Currency

(Note that Friday will see both the release of the August 2019 Statement on Monetary Policy and the appearance of RBA Governor Lowe before the House Stranding Committee on Economics. Unfortunately, both take place after the cut-off for the weekly note but will be covered next time.)

The 6 August meeting of the Reserve Bank Board left the cash rate unchanged at one per cent, in line with market expectations.

After the Reserve Bank of New Zealand surprised markets with a 50bp cut to its official cash rate on 7 August (they’d been expecting 25bp), a sell off in the NZ dollar took the Australian dollar along for the ride, with the latter dropping to its lowest level against the greenback in more than a decade during the day’s trading.

Australia’s trade balance hit a record $8 billion in June. Current account surplus ahoy?

The value of new lending to households rose 1.3 per cent in June with the month seeing increases in commitments for both owner occupier and investor dwellings for the first time in a year.

Annual growth in the volume of retail trade in the second quarter of this year was the weakest recorded since the early 1990s.

In an apparent riposte to US President Trump’s threat late last week to increase tariffs, Beijing allowed the yuan to drop below seven to the dollar for the first time since 2008. The US Treasury promptly responded by labelling China a currency manipulator. Currency wars have now joined trade and technology wars on the global worry list.

What I’ve been following in Australia . . .

What happened:

The Reserve Bank Board decided to leave the cash rate unchanged at one per cent at its 6 August meeting. According to the accompanying statement, the Board thinks that it ‘is reasonable to expect that an extended period of low interest rates will be required in Australia to make progress in reducing unemployment and achieve more assured progress towards the inflation target. The Board will continue to monitor developments in the labour market closely and ease monetary policy further if needed to support sustainable growth in the economy and the achievement of the inflation target over time.’

The same statement also provided a review of the RBA’s revised outlook for the economy, ahead of the publication of the latest Statement on Monetary Policy due on 9 August. Noting that growth in the first half of this year was weaker than it had previously anticipated, the RBA’s ‘central scenario is for the Australian economy to grow by around 2.5 per cent over 2019 and 2.75 per cent over 2020 . . . The unemployment rate is expected to decline over the next couple of years to around five per cent . . . The central scenario remains for inflation to increase gradually, but it is likely to take longer than earlier expected for inflation to return to two per cent. In both headline and underlying terms, inflation is expected to be a little under two per cent over 2020 and a little above two per cent over 2021.’

Why it matters:

After delivering two rate cuts in as many months, the RBA had been widely expected to leave the cash rate unchanged in August: a Bloomberg survey of 31 economists had all 31 predicting no change. Financial market pricing had also indicated a rate cut was unlikely, although the escalation of the trade, technology and now potentially currency conflict between Washington and Beijing had triggered a late rise in the implied probability of a policy shift. Before the meeting, markets had been expecting that another rate cut would arrive later in the year, and with the RBA noting that it will ‘ease monetary policy further if needed’, central bank watchers are set to persist with their bet on at least one more cut in the cash rate before year-end.

Those views are likely to be reinforced by the downward adjustments to the RBA’s outlook for the economy, with a lower trajectory now expected for growth and inflation: instead of 2.75 per cent, growth this year is now expected to be about 2.5 per cent, while inflation is now expected to remain below two per cent through next year. Likewise, the commitment to a sustained period of low interest rates – as flagged in Lowe’s speech on inflation targeting of a couple of weeks ago and reiterated here – is also consistent with the Board’s view that unemployment will still be around five per cent in ‘a couple of years’ and therefore remain above the 4.5 per cent rate the RBA now thinks is consistent with meeting the inflation target.

And then there’s the potential adverse impact of the deterioration in the global environment. The 6 August Statement characterised the outlook for the global economy as ‘reasonable’, but that outlook remains hostage to what now threatens to be an escalating economic confrontation between Washington and Beijing. Still, even that dark cloud hanging over the global economy comes with something of a silver lining attached: the RBA has argued that the reductions in the cash rate should stimulate the economy through lower debt service costs and a lower exchange rate. In that context, the resumed slide in the Australian dollar that has been one consequence of the deterioration in the external environment should provide some offsetting economic support.

10-year government bond yield and cash rate

Finally, it’s worth noting that this week saw the yield on Australia’s ten-year government bond rate fall below one per cent for the first time, dropping below the value of the cash rate. The RBA may have paused in its policy easing this month, but the bond market is expecting more to come.

What happened:

The Reserve Bank of New Zealand (RBNZ) cut the official cash rate by 50bp to one per cent on 7 August. Markets had been expecting a 25bp cut and were taken by surprise, prompting a sell off in the NZ dollar that took the Australian dollar along for the ride. The AUD fell below US$0.67 during the day’s trading, hitting its lowest level since March 2009 before closing back above US$0.67.

AUD-US dollar exchange rate

Why it matters:

As just noted above, all else equal, a weaker dollar will be welcome news for the RBA in terms of both the growth and inflation outlook. But the sharp move in the exchange rate could also be serving notice of the kind of abrupt adjustments a world of currency wars might deliver.

What happened:

According to the ABS, Australia recorded a record $8.036 billion trade surplus in June (seasonally adjusted).

Trade balance

For 2018-19 overall, Australia recorded a trade surplus of $49.9 billion. That represented a dramatic increase of more than $42 billion over the $7.6 billion surplus recorded in 2017-18 and reflected a 17 per cent increase in exports of goods and services compared to a six per cent rise in imports over the same period. Export growth has been powered by the resource sector, with the recent surge in iron ore prices and the sustained ramp up in LNG exports both making a significant contribution.

Selected exports of resources

Why it matters:

In contrast to the soft domestic environment, the external side of the economy continues to post strong results: the combined trade surplus in the second quarter of this year was a hefty $19 billion, following on from an almost as impressive $15 billion in the first quarter. Indeed, it’s now likely that the Q2:2019 balance of payment numbers due on 3 September will see Australia record its first current account surplus since the June quarter of 1975.

Current account balance

Some of the lift from high commodity prices may now be past, however. Over the past few days, what had been sky-high iron ore prices have been feeling the pull of gravity as supply concerns have eased at the same time as perceived risks to future demand have risen.

Iron ore price

What happened:

The value of new lending to households rose by 1.3 per cent month on month (seasonally adjusted) in June. According to the ABS, there were increases in commitments for both owner occupier and investor dwellings for the first time in more than a year, with the rise in investor lending driven by the first increase in New South Wales since April last year.

Lending to households for dwellings

Personal finance (excluding refinancing) was also up 4.9 per cent over the month, but lending to businesses was down sharply, dropping by more than 16 per cent.

Why it matters:

Along with the (very) modest gains in house prices reported in June and discussed last week, the data on new commitments provides more evidence of stabilisation in Australia’s housing market, although, again as noted last week, the construction sector continues to suffer.

What happened:

Last Friday, the ABS reported that retail turnover rose by 0.4 per cent over the month in June (seasonally adjusted), up from a 0.1 per cent rise in May and a 0.1 per cent contraction in April1. In annual terms, growth was 2.5 per cent.

In real terms, retail trade was up 0.2 per cent over the previous quarter. But annual growth was a lacklustre 0.2 per cent, marking the weakest annual outcome for retail trade volumes since the early 1990s.

Retail trade volumes

Why it matters:

Although the monthly reading for June indicated a modest pickup in retail performance with the monthly rate of growth beating consensus expectations for a 0.3 per cent rise, the overall consumption picture remains subdued. In particular, the soft outcome for retail trade volumes in the second quarter indicates another weak contribution from consumption to Q2 GDP.

. . . and what I’ve been following in the global economy

What happened:

The economic confrontation between Washington and Beijing escalated this week, with China allowing the yuan to fall below seven to the US dollar for the first time since 2008. The decision to allow the yuan to ‘crack seven’ saw the US Treasury designate China as a currency manipulator.

Last week, the resumption of trade talks between the United States and China in Shanghai was followed by President Trump’s announcement that a 10 per cent tariff would be imposed on a further US$300 billion of Chinese exports with effect from the start of September. The move will raise the average tariff on Chinese imports to 21.5 per cent, up from the average 3.1 per cent most favoured nation (MFN) rate that applied before the start of the current trade war. It would also mean that virtually all of China’s exports to the United States would be subject to tariffs. Moreover, Trump has previously threatened to impose 25 per cent tariffs on virtually all Chinese trade, which would imply an average tariff rate of almost 28 per cent.

Average traffics on Chinese imports

The increase in China-specific tariffs has arrived in several waves2. In August 2017, the new Trump administration started an investigation into China’s trade practices under Section 301 of the US Trade Act of 1974, a piece of legislation which allows a US President to unilaterally impose tariffs. The investigation was in response to President Trump instructing the US Trade Representative (USTR) to determine under Section 301 ‘whether to investigate China’s law, policies, practices or actions that may be unreasonable or discriminatory and that may be harming American intellectual property rights, innovation, or technology development.’ The USTR issued its report (pdf) in March 2018 and the following month President Trump announced he would impose tariffs on China in response to its findings. The first round of tariff increases then took effect in July 2018, when the US imposed a 25 per cent tariff on US$34 billion of imports, which was subsequently extended in August 2018 to include a further US$16 billion of imports. Then in September 2018, the US imposed a ten per cent tariff on an additional US$200 of Chinese trade. Next, in May this year, Washington increased tariffs on that US$200 billion to 25 per cent. And now the remaining US$300 billion of Chinese imports have been targeted.

China’s response on the trade front has been to increase tariffs on US exports to China, although as these are much lower than Chinese imports to the United States, Beijing has had a smaller target to aim at. Still, China’s retaliation has seen the average rate of tariffs it imposes on US imports increase from eight per cent in January 2018 to almost 21 per cent by June this year.

Average tariffs on US imports

The trade war has also extended into a technology war, with Washington announcing in May this year that it was placing Huawei onto the so-called Entity List – basically a list of people and companies that the US authorities deem to be a national security risk. US companies that want to export products or software to a listed entity are first required to obtain a licence to do so, where the US policy for most companies is intended to be a ‘presumption of denial’ of any such application.

And this week’s events now mean that we can potentially add the foreign exchange market to the arenas of economic conflict between the two economies.

So, is China deliberately manipulating the yuan as charged?

Onshore spot exchange rate (CNY) against the US dollar

It’s fair to say that ever since the unification of the country’s dual exchange rate system in 1994, the exchange rate has played an important part in China’s economic story. For most of the subsequent years, the authorities have kept the currency under close control, seeking to balance the gains from maintaining a competitive exchange rate with an equally strong preference for stability / aversion for volatility3.

After kicking off the new regime in January 1994 with a 33 per cent devaluation that left the yuan at 8.7 / US$, the authorities allowed the yuan to gradually appreciate against the greenback until it reached around 8.28/US$ in 1996. The onset of the Asian Financial Crisis then saw Beijing opt for stability, and the Peoples Bank of China (PBOC) kept the yuan pegged to the dollar at this rate through the crisis and then continued to maintain the peg in its aftermath.

Following China’s accession to the WTO in December 2001, international pressure on Beijing over its exchange rate regime started to mount, and this intensified after 2003. In July 2005, the PBOC announced that China would move away from the US dollar peg to a more flexible arrangement, which it described as a ‘managed floating regime’.

In practice, however, the approach retained a tight link to the US dollar, with a central parity rate (the ‘fix’) announced before the start of each trading day. The yuan was then allowed to fluctuate in a daily band of ± 0.3 per cent around the central parity, which was the previous day’s close. The July 2005 reform was also accompanied by a 2.1 per cent step revaluation of the yuan to 8.11/US$. Over the following years, the daily band around the central parity was gradually widened, eventually reaching ± two per cent by 2014.

While this regime did allow a gradual appreciation of the yuan, it was far from a true float. Rather, the arrangements worked as a crawling peg against the US dollar, with the PBOC intervening heavily in the foreign exchange market to cap the degree of appreciation. (And during the global financial crisis, the PBOC returned to an effective peg to the US dollar, with the yuan held stable at around 6.83/US$ between July 2008 and June 2010.) This prolonged period of sustained market intervention saw China’s foreign exchange reserves rise from around US$730 billion in July 2005 to a peak of almost US$4 trillion by June 2014. With China pursuing its own version of an East Asian growth model based around of export- and investment-led growth, the maintenance of a competitive currency played an important role in Beijing’s economic strategy4. It was in this extended period, between (roughly) 2003 and 2013 that the accusations of China being a currency manipulator were the loudest, and also when they had the most merit.

Foreign exchange reserves

By 2014, however, the dynamics had changed and there was an active market debate as to whether the yuan was becoming overvalued. Capital outflows from China – both officially sanctioned and in the form of capital flight – had started to increase, and from around mid-2014 the nature of the PBOC’s intervention in the currency market changed: instead of accumulating reserves to cap yuan appreciation, it started to sell reserves to limit the degree of depreciation.

In August 2015 the PBOC announced another change to the exchange rate regime, combining a 1.9 per cent depreciation against the dollar with a new approach to setting the fix. The shift came as a surprise to the markets, prompted fears of further, future large depreciations which in turn triggered an increase in capital outflows. The PBOC’s response was more intervention along with the introduction of tighter capital controls, and yet more PBOC intervention was required in early 2016. Arguably, it was only by early 2017 that downward market pressure on the yuan had ended. Certainly, foreign exchange reserves had fallen to a low of just below US$3 trillion by January 2017 and only then stabilised as the global environment improved. 

The irony regarding the timing of the US Treasury’s finding of currency manipulation, then, is that it comes at a point when the PBOC has once again been seeking prop up the yuan, rather than hold it down as it had been doing back during the 2003-2013 period. And, of course, one significant source of the current market pressure for a depreciation of the yuan is US trade policy and the tariffs that Washington has imposed on Chinese exports. Seen in that light, what China did this week was not to seek to thwart the foreign exchange market’s view on the fair value of the yuan, but rather to – briefly – stop trying to so. That said, Washington does of course have half a point with the currency manipulation charge: it’s crystal clear that the timing of this week’s move was a deliberate signal in response to the latest US move on tariffs. But it’s still only half a point.

Why it matters:

After sending a strong signal at the start of the week, the PBOC has moved back to a more typical conservative approach. And the US Treasury report is more about political theatre than anything else, with the required consultation process with the IMF unlikely to deliver much. Even so, this week’s developments sent a strong, negative signal about the prospects for the world economy. That’s the case for at least three reasons.

First, they appear to indicate that Beijing has decided that the near-term chances of reaching a deal with Washington have receded. Until now, one of the reasons China has been defending the yuan has presumably been to avoid US charges of currency manipulation and the damage that would do to the trade negotiation process. That calculation has now changed.

Second, to the existing risks of trade and technology wars, we can now add the threat of currency wars. That further clouds an already troubled global economic outlook and adds an additional hazard for policymakers and businesses to navigate.

Third, currency wars come with a different set of risks and challenges than the other two economic conflicts. Granted, trade and technology wars have already taken a toll on global trade flows, manufacturing output and investment and have also triggered some significant bouts of asset market volatility. That’s plenty of damage. But much of the serious fallout from disruptions to trade and technology will take some time to manifest, serving as a drag on global productivity performance and therefore the medium-term growth outlook. Currency wars, on the other hand, with their direct link to asset prices and global capital flows, have the potential to have much quicker and much more dramatic consequences, including through contagion effects.

Still, some of the more extreme talk about China ‘weaponising’ the yuan heard over the past week needs to be taken with a good few grains of salt. There are two important constraints that Beijing has to consider before seeking to wield the yuan as a weapon. First, China is home to a large pool of undiversified domestic savings that would become even keener to move into foreign assets in the event of sizeable falls in the exchange rate. And second, there is some evidence that Chinese residents are particularly prone to herding behaviour. The combined effect of these two factors is that outward capital flows are very sensitive to movements in the yuan, and that in turn increases the risks of any sizeable depreciation subsequently becoming much larger and more disorderly than the authorities would be prepared to tolerate. The sizeable amount of foreign currency debt that some Chinese companies have accumulated in recent years makes this risk even more problematic and while China’s extensive capital controls do offer some protection against this kind of scenario, capital controls are never perfect.

What I’ve been reading: articles and essays

RBA Assistant Governor Michele Bullock on financial stability through the lens of business. She points to relatively positive conditions for most listed companies, with a run of decent profitability for non-financial corporations, trend falls in gearing and debt service ratios and stronger liquidity, all of which imply decreased vulnerability to economic shocks. That relative improvement also applies to even the most vulnerable to 25 per cent of businesses. By sector, retail is of course doing it tough, and while ‘listed discretionary goods retailers appear to be in good financial health overall, there were some signs of financial difficulties in some unlisted and smaller retailers…[although] there is no current evidence of widespread vulnerability and difficulties in the sector appear unlikely to pose a significant risk to the banking sector.’ In contrast, the mining sector has been enjoying much stronger conditions, and the scope for positive spillovers ‘mean that the improved position of mining firms reduces risks to firms in other parts of the economy.’ Finally, Bullock points to the tighter credit conditions facing small businesses, concluding that it ‘is possible that these tighter credit conditions might push small businesses into failure and default on their loans. But any impact from this channel on the financial system at this stage is still quite small. Non-performing loans in the private unincorporated business sector have risen a bit over the past year or so but they remain at relatively low levels.’

The RBA has also published its August chart pack.

ANZ’s Catherine Birch analyses the shifting relationship between the ANZ’s monthly job ads series, the ABS’s data on vacancies and the unemployment rate. The series on job vacancies and job ads appear to have diverged with a large gap opening between the two, while the traditional inverse relationship between ads and the unemployment rate also seems to have changed. Potential explanations include a decline in the efficiency with which the labour market is matching job seekers to vacancies, a shift to using labour hire agencies relative to job ads, and a change from an ‘advertise and apply’ approach to recruitment to a ‘find and engage one’, including through a greater reliance on social media.

The Grattan Institute’s Tony Wood thinks that gas prices are likely to stay high but also identifies some positives in the latest set of energy policy initiatives.

Writing for Reuters, John Kemp thinks that the global economy is probably in recession.

George Magnus makes the case that China allowing the yuan to slide below seven to the US dollar is a watershed moment, symbolically equivalent to the United States and other economies abandoning the gold standard in the interwar period or the collapse of the Bretton Woods system of fixed exchange rates. Seems a bit hyperbolic just for breaking seven, but if instead the move is seen as representative of the definitive unwinding of the US-China co-dependency that has helped shaped the modern era of globalisation, he may have a point.

Peter Drysdale and Mari Pangestu say that Asia’s Regional Comprehensive Economic Partnership (RCEP) is now vital in defending the global trading order.

John Lanchester in the New Yorker on the invention of money, taking in Marco Polo, John Law and Walter Bagehot.

The FT’s Rana Foroohar argues that the age of wealth accumulation is over. Instead, we can look forward to a battle ‘over who gets what share of what looks to be a slower growing pie in what appears to be a slower growth economy.’

Tyler Cowen looks at the ECB’s negative interest rate policy and the adverse German reaction to it.

In the Atlantic, Derek Thompson wonders why no one wants to talk about the booming US economy. He thinks it’s because Democrats don’t want to give any praise to President Trump while Republicans – who have presided over the largest two-year deficit increase in US history outside of a recession – are nervous of being viewed as closet Keynesians. Alternatively, if financial market forecasts of a looming recession are right, maybe they just think it’s too good to last?

The NAB’s China economic update explores how successful Beijing has been in deleveraging the Chinese economy. While the authorities look to have managed to stabilise overall debt levels across 2017 and 2018, the recent need to sustain growth against the challenges posed by trade wars has put debt levels on the rise again.

The Economist asks, are modern democracies becoming ungovernable?

1 Thanks to a Friday release, I missed covering the retail turnover data in last week’s note and therefore have included a brief summary here.

2 Note that Chinese trade was also hit by non-country specific US tariffs on imports of steel, aluminium, solar panels and washing machines.

3 For a useful overview of developments in China’s exchange rate regime since 2005, see this recent IMF working paper.

4 Note that the yuan did appreciate quite significantly in effective nominal and real terms over this period: the IMF estimates that between July 2005 and July 2015, the yuan appreciated by 26 per cent against the US dollar, but by 44 per cent in nominal effective terms and by 58 per cent in real terms. But critics at the time charged that the appropriate degree of appreciation should have been much greater.