The ECB is not behind the euro's appreciation
While the early year consensus assumed a gradual appreciation of the euro vis-à-vis the US dollar, which would have eased the problems of peripheral European nations, if for no other reason than the extra growth brought to the German economy, China's recent manoeuvres have radically altered this scenario.
More than Mr Trichet's austere message last Thursday or his comments on RTL this weekend, which many rushed to interpret as a warning against an earlier-than-expected hike in the ECB's key interest rates, I think it makes at least as much sense to attribute the euro's steep rise against the dollar to China's interventions (with Japan following suite).
Not only did the euro's stabilisation and resurgence begin Monday 10 January (i.e. three days before Mr T's speech), but, if we actually read his comments, we see that they are not nearly as conclusive, as initial reactions would have us believe. After all, he explained in the same paragraph that the ECB monetary policy was appropriate, despite the short-term upward pressure on the headline inflation index.
While he did indeed emphasise the ECB's concern about these tensions, he immediately followed up by saying that these same tensions mainly stemmed from hikes in commodity prices and that, even if the inflation index were to gradually increase in the coming months, it should settle down towards the end of the year. He added that inflation expectations remain anchored at the ECB's target.
Mr Orphanidès, our Cypriot hero, clarified this morning that "markets had undoubtedly overreacted to this speech", that "measures of underlying inflation remained low" (+1.1% core inflation), that the "ECB expected that overall inflation index to moderate" and that it would be "inappropriate to overreact to a single monthly figure". In the wake of these clarifications, short-term interest rates on European debt (Euribor and Schatz), which had been under severe attack since Thursday, quickly eased.
In contrast, the euro remains stuck at about 1.33 vis-à-vis the dollar. Even if it declines somewhat tomorrow, when American investors, who have learned of this clarification, return to the market (US markets are closed today), we will have to keep a close watch on the manoeuvres of China and Asian powers in general.
It is an opportunist China
While the economies of Germany, China and Japan are driven by a mercantilist culture, only China dares intervene so flagrantly on forex markets to manipulate the exchange rate of its currency to its own advantage. It is true that Japan also intervenes on forex markets, but only very occasionally to counter what it terms "excessive" fluctuations in its currency's exchange rate while China not intervenes daily on the Renminbi but also on the currencies of all its trading partners with its investments on the government bonds markets of Japan, South Korea and, now, Europe.
As such, its renewed appetite for Spanish and Portuguese bonds must not be confused with a sign of good will, but as furtherance of its own self interest. By intervening in these bond auctions in such a visible way, China achieves a quadruple goal.
- · It supports the eurozone by helping to temporarily ease pressure on peripheral nation debt markets, thereby allowing it to stabilise its leading trade partner, as it tries to cool off its own growth rate to fending off the growing inflation threat. This weekend, it upped the requiredrequire reserves rate for its major commercial banks by 0.50% to 19.50% to damper the growth of credit volumes. This amounts to the seventh hike in the past year (the fourth in three months), and comes on the heels of the hike in key interests by the Peoples Bank of China in December!
- · This intervention also enables China to protect the value of its existing portfolio; It already possesses €43bn in Spanish bonds (1/5 of outstanding bonds). And let us not forget bad portfolio management in the Middle Kingdom can result in more dire consequences than mere loss of employment (China executed Tuesday the former manager of a securities company).
- · By investing part of its currency reserves in eurozone government debt, it pushes up the euro, just as it has the American currency, not just vis-à-vis the dollar but vis-à-vis the Chinese currency itself. As you can see in the graphs, below, that such an attitude is perfectly deleterious for its trading partners!
- · These investments, by "solidarity", in Europe also bring it much higher yields than they could obtain on the US bond market. On a five-year maturity, for example, Portuguese debt offers a 5.70% yields, which compares to 1.90% in the US. This represents an extra capital gain of nearly 20% over a five-year period!
· Since European leaders, particularly those of the ECB, endlessly repeat to all those still listening that no eurozone country will default or restructure its debt, why are they allowing the spearhead of Chinese currency manipulation (SAFE) rack up such yields?
These yields are simply the reflection of the uncertainty stemming from the dilly dallying of our beloved decision makers which has caused a plunge in European debt markets!
But this could change quickly.
Europe will save Europe
We have argued since the beginning of this crisis that the wealthy countries of the eurozone will in one way or another grant whatever loans are needed to countries who have lost access to financial debt markets in exchange structural reforms. Moreover, they will be driven by the need to defend their banks and savers, heavily exposed to peripheral nation debt risk, and the need to protect German trade in these same countries while protecting the euro. By so doing, they can help accomplish a qualitative advance in Europe construction.
The most alarming scenarios are circulating today, like that published by the The Economist (Time for plan B). All these gloom and doom scenarios start from the principle that the hike in the debt ratios of the PIGS nations (165% for Greece in 2014?) will inevitably lead them to bankruptcy and default.
Such a simplistic analysis forgets that what is really important is not the debt load itself, but the percentage of fiscal receipts allotted to the payments of same debt.
This percentage depends as much on the interest rate paid government debt as on the amount of existing debt!
As I have repeated many times in these lines, the top down solution to this crisis will come from the accordance of loans at interest rates discreetly subsidised by wealthy countries, once public opinion in these countries has turned to other hot topics (Olympic Games in London in 2012?).
In fact, I am unable to find anywhere the official details of these loans, at least with respect to the European part; the IMF's part of the loan was clearly communicated: Press release n° 10/462.
This reminds me of the secret European defence syndrome, like the way in which national central banks (Ireland today) rush funds to their commercial banks (reportedly without collateral) or the way in which the ECB decides whether or not to buy sovereign debt.
However, the latest information on this subject, following the EU's successful bond issue for the Irish plan, however, refers to a new rate of 5.59%. If the EFSF plan is set at the same rate, the rate for the overall plan, including the IMF contribution, will be 4.90%.
That is better, but given that these funds cost the European Union only 2.59%, but we have to wonder if it is really necessary to loan Ireland these same funds at 5.59%. Does a margin of 300 basis points really signify European solidarity? Is this punitive aspect of the rescue plan, so consistent with the philosophy of creative destruction, really appropriate at this historic moment?
Imagine if these loans were granted with a margin of just 100 bps, covering well in excess of administrative costs; that would bring the overall rate to 3.55%.
At that rate, observers would no longer be talking about the inevitability of default, since the costs of debt financing would remain within manageable limits.
The EFSF must buy everything
If we follow this reasoning to its logical conclusion, the European Financial Stability Facility (EFSF) should intervene massively on the secondary debt market of peripheral European nations!
Indeed, why let the Chinese (among others) recycle their trade surpluses on such favourable terms (over 5% yield) when Americans, who seem to understand better than we do the meaning of monetary sovereignty, not only manipulate their currency exchange rate but also the yield on the dollar. The Chinese have been stuck with hundreds of billions of dollars stuck in short-term maturities (US T-bills), which have generated just a few cents in yield for over two years now.
Under these circumstances, it is easier to understand the Chinese drive to diversify their investments, and their yield offer should be viewed as scandalous, because it is absolutely not in our interest to allow them to recycle their trade surplus in European government debt, which only lead to the euro's appreciation.
If they really want to support to the euro, let international investors buy EFSF paper at 2.50%, so that we can make us of these ensuing funds to buy all debt on secondary markets that yield more than 3.5%!
The US trade deficit vis-à-vis Europe and China
· America's problem is not with the eurozone.
· But given the US trade deficit with the eurozone, the euro does not have to decline against the dollar, excluding the current institutional problems.
Euro vis-à-vis the yuan and the European trade deficit with China
The currency exchange rate is not everything, but it counts…
A number of phases can be seen in these graphs.
Phase 1 in red compares the euro's appreciation vis-à-vis the Chinese currency from 2001 to the beginning of 2005 with the dollar's rise from €1.00 to €1.30 at which the yuan has remained ever since.
The yuan's depreciation vis-à-vis the euro has been accompanied by a massive surge in the eurozone's deficit with China (phase 1 in blue), from an annual average of €2bn to €8bn, then to €10bn and €12bn. This deficit deficit has continued to grow while the euro-yuan parity was stabilising at €10bn to €11bn between 2004 and 2008. (Phase 2 in red)
Phase 4 in red traces the stability of the euro-yuan parity at around 9, from year-end 2008, but, after 18 months of stability at around €7.5bn, the trade deficit climbed back to about €12bn. (Phase 3 blue).
As such, the euro-yuan does not alone the growth in Europe's trade deficit with China. After all, aggressive trade practices count for a lot, as demonstrated by Germany's huge car exports to China (‘European car craze in China presses ships’).
But the fact remains that, in addition to bringing it hefty yields, China's purchases of European debt pushes up the euro at a time when it needs it least while making Chinese products all that much more competitive!
But the current situation appears so aberrant that I think it calls out louder for the EFSF to buy peripheral nation debt on both secondary and primary markets in exchange for which the aided countries will agree to much stricter controls to ensure future economic soundness, instead of allowing outside investors to rack up usurious yields!
Have a good day.
Erwan Mahé - Asset allocation and option strategy
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