G7: Lots of Thunder, Little Rain

Encouraged by French and German comments implying concern about the weakness of the yen, next week’s G7 and IMF meetings are taking on new significance in the foreign exchange market. Given the heightened uncertainty, speculative players are likely to continue to reduce their exposures in the days ahead. This means that the risk is on the dollar’s upside against the European currencies, but greenback is likely to under-perform against the yen.

There are unlikely to be fresh initiatives in the foreign exchange market. Indeed, if anything, the risk is that the statement is not as strong as the April statement, which it will be recalled included an appendix that seemed to call for a greater role for the currency markets to reduce global imbalance. The market understands official concerns about global imbalances to be a euphemistic way to talk the dollar down.

Japan chairs the G7 meeting. Japanese officials countered Germany’s deputy finance ministers claim that the G7 would discuss the yen’s weakness. Officials routinely discuss foreign exchange at G7 meetings. As BOJ Governor Fukui commented at the press conference today following the decision to leave rates unchanged (overnight rate at 0.25% and the discount rate at 0.40%), the market is focused on the interest rate gap and this is main source of yen weakness. No conundrum here, thank you.

While it is technically true that the euro was recently trading at record levels against the yen, it is misleading because the euro has not been around so long. If one looks at the old German mark/Japanese yen cross, one would see that the yen has been in the past more than 20% weaker than it is today. Moreover, there seems to be little evidence that the weakness of the yen is translating to problems for European exporters. German exports were up 13.4% on a year-over-year basis in July. French exports were up 11.2% in the year through June, the latest data available. As a whole, euro-zone exports (in June) are up more than 11% from year ago levels.

Even if officials felt that the saliency and urgency of the issue required action, what can be done? The risk is that officials find themselves in the position of the mice is Aseop’s fable. Remember it ? The mice are being terrorized by a cat. They have a town hall meeting. After much paw-wringing, one mouse suggests tying a bell around the cat’s neck. All the mice loved the idea—an early warning signal—and yet when it came to doing it, there were no volunteers.

If Fukui’s view, which we share, is accurate, that interest rate considerations are dominant, rather than currency market manipulation, which is what some US business lobby groups argue, an interest rate adjustment might stem the tide. Yet it is unlikely to be forthcoming. While Fukui defended the BOJ’s decision to raise rates in July and reiterated his conviction that inflation, even with the new CPI basket, will continue to trend higher. However, he also indicated that the market’s response to the lower than expect CPI figures was “fair”. The market’s response was two-fold. Sell the yen and reduce the perceived likelihood of another BOJ rate hike this year.

At the same time, the head of the European Central Bank and the head of the Bundesbank appear to have launched a campaign recently to warn that market that its assumption that the rate hike cycle will be finished this year is probably wrong. They have strongly suggested the rate hike cycle will continue into 2007. Nearer term, there is little doubt that the ECB will hike rates again in early October. Each of the ECB hikes this year has been preceded by reference to the ECB’s “strong vigilance”. ECB President Trichet used that signaling phrase at last week’s press conference and the ECB’s monthly bulletin repeated it. The interest rate differential story has legs.

Of course, nearly all officials advocate greater flexibility for Asian currencies. There is flexibility and then there’s flexibility. In the April statement, the G7 (one can almost hear Snow and Adam’s voice) called for flexibility so the yuan can appreciate. This gives the clear impression that the G7 does not really want flexibility, they want appreciation. Given the weakness of the yen and Swiss franc, both of whom record substantial current account surpluses, officials cannot really be confident that a current account surpluses necessarily lead to stronger currencies, even when the market has greater influence than it arguably has in determining the value of the Chinese yuan.

US Senators Schumer and Graham are threatening to push for a vote on their punitive bill before the end of the month if China does not allow the yuan to appreciate markedly. Recall the bill would impose a 27.5% tariff on all Chinese imports into the US if a six month negotiating period failed. This is as disingenuous as the conflation of flexibility and appreciation. What Graham and Schumer have in mind is dictation not negotiation. They want China to do something it does not want to, but failed to provide any inducements. And simply to say that it is in China’s interest to do so does not make it true no matter how often it is repeated.

They do not address the reasons China offers for its desire for general currency stability. China recognizes that the benefits of a flexible currency regime require businesses and investors to learn how to hedge. This is not something that is achieved quickly as many treasurers at US companies can attest. The overriding policy objective for Chinese officials is sustaining strong growth to maintain social stability. Chinese officials believe they have to create something on the magnitude of 25 million jobs a year. A sharp appreciation of the yuan would jeopardize the viability of numerous small businesses that operate on a couple percentage point margins.

Graham and Schumer apparently also do not grasp how China fits into the world economy. Its rapid growth has been predicated on domestic reforms and a conducive environment for businesses. Nearly half of China’s manufactured goods are form companies with ties to foreign firms. The US tactics that may have worked with Japan are unlikely to work with China. To this day, foreign direct investment in Japan remains modest compared to Japanese companies direct investment abroad. It is the opposite case in China. Many US multinationals would be hurt by Schumer and Graham’s measure.

Moreover, their claim of bring the bill to a vote before the end of the month is likely a bluff. They cannot say this of course. Both the US House of Representatives and the Senate are set to adjourn on September 29 until after the mid-term election on November 7. They are likely to delay the bill again. The fact of the matter is the pace of yuan appreciation has accelerated, even if not as much as many would like. The Chinese yuan has appreciated by 1.83% over the past 12-months. The bulk (1.26%) has taken place in the last six months. More than half of that (0.76%) has taken place in the last three months. And more than a third of that (0.31%) has taken place in the last month. Are we really expected to believe that the US would risk Smoot Hawley redux not action or direction, but over the speed of the reforms?

The IMF meeting is likely to be more interesting than the G7 meeting. Two important things will take place at the IMF meeting. First, the process of updating the distribution of votes at the IMF will begin. China, Mexico and South Korea are likely to receive more voting power. The effective veto the US enjoys will most likely be retained. Second, at the April meeting, prior to the voting re-jig the IMF was given a new mandate to refocus on global imbalances. A report on its progress (or indeed the lack thereof) is expected to be delivered.

Ahead of the G7 meeting at the end of next week, the risk is that there is continued adjustment of positions. Sterling’s 2% drop over the past five days probably reflects large scale long liquidation. The euro has declined half as much. This warns that in a bout of position adjusting the euro may under-perform. The yen has gained an inconsequential 0.13% over the past five sessions. Although short yen positions appeared to have been squeezed out, many players were quick to re-establish, leaving the market quite short the Japanese currency. Again, generally speaking, after about a 2-month recovery from the May-June debacle, the emerging market currencies have entered a new consolidative/weakening phase. This too is likely to continue.