CURRENCY WAR HEATING UP FOR YEN AND EURO / THE FINANCIAL TIMES COMMENT & ANALYSIS

Currency war heating up for yen and euro

Roger Blitz and Leo Lewis

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Like frogs in a pot of water, European and Japanese policymakers face being trapped in rising temperatures caused by China’s dramatic renminbi devaluation.

Beijing’s surprise move to weaken its currency is causing ripples across emerging markets and commodity-based currencies, amid worries about the impact on competition for exports, their equity markets and deflation.

So what of the big currencies? Although a rising dollar may give the Federal Reserve reason to delay raising rates next month, the US economy is seen by several currency strategists as sufficiently protected from the direct consequences of China’s devaluation.

 

That may not be the case for the eurozone and Japan. Both economies, at different stages of monetary easing, have been — indirectly — pushing their currencies weaker in an effort to bolster exporters that have big trading relationships with China. Amid signs the Chinese economy is slowing, a falling renminbi will make that country’s exports more competitive, thereby hurting the eurozone and Japan twice over.

Worse for the European Central Bank was seeing the euro rise last week against the dollar on the back of China’s devaluation. This was not because the market believes the eurozone economy is growing, as appeared to be the case in May, but because short euro positions are being unwound, reflecting its role as a funding currency.

 

China’s currency move comes at a problematic time for the eurozone. Despite cheap oil, monetary easing and a competitive euro, growth remains fragile, as last week’s poor GDP data from Germany, France and Italy showed, and eurozone inflation is in the doldrums.

 

China was worrying the ECB before last week’s shock move by its Beijing counterpart, the People’s Bank of China. Minutes from the ECB’s July meeting warned financial developments in China “could have a larger than expected adverse impact” on the eurozone’s economic Outlook.

Against that backdrop, a rising euro is hardly a welcome development for ECB president Mario Draghi, says Jane Foley, G10 currency strategist at Rabobank.

 

So how to respond? “I think in the first instance, Draghi will use dovish rhetoric to try and pressure the euro,” she says.

He may have to do more than that. The market’s eurozone inflation expectations dropped sharply after the renminbi devaluation, with the five-year, five-year forward swap rate of inflation — a guide closely followed by the ECB on long-term inflation expectations — falling to its lowest level since March.

Barclays strategists think renminbi devaluation has increased the risk of the ECB announcing an extension of its quantitative easing programme beyond its proposed end-date of September 2016.

Economists at Bank of America Merrill Lynch say poor inflation will prompt further debate on extending QE.

The Bank of Japan may be thinking along similar lines. Second-quarter GDP contracted 1.6 per cent, undermining Prime Minister Shinzo Abe’s much-vaunted “Abenomics” recovery strategy, now two-and-a-half years in duration.

 

The risk, say Commerzbank forex strategists, is low oil prices and currency depreciation from big trading partners such as China dragging down import prices and weighing on inflation.
“We are starting to wonder just how many setbacks the BoJ can accept. It seems that it will increasingly welcome a weaker yen,” they say.

Currency traders in Tokyo believe the politics of devaluing Asian currencies will become an issue for the prime minister, as Abenomics falters and the electoral maths of a weak yen begin to weigh on his already sagging approval ratings.

A weaker yen has provided a tailwind for Abenomics and the top end of Japan’s export sector, but becomes much less helpful to small and medium-sized domestic companies, which employ the overwhelming majority of Japan’s workforce.

For now, say Nomura analysts, the immediate direct impact of renminbi devaluation on Japan’s economy will be limited. Japanese exports to China tend to be in higher-end areas where there is low price elasticity, and inbound tourism numbers continue to rise strongly, along with associated spending.

But Tomo Kinoshita, an economist at Nomura, says because the PBoC’s move means the renminbi will now reflect market supply and demand conditions better, “a further depreciation of the currency could have a larger impact on the Japanese economy”.

 

According to Shin Kadota, currency strategist at Barclays in Tokyo, the assumption for dollar-yen before renminbi devaluation had been for the pair to trade in a Y121-Y123 range till year-end.
 
The yen has traded comparatively calmly in the wake of the Chinese move. But the new expectation for the renminbi to dip a further 6 per cent this year could see those forecasts change.

Across Europe and Japan, economists continue to wrestle with the central issue arising from the PBoC move — is the shift part of a programme of structural reform, or a tacit admission that the China economy is slowing down more rapidly than previously acknowledged?

The temperature in the currency pot is rising. It may not be long before European and Japanese policymakers start to jump.