long-term interest rates in the US, this would inevitably trigger the long-feared double dip, as investors (from the Middle East, Europe and, especially domestic savings) come to replace them.

In any case, once these parities are adjusted, it will be very much in China's interest to stock up on T-notes once again, both to prevent the greenback from spiralling out of control and to obtain an attractive average investment price.

As such, the Chinese would immediately take a hit on their dollar-denominated assets, which, for the Americans, would result in an implied reduction in the principal and remaining interest on their sovereign debt.

As Mr Wolfe explained so eloquently in the above-mentioned text, if China refuses to change its currency policy to take into account the current situation (difference in growth and monetary policy, currency imbalance), I do not see how the United States (and its main trading partners, like Europe) can indefinitely hold off protectionist pressure from their people, fuelled further by the dramatic growth in unemployment.

Officials can explained as much as they like the importance for developed nations to consider the needs of workers in emerging countries; if this process is too brutal and does not allow for needed adjustments in training (university and tech), we are heading straight to a repetition of the dramatic events of the 1930s, and not just on the economic level of protections.





Now I return to today's title, which relates to the trip of  Trichet, Almunia and Juncker in China on 27 and 28 November which has received so much media coverage.

Everyone knows about the trip's goal: all we have to do is read recent statement by the three individuals in question.

Since Europe still takes at face value American declarations of fidelity to a strong dollar and that the  USA is ready to use its monetary leverage to the maximum, if the eurozone wants to avoid a deflationist black hole, it must at least try to get the Chinese to unpeg their currency to the US dollar to put a brake on the negative consequences of the "Workshop of the World's" exportation of deflation to the world.

And for those who are not yet convinced of the dramatic consequences of a real deflationary period in Europe, instead of reviewing the history of Japan's lost decade(s), take a look at the graph at the bottom of this note; If can explain this graph by something other than return of deflation in Japan, I am all ears.

Mr Trichet:

We consider that an orderly and progressive appreciation of the currencies of the emerging economies, particularly in China ... is something which would be welcome for the overall prosperity and rebalancing of the global economy.

This is not new; it is a message that you could hear from us in the last G7 communiqué

A stronger Chinese currency would be “welcome.”

Mr Juncker:

We think the Yuan is [undervalued] and we have to make that clear. It's a problem that worries us,

We will explain to our Chinese colleagues what our expectations are for the...coming years

Mr Almunia:

The Chinese leadership knows and accepts that it must rebalance its economy and that, to do so, a revaluation of their currency is necessary.

The euro is overvalued, while some currencies with an official exchange rate, such as the Chinese Yuan, are undervalued

It would be "the best system for all of us" if China's currency and those of other developing countries were decided by the market and with less public intervention.

All that is fine and dandy, and we just can't wait to see Chinese officials fold like an accordion before the demands our three-man team of commandos.

Unfortunately, as all the statements by Chinese officials in recent days show, it is far from certain that these meetings will lead to the desired result. In fact, it is more than likely this trip will end up being just as much of a flop as the last one by this same team in November 2007 for the same reasons.

Just consider Stalin's response in 1945 to Winston Churchill, who had called on him to respect religious freedom in Eastern Europe; "How many divisions does the Pope have?" We could just imagine the Chinese response to European demands:

How many assets are on the ECB balance sheet?

Make no mistake about it: If in this global currency mayhem, the euro appears to be virtuous, it is because the ECB appears in the eyes of the world to be an example of total monetary rectitude.

As you know, we have long railed in these lines against the line taken by the ECB, including the decision to hike rates while in the vortex of the crisis, refusing to bring them down to 0% (although all the models, including the most Monetarist, Taylor Rule, show that that is precisely what was needed, like in the case of the US with negative rates), while boldly refusing to even explain why.

However, one thing is for sure: one of the main reasons investors are abandoning a major currency for another, as in the case of the US and the UK, is the size of their Quantitative Easing.

These programmes are mistakenly confused with the monetization of debt, like when central banks (Weimar Republic, Zimbabwe) printed new money to pay down government debt.

In fact, they are today much closer to carry positions in that these purchases of bonds, MBSs and other more or less long paper, paying 2%, 3%, 4% or 5%, are in fact financed by the reserves of commercial banks with the very same central banks!

Moreover, the central banks in question have a much higher level of independence from elected officials in comparisons with the 1930s and 1970s. As such, it seem reasonable to assume that they do what is needed to slay the dragon of inflation if it escapes from the cage in which it has been kept by deflationist policies for these past 30 year.

However, this does not change the fact that the impression of monetization is fuelling currency movements (and gold and commodities, in general), and that the only threat Trichet can hold over the Chinese is to join the monetisation camp, by have the ECB buyback eurozone government bond and, why not include the Greeks, while he's at it.

It is very, very unlikely that Trichet will brandish such a threat (not to mention executing it), especially since ECB board members have been rushing to explain how the ECB will do such a good job by gradually ending its unconventional measures.

Furthermore, we could easily imagine the response of Chinese officials: "ECB policy is your business, and if you think that this approach is the best way to put the European economy back on the path to growth, do as suits you best".

Such an approach by the ECB would have no impact on dollar-yuan parity, which is entirely in the hands of Chinese authorities, but if it help pump up economic activity on the eurozone by lower yields in the middle of the curve (3-7 years), that would suite the Chinese export machines just fine.

In conclusion, while I understand the motivations behind this trip by Juncker and Almunia, two major figures in Europe, I can only say this about Trichet's role:

What in the devil is he doing in this mess?



Here is the graph promised earlier, tracing the performances of the S&P 500, Eurostoxx 50 and Topix, which is more revealing of the movements of all Japanese equities than is the Nikkei.


You will see that this index behaving differently during the latest market rally begun in July of this year.

While the S&P and the Eurostoxx 50 were climbing 26% and 30% on the period, it declined 2%.


This 30%+ difference in performance is not necessarily surprising, given the exceptional period we are experiencing today, but it is worth noting that this same Topix, at 838 this morning, was at 2,880 in 1989. Given this 70% plunge in 20 years, it is earlier to understand why buyer of JGB are no so unhappy as all that, even at 1% or 2% on 10 years.

S&P 500, Eurostoxx 50 and the Topix since July

Is this divergence du to the resurfacing of a deflation scare?


There you have it, at around 8pm, I am sorry for the lateness of this missive, but I consider the subject matter important and the research and discussions needed to put this text together took longer than expected.

Have a good evening.

Feel free to contact me at any time.

Erwan Mahé - Asset allocation and option strategy

22, rue des Capucines - 75002 Paris

TEL : + 33 1 53 05 57 20

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