Wednesday, October 10, 2007

Something to (dis)agree on?

by Claus Vistesen

cross posted from Alpha Sources

Whether or not the the recent ECB meeting provided some kind of a breather to an otherwise volatile EUR/USD currency pair is of course debatable. With the EUR/USD today trading just shy of 1.40 it could seem as if the current level will remain for the next couple of weeks. However, volatility is looming ever so much in the background threatening to take the EUR/USD up towards 1.45 which really would cause problems all over the place in the Eurozone pending of course on what happens in the US and at the FED. In fact, quibbles and niggles have already emerged as we have all observed in recent weeks and uncertainty is set to linger on the back of the ECB's 'all-doors' open approach. Clearly, only very few expect the ECB to actually raise (Bartsch' recent note is good) but what if the Fed sees room for lowering further? In short, expectations of interest differentials driven by economic reports and general indicators are the stuff to watch at the moment I think as main driving forces keeping the EUR/USD in a band between 1.40-1.45. Yet, how big of a problem is, in fact, the perky Euro? Well, we all know Monsieur Sarkozy's position and even the ever so faithful squire to the ECB Angela Merkel has also been busy on the phone with Brussels talking about what "to do". All this uncertainty and worried minds also regarding, I would reckon, the global economic environment in general was epitomized in the preparations to next week's meeting of the currency-manipulating club galore (hint; the G7). In this way, the Euro finance ministers, as reported by Bloomberg, found it mighty difficult to come to a common conclusion on the strong EUR/USD ...

European finance ministers failed to find common ground on tackling the euro's appreciation to a record against the dollar as they prepared for next week's meeting of the Group of Seven nations.

``I prefer a strong euro,'' Germany's Peer Steinbrueck told reporters at a meeting of euro-area finance ministers in Luxembourg today, a comment echoed by counterparts from the Netherlands and Austria. France's Christine Lagarde, whose government has said the European Central Bank should do more to curb the currency's gain, said she doesn't feel isolated as she arrived for the gathering.

Officials from the 13 nations that use the euro differ on how to respond to the currency's rally, which French President Nicolas Sarkozy says threatens to hurt an economy already confronted by a rise in credit costs over the past two months. While Lagarde said last week she will push for the central bank to sell euros, ECB President Jean-Claude Trichet has so far refused to signal increased concern about the currency.

Now, as should be well known for those of my readers with only the faintest idea of group dynamics, internal disagreement between members of group can be effectively solved with the invocation of a common enemy. Exhibit one for the relevance of this Freudian pocket analysis of mine is to be found in the common statement from the same meeting in Luxembourg between European finance ministers about sanctioning and essentially re- schooling the naughty boy of the class of the current market turmoil, the rating agencies. Now, one of the implicit narratives here and this should never escape our attention is also that the rating agencies have been too slow to downgrade too risky debt thus implying that the agencies' standards towards credit ratings should be tightened. I imagine that the Italian representatives have been sitting at the table with some uneasiness during this discussion. However, the real treat of the finance ministers' meeting was of course, and despite the inability to reach agreement on the EUR/USD question, the call for China to appreciate the remninbi; they even so far as to pull in the Yen too in this discussion which makes you wonder whether the finance ministers have actually been looking at what is going on in Japan. Yet, on the question of the remninbi the minister' call might be more warranted. Brad Setser has some timely analysis based on a recent article by the Economist's European correspondent Charlemagne. In the context of those famous global imbalances which is of course Brad's speciality he particularly makes one interesting point ...

China cannot run a large surplus with Europe without financing the US since its surplus with Europe reflects its decision to limit the pace of the RMB’s appreciation v the dollar, and thus to let the RMB depreciate v the euro. Nonetheless, the growing disconnect between China’s trade (increasingly with Europe) and China’s financial flows (still overwhelming toward the US) is a potential source of instability in a global financial system whose stability still hinges on large-scale Chinese financing of the US, at considerable (financial) cost to China ...

Clearly, China still ships a lot of widgets to the US but in percentage growth terms there is no doubt that the surplus with Europe has grown faster in the recent year. Another point which is clearly bound to emerge again and again with increasing force is the unwillingness of the Chinese authorities to let the remninbi appreciate even if the economy is beginning to nudge up the value chain. Or as Brad notes ...

There is another reason, beyond the RMB's depreciation, why tension is likely to rise: China is increasingly starting to produce products that compete directly with European and American products, not just with other low-wage economies. Think auto parts. Think autos for that matter. Europe makes a lot of machinery. Increasingly, so does China.

Of course, we can ask whether an appreciation of the remninbi would actually do much to reverse the flows but that is another question entirely and one which is best saved for another post.

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