EEF blog

Last week I noted the low likelihood of Ireland or other distressed PIIGS leaving the euro. Investors would take flight, debt would balloon, default would be likely. The converse of this situation is what if Germany chose to leave the euro? Stephanie Flanders notes that this could make economic sense for both Germany and everyone else.

Germany’s new deutschemark (DM) would likely rise relative to the euro. Therefore there would be no big jump in the value of German Government debt, in fact the opposite, euro-denominated debt would be worth less in terms of DM. Commentators on the German economy claim that their dynamic economy is the main driver of their strong export performance, not the euro. Dumping the euro would certainly test that assertion. Assuming they're right a higher currency would not cripple exports.

And for everyone left in the euro, there would likely be a small gain in the competitiveness of their exports. The relative strength of the new DM compared with the euro should see German consuming more imports from their neighbours. This would help them with the export-led growth they need to climb out of their respective sties.

But I don’t think this will happen.

Whether they want to admit it or not, a lower euro vis-à-vis a theoretical DM does benefit Germany’s export sector, even if we assume that internal dynamism is more important. A lack of currency fluctuation for exporters, particularly small exporters, inside the eurozone is also highly beneficial.

Even contemplation alone of exiting the euro may threaten stellar German business and consumer confidence, which at the moment seems to be sailing straight through the sovereign debt crisis storm. Uncertainty about the impact would be a negative force, even if calculations suggested a net benefit.

And while a fall in the value of euro-denominated debt may benefit the German Government it would be at the expense of many bondholders in the German private sector.

Convincing as all this is, in the long run I think the strongest motivation for Germany to stick with the euro is political economy. Germany is the biggest eurozone economy and the strongest – its bunds are the reference against which peripheral euro members’ widening bond yields are measured.

It means Germany has the biggest say in how institutions in the EU are being designed to deal with the current crisis – but also how they should be designed to put the system onto a stable and sustainable footing. You might argue they’re not doing a great job of that – but they are having a big influence. And if things come right - and even if they don't - that influence is likely to be felt for many years.

Other countries looking for a bailout need to lobby Germany. It’s the biggest donor to these deals. Using this lever the Germans can press for policy reform in their interests. They may not have succeeded in getting Ireland to push up its corporation tax rate – but they got this sacred cow on the table for discussion.

As the biggest player in the EU, the augmentation of institutions along German lines surely is seen as an opportunity by German politicians to increase their power. So for example future sanctions on fiscal recalcitrant behaviour aren’t going to hurt Germany given its record – and look who’s pushing this issue? Germany.

Reading all the commentary on the latest Irish sovereign debt crisis there’s a lot of wise words being bandied around the UK about why Ireland should never have joined the euro. Like Greece earlier in the year some even darkly foretell that Ireland may eventually have to leave the monetary union to resolve its economic malaise.

There’s three questions that come to mind in response to these views:
• Is the currency union to blame?
• Is it realistic for Ireland to pull out of the euro?
• What’s the impact of the eurozone stress on the UK and in particular our exporters to places like Ireland?

On the first, most commentators agree that Ireland enjoyed a sustained real economy boost before succumbing to a debt-fuelled property boom. Currency union kept interest rates down from what they otherwise might have been. This exacerbated the debt binge – but it’s at least questionable whether it caused it. And although export growth tapered off at around this time, Ireland has remained consistently and massively in trade surplus.

Similarly New Zealand has its own currency but it also had large increases in private debt fuelled by cheap credit at the same time. But in New Zealand’s case the monetary authority tightened the interest rate screws to dampen the inflation it saw in housing prices, loans were made more expensive but still the bubble continued. And by having higher interest rates the exchange rate jumped up as investors and then speculators piled into the Kiwi. New Zealand’s export sector was badly squeezed and NZ has consistently been in trade deficit. The level and volatility of the exchange rate is consistently cited as an issue for NZ exporters.

Similarly the UK has its own currency, so the vicious euro hasn’t wreaked its havoc here either. But just like Ireland and NZ, private debt in the UK soared during the credit boom. And just like Ireland, major banks in the UK have failed. Surely not to the same extent but Robert Peston points out the difference is one of scale not kind.

This is not to say that joining the euro was a great idea; it may be just as many are saying that it was a bad call and that if Ireland wasn't in the euro now, everything would be rosy. But clearly it's more complicated than simply having the euro = bad/not having the euro = good. There are costs and benefits of both options and the debate at the moment is a bit revisionist and one-sided.

I think that the banking sector is a much more significant factor than the currency union for explaining the current mess. The bad loans in the Irish banks represent a failure of regulation of the financial sector. Ireland has the misfortune of being more exposed than most and the Irish Government guaranteeing all the Irish banks’ debts.

So what now? Should Ireland dump the euro, restore the punt and devalue its way to prosperity? A recent BBC article showed the fallacy in this logic. If Ireland dumps the euro and looks to devalue its new currency immediately, the value of its euro-dominated debt will go through the roof. This greatly heightens the chance of default and, anticipating this, investors rapidly withdraw their capital from Ireland before the cross-over to the new currency. That would make a bad situation worse.

What does all this mean for the UK can be boiled down to impacts on demand for our exports and systemic impacts on our financial system.
The Govt’s attitude so far is illustrated by its willingness to participate in the ‘bailout’ of Ireland. But many of Mr Osborne’s Conservative colleagues have questioned why the UK is helping.

Both Cameron and Osborne have stressed the national interest angle, the interlacing of the economies etc. But what if another bailout is needed or, more likely to involve the UK perhaps, the EFSF proves insufficient faced with multiple bailouts. Where then does the interest lie?

The stability growth of the eurozone matters for UK exporters. It matters directly; without it demand for our exports will be lower as eurozone consumers confidence and consumption dips. Even in its parlous state, Ireland still accounts for 6% of UK exports and perhaps more surprisingly, since the end of the recession, Ireland has accounted for 4% of UK export growth.

A similar calculus is possible with other eurozone countries, such as Portgual, supposedly next in line. Although Portugal makes up a much smaller proportion of UK exports, its share of UK export growth, since the end of the recession, exceeds 1%, which is not trivial.

And the more bail outs there are, the more the systemic health of the banking system comes into considerations. I don’t think it’s beyond possibility that it could be in UK banks’ (and via their lending to businesses, the economy’s) interests to support further bailouts, or a replenishing of the EFSF, if the situation became severe enough. The involvement of the IMF in the bailouts already suggests the importance of these issues is wider than just Europe or the eurozone.

A currency war is on hold – though it depends on the performance of the US Economy

 “The prospect of a full blown trade war is unlikely; it benefits nobody” … “it is not in China's interest to provoke the US”
World_First

Additionally, currency intervention… “May go off US agenda if QE2 works/economy grows” … “I suspect that a war will be averted”
JeffreyPeel

“The G20 is split - Washington consensus is dead. But sanity may prevail. No-one really wants no-win #cwars or #fx wars”
JeffreyPeel

Chinese currency depreciation is not win-win

JohnPullin asked “What will be effects on scarcity of raw materials including strategic metals?”

“that is defintely one of the aces up China's sleeve and should we see supply concerns come to the fore then the pressure will rise”
World_First

“If the West achieves its objectives re. Chinese revaluation may mean more expensive input costs”… “may be good for US steel and other traded goods though - China hasn't all aces”
JeffreyPeel

For UK manufacturers the largest impact of currency wars is likely to be price volatility

We asked whether the UK would “be collateral damage from fx volatility?”

“you have a point. To an extent it depends how much the Chinese are prepared to pump-prime and how much US resists”
JeffreyPeel

“we are advising manufacturing clients to hedge at these GBP levels to negate volatility and lock in profit”
World_First

Or, as we put it on twitter: "currency war is on hold as QE2 gets going & eurozone distracts markets. But..." "QE2 could go down like the Titanic if it hits China's raw materials iceberg." "So for now, UK manufacturers have little to worry about, except maybe protecting themselves from #fx volatility."

In the G20 meeting in Seoul last week one of the key issues was how to avoid the currency wars which threatening global economic recovery. Although some agreement was made over continuing discussions, tensions have not dissapated. On Monday 15th November at 3pm EEF is hosting a twitter debate on the impact of currency wars on the UK, and UK companies. 

As a background to this, here are some key articles and blogs that have been written on currency wars in the last couple of months:

What is a currency war?

The BBC’s animated guide: http://ow.ly/388kiOr, if you’d prefer something to read, Stephanie Flanders’ summary is here: http://ow.ly/38bb7

When did this one start?

The first rumblings of currency hostility started in March 2010 when 130 bipartisan US Congressmen sent a letter last week to US Secretary of Commerce Gary Locke, calling for the government to identify China as a currency manipulator. However, it was Guido Mantega, Brazil’s finance minister, whose announcement on September the 28th branded competitive depreciations as “currency wars”. Reported by the FT: http://ow.ly/38bp8

Who is fighting whom?

The BBC’s Andrew Walker sets out the key players and the main battlegrounds: http://ow.ly/388oq What impact could currency wars have on the global economy?Competitive depreciation could represent a very serious risk to the global recovery. In particular, the global rebalancing which debtor countries are relying on to boost growth could be hindered by surplus countries accumulating excess reserves to boost their own exports. The FT reported here: http://ow.ly/38bOK

What has happened with currency wars in the past?

Douglas Irwin at the Wall Street Journal summarises how high tariffs and currency wars caused problems in the 1930s: http://ow.ly/38bxy

What happened at the G20?

According to the Guardian "the summit set vague "indicative guidelines" to measure imbalances" however "the leaders were unable to agree on how to identify when global imbalances pose a threat to economic stability, merely committing themselves to a discussion of a range of indicators in first half of 2011": http://ow.ly/39MMK  

Therefore, questions remain: What would trade wars mean for the UK? Crucially, how will UK companies be affected if exchange rates become increasingly volatile, or if currency tensions lead to increased protectionism?

Join the debate! On Monday 15th November follow @EEF_Economists on twitter, or use the 'hashtags' #fx and #cwars. The debate will start at 3pm and last for 45 minutes. 

Next Monday at 3pm EEF will be hosting a twitter debate asking "Does the UK have anything to fear from currency wars?"

The image below gives a summary of the 'currency wars' story so far. 

Click the image to view an enlarged version

To join in the debate follow @EEF_Economists on twitter, or the 'hashtags' #fx and #cwars. The debate will start at 3pm and last 45 minutes. 

Currency wars - timeline (updated).pdf (15.46 kb)

As Brazilian finance minister Guido Mantega pointed out last week, and we noted here, 'currency wars' - where countries compete to deprecitate their currencies - are a risk to the recovery.

Today the FT reported that the head of the IMF, Dominique Strauss-Kahn has warned that competitive depreciation would represent a very serious risk to the global recovery. In particular, the global rebalancing which debtor countries are relying on to boost growth, will be hindered by surplus countries accumulating excess reserves to boost their own exports.

This week Brazil’s finance minister Guido Montega stated that an “international currency war” had broken out, as several governments have sought to increase the competitiveness of their exports by lowering exchange rates. A currency devaluation is traditionally thought to improve a country’s balance of trade by reducing the price of exports and increasing the price of imports. Consequently competition to reduce the value of currencies is damaging for those countries that don’t engage in the practice.

The Brazilian finance minister’s comments come at a time when the relationship between the US and China has become particularly strained by this particular issue. The US Congress has passed a bill defining China as a ‘currency manipulator’ and this could lead to new tariffs against imports from China. The Chinese, for their part, claim that allowing the renminbi to appreciate by the 20% Washington has requested would bankrupt the country’s exporters.

But it is not just China that has been trying to maintain an export advantage through keeping its currency at a competitive rate compared with the dollar. A rising number of countries see a weaker exchange rate as a way to lift their economies. There have been a series of recent interventions for example by South Korea and Taiwan. This month Japan intervened in foreign exchange markets for the first time in six years, selling around $20 billion worth of yen.

But this kind of exchange rate competition is unlikely to support global economic growth. Over the longer term currency intervention may be worse for the economies concerned. Devaluing a currency improves competitiveness artificially and reduces incentives for actions by governments or businesses that could boost productivity and output.

It will be difficult for the global rebalancing that debtor countries need to see to happen while surplus countries are accumulating excess reserves to shore up their own exports.

Coming back to trade, I think we still should expect some boost to net trade from the devaluation. In the short-term I think it’s completely understandable for exporters to pocket an additional margin. A big part of that has to be the uncertainty at the moment with demand. With the recession still very fresh in exporters’ minds, they have to be wary about increasing production. Plus increasing production can soon run into capacity limits, particularly if capacity has been reduced during the recession either permanently or in ways that are not easily reversible. So if you’re looking at a big investment to ramp up your productive capacity you want to be sure demand is going to be there to deliver a return.

But putting this uncertainty to the side for a moment, isn’t there an opportunity for our exporters to increase their exports through at least some of that devaluation appearing as lower prices? In the longer term aren’t we made more competitive by a structural shift in the exchange rate? And isn’t that what we’re relying on to boost the UK’s recovery and rebalance the economy?

Maybe, but there are several other things we need to consider. For a start the competitive (or not very) situation facing some exporters. If a lot of firms export similar products then chances are at least some might try to take advantage of a devaluation to capture higher market share by offering lower prices than competitors. How many exporting sectors this would apply to though might be questionable, particularly if many produce highly differentiated products with no real substitutes.

I mentioned above uncertainty on demand perhaps discouraging investment but there could be other barriers to expanding capacity. A really topical one at the moment is access to finance. Some of our recent research and discussions suggest, perhaps not surprisingly firms overwhelmingly favour internal finance – retained earnings mainly – to fund expansion. While expansion can be risky meaning debt finance may not be appropriate there are other forms of external finance that might be. Barriers facing particularly our smaller firms in accessing say, new equity, might be one reason why it might take some time to expand capacity.

What about a deterioration in trade finance, possibly particularly important to fast growing developing economies where trade is commercially riskier. Following the onset of the financial crisis, there was a pretty appalling withdrawal of trade finance and I had heard that while it’s coming back, premiums between countries have spread much more than pre-crisis. Could this be limiting the expansion in exports?

None of this is the full explanation and as per the latest official growth outturn (and our own research), exports do now appear to be gathering momentum at last. But it would be interesting to dig more into the significance of each of these factors…

Yesterday Andrew asked why it was that UK exports haven’t grown more strongly, especially compared with the export growth that has been seen in Germany.

One point I find particularly interesting is that Germany has seen export growth despite the appreciaiton of the Euro. Following the depreciation of Sterling it seems counterintuitive that export growth has been so dismal: prices go down, sales go up, right?

This doesn't appear to be the case, but perhaps this is because price is not the only thing purchasing decisions are based upon. For the average consumer, loyalty (or inertia) plays a part: I might keep going to a particular coffee shop even though it gets more expensive and another is getting cheaper. And this might not even be because the coffee in this particular shop is better; I’m just used to going there. Used to the route I take to the shop. And the staff are used to me ordering the same thing.

Well inertia applies to exports too. The so-called J-curve charts a relationship between exchange rate depreciation and a (temporary) worsening in the current account balance. This is based around the idea is that straight after a depreciation customers don’t switch suppliers, because they’ve placed orders with them, or they’re used to that way of doing business etc. The current account worsens because importers are doing the same thing, only the imports are now more expensive.

Eventually – after a time lag – customers realise they could be getting a better deal and they switch suppliers, and net exports improve.

Or do they?

Let’s go back to my coffee shop scenario – I’m considering switching coffee shops: I’m a bit fed up with how much I’m paying. The problem is the price at the second coffee shop seems to change every day. It swings by enough to mean that sometimes the extra effort of walking the five minutes it takes to get there isn’t really worth it. How do I know if I really want to bother going to that shop?

The answer is: I don’t. And with the huge currency price-swings we’ve been seeing it means there’s a possibility of getting stuck in a long-term J-Curve situation.

This is not necessarily bad for manufacturers. If customers are less price-sensitive it means that if manufacturers choose to maintain relative prices (by increasing nominal prices) they will be able to increase their profit margins and benefit from the exchange rate depreciation in this way. Evidence from our Business Trends Survey showed that during the recession UK manufacturers were doing just this.

But what does this mean for export-led growth prospects? When we talk about rebalancing the economy, improving the external balance of exports less imports is a key factor. Can we really rely on the lower value of Sterling to boost exports, or will it take more than that?