Japan and China Can't, but Europe Can?

Many observers and policy makers expressed frustration with Japanese officials in late 2012 and early 2013 for seemingly making the exchange rate an objective of policy and explicitly talking the yen down. European and US officials insisted in February 2013 that Japan pledge to use monetary policy for domestic purposes and not target foreign exchange rates.

More recently China's yuan has depreciated, and there is some evidence that Chinese officials got the ball rolling and may be continuing to guide the currency lower. From the middle of January through the end of April, the yuan depreciated by 3.5%.

This has been the cause of great consternation for G7 policy makers. Some suspect that China is sanctioning currency depreciation to boost its flagging exports. High frequency data is often noisy and using a moving average helps smooth it out. The three month moving average of year-over-year export performance was negative in April (-7.9%) for the third consecutive month. It is the first such contraction since 2009. The 12-month average stands at 1.6%, its lowest level since 2010.

We have argued against such an interpretation. China's exports are import intensive. That is to say that China's inputs for its exports are often invoiced and paid in US dollars and yuan denominated inputs are relatively small. Another way of saying this is the value-added generated in China is modest, meaning that it likely takes a substantial depreciation of the yuan to boost the price competitiveness of  its exports.

We find it more persuasive that Chinese officials helped engineer the reversal of the yuan as part of an attempt to manage the deflation of some financial excesses that had built up under the gradual multi-year yuan appreciation campaign. During this recent period, the PBOC widened the band the yuan can move against the dollar to 2% (from the officially set reference rate or "fix"). PBOC officials have not deigned to explore the entire range, but it has accepted somewhat more price movement, and this is reflected in the more than doubling of the (three-month) historic volatility.

In any event, the US and Europe have pushed back against Japan and Chinese efforts that weakened their respective currencies. Now, however, European officials have been purposely talking the euro lower. In fact, much of the discussion about the ECB's policy options relate to combating the strength of the euro. It is not just French officials, like Economic Minister Montebourg, who are entering the fray, trying to talk the euro lower. It was the ECB's Draghi who first crossed the Rubicon and other ECB officials have followed suit, though quick to add that the central bank has no target (except apparently lower).

Consider that the latest polls show the center-right with a slight lead over the center-left in this week's EU Parliament elections. The presidential candidate for the center-right EPP) is the former Prime Minister of Luxembourg and Eurogroup head Jean-Claude Juncker. He indicated that the treaties allow the EC to suggestion the general orientation to European finance ministers who then could instruct the ECB. Juncker was clear he wanted to give the ECB instructions on the exchange rate (though he refused to comment about instructions on interest rates).

In its semi-annual report on the foreign exchange market and international economic policy, the US Treasury was critical of Germany's large trade and current account surpluses. The report noted this is in contravenes to the G7/G20 agreement to reduce global imbalances. Previously, the German surplus offset the deficits in most of the remainder of the euro area. However, now a combination of demand compression in the periphery and an adjustment in relative prices means that the deficits in the periphery are been reduced, or completely disappeared.

We have argued that if the problem is one of lackluster growth and the ECB wants to ease monetary policy more than it can due to the zero-bound that it could take a page from the Swiss National Bank and buy foreign rather than domestic (i.e., euro area bonds). This would have the appearance of selling euros and buying US Treasuries. Euro area officials, however, haranguing about the currency has tainted this approach, as much as the some of the officials in the Abe government who had tried to talk the yen down.

Some observers seem confused. They want to equate currency manipulation with interest rate manipulation. Manipulation is manipulation, they say, defending some sort of free market purism. However, this is not the issue. The crux is that manipulating foreign exchange prices simply borrows (steals, if you are so inclined) demand from elsewhere. It is a zero-sum exercise. Interest rate manipulation can increase aggregate demand. It is a non-zero-sum exercise.