The Capital Note

The Capital Note: Currency Clash

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Welcome to the Capital Note, a newsletter (coming soon) about finance and economics. On the menu today: Dollar Dominance, Euro Strength, and Japan’s Phillips Curve.

Dollar Dominance in Hong Kong

The dollar’s recent decline has led to predictions that the U.S. will lose its global currency hegemony. With Treasury yields at all-time lows and massive fiscal deficits increasing the risk of inflation, some commentators predict that international trade and finance will shift to other currencies, such as the euro, yen, and renminbi, at the expense of the greenback. Never mind that dollar depreciation is, as I pointed out in July, an intentional outcome of the Federal Reserve’s liquidity measures.

In times of economic weakness, a strong dollar tightens credit conditions, making it harder for firms and households to stay solvent. We should be relieved that policymakers succeeded in opening up the spigots of liquidity during an unprecedented global shutdown. And while meaningful inflation could hurt the dollar, deflation is a much greater risk during a demand-led recession.

The “exorbitant privilege” of reserve-currency status includes generally lower borrowing costs, a small amount of “seigniorage” on dollars held overseas, and the ability to act as a gatekeeper to the global financial system. On the latter point, Washington can use financial sanctions as a foreign-policy tool because dollar funding is a prerequisite for participation in the global financial system.

So recent U.S. sanctions against Chinese officials responsible for the takeover of Hong Kong serve as a test case for the dollar’s standing in international markets:

China’s largest state-run banks operating in Hong Kong are taking tentative steps to comply with U.S. sanctions imposed on officials in the city, seeking to safeguard their access to crucial dollar funding and overseas networks.

Major lenders with operations in the U.S. including Bank of China Ltd., China Construction Bank Corp., and China Merchants Bank Co. have turned cautious on opening new accounts for the 11 sanctioned officials, including Hong Kong Chief Executive Carrie Lam, according to people familiar with the matter. At least one bank has suspended such activity.

So crucial is dollar funding that even arms of the Chinese state must enforce sanctions against themselves. Though Beijing has attempted to create a renminbi-based international payments system in Hong Kong, offshore trade and borrowing in renminbi remain too small for Hong Kong’s banks to survive without dollars.

That state-run banks have capitulated to U.S. sanctions is an admission of defeat for the Chinese Communist Party — at least in the near term. It also demonstrates the resiliency of the dollar.

— D.T.

The Rise of King Euro?

The euro has risen some 7-8 percent against the dollar since the beginning of May, and it is up some 3-4 percent since the period in July just before the recent EU summit (technically a meeting of the EU’s “Council”) at which the union’s leadership agreed both its budget (which, as usual, is a multi-year deal) and a €750-billion-coronavirus-rescue package of loans and grants to the countries most affected by COVID-19.

Bloomberg:

[T]he European Union’s landmark rescue fund has gone a long way in soothing concerns over the bloc’s structural risks, and efforts to control the coronavirus and reignite the economy look particularly promising compared to the U.S. Those factors are setting the stage for a long-lasting change for the euro.

“This is not a matter of growth this year or next year or predictions about the cycle — it’s really something more structural,” said Nicolas Veron, a senior fellow at the Peterson Institute for International Economics. “The budget deal changes the way financial markets look at the euro zone in a significant way,” he said, adding that “it’s a big reinforcement of the EU and of the euro.”

While I suspect that weeks of disorder in the U.S. (together with many different types of worry about what November might bring), as well as a fresh coronavirus wave, might just have something to do with the dollar’s decline against the euro, there’s quite a bit to what Veron says. While the rescue package was sold as a “one-off” in order to enable the E.U.’s more frugal members to sign off on it, no one should believe that claim for a moment. There will be other “one-offs,” not least because the structural problems that plague the euro zone have not gone away.

According to the Bloomberg report, “the rescue fund, which will be financed by the sale of joint bonds, has helped calm fears of a breakup.”

Joint bonds, yes, but only up to a point: The new debt will not come with “joint and several” guarantees (meaning that they are not guaranteed in their entirety by every member state). That said, I doubt that many (if any) market participants were seriously expecting a break-up any time soon. If they had done, the spread between Italian and German yields would have shot up whatever the European Central Bank was doing.

What the markets were worried about was an Italian crisis later this year, as Italy’s debt grows relentlessly to a level that will exceed 150 percent of GDP by year-end. The deal (and the ECB’s activities) have greatly reduced the danger of an Italian meltdown in 2020. Under the terms of the deal, no new money will reach Italy until next year, but the thought that it is coming ought to be enough to reassure lenders for now.

This deal does a lot more than those who are selling it as a one-off may claim, but, at best, it is (for now) only an incremental adjustment to the management of a currency that simply does not work for all its members — one size still does not fit all — and, in all probability, never will. In constant-dollar terms, Italy’s GDP per capita (expressed in constant dollars) is about where it was in 2000, and Italy is by no means the only casualty of this reckless monetary experiment.

It is a topic for another time, but the least bad solution (as it has been for years) is the division of the euro into “northern” and “southern” units, but that is not even on the horizon, so a break-up is not something that needs pricing in and, with the US looking less enticing for now, the euro may enjoy its time in the sun for a while longer. As the Bloomberg story points out: “[W]hile the currency has taken a breather in the spot market in August — rising 0.2% to $1.1799 on Tuesday — net-long positions in the security rose to an all-time high, according to CFTC data.”

Then again, to some, that might indicate that the euro is looking overbought. As (almost) always with currency markets, who knows?

— A.S.

Around the Web

Yet more on the way that the pandemic is speeding up the automation wave:

Upheaval from the coronavirus pandemic is pushing more companies to consider automating distribution and fulfillment, as the consumer rush to online shopping and social distancing practices within warehouse operations add to the challenges in strained logistics networks. Although fulfillment operations still rely largely on human labor, companies have been incorporating more technology in recent years as they seek to boost output and handle swings in demand more efficiently.

And, according to McKinsey, “By some estimates, we have vaulted ten years ahead in consumer and business digital penetration in less than three months.”

Storm clouds over South Africa:

With debt surging and the coronavirus pandemic threatening the deepest economic contraction in almost 90 years, business leaders are warning that President Cyril Ramaphosa’s government can no longer procrastinate. With the situation deteriorating rapidly, they say, South Africa faces a choice between loosening the grip of vested interests to embrace radical — and likely painful — reform, or risking a sovereign debt crisis and more permanent scars…

South Africa may now be running out of road. Without urgent action, national debt could exceed 140% of gross domestic product by the end of the decade, according to an emergency budget presented in June. That’s almost on a par with Lebanon, and compares with only about 26% in 2008, when the last global economic crisis began.

Random Walk

A country’s economy can be said to mirror its national spirit. In the gunslinging United States, tech and finance make up the lion’s share of the corporate sector. Austere, competent Germany relies on high-value-added manufacturing. China’s state-run economy could be said to reflect the Confucian values of loyalty and filial piety.

In the case of Japan, measures of inflation and unemployment literally mirror the country’s geography: Japan’s Phillips Curve Looks Like Japan.

Notes economist Gregor W. Smith:

Clearly visible are the islands of Hokkaido and Honshu, though it is somewhat difficult to separately distinguish the southern islands of Kyushu and Shikoku. The Noto-Hanto Penninsula is evident to the north of the southern end of the main island of Honshu. Tokyo Bay is also visible.

— D.T. 

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