Market hopes for a Plaza-type agreement at the 26-27 February G20 meeting in Shanghai 26-27 February, to help ameliorate the substantial issues facing the global economy and calm market volatility, have been growing. But I’m not expecting any really impactful policy announcements, much as I wasn’t expecting Yellen’s Congressional testimony to be a silver bullet (see here). While macro-financial conditions are stressed we’re not yet in the full meltdown crisis scenario likely required to prompt significant G20 action. Moreover, the propitious set of circumstances which underpinned the September 1985 Plaza accord, plus it’s effectiveness, aren’t currently replicated. Indeed, its unclear where any coordinated FX intervention should focus at present (CNY, USD or JPY depreciation?) and whether it would meet the success criteria of going with the grain of underlying macro fundamentals. It will also be difficult to get any agreement amongst the diverse G20 countries (unlike the 5 signatories to the Plaza agreement) and the FX market is now significantly larger. Plus in any case FX interventions go against the spirit of recent G20 pronouncements, with their focus of market-determined outcomes except in extraordinary circumstances.
So overall the G20 seems most likely to simply recognise that the global economy has substantial issues i.e. signal that they’ve got their eyes on the ball, and promise to continue refraining from competitive devaluations (even if some recent policies arguably looking suspiciously like at attempts at precisely that!). The obvious solution to the overarching underlying issue of weak/deficit global demand of coordinated fiscal expansion faces implementation challeges given fiscal constraints, even if the US seems likely to pressurise the EA and Japan on this. While China may be more likely to loosen fiscal policy again, the further rise in debt could have lomger-term costs. And the likely rhetoric on the growth-supporting benefits of structural reforms face the challenge that the beneficial effects come with potentially long lags, whereas demand support is required now. Indeed, some reforms can exacerbate deflationary pressures in the near term. But the G20 may also announce some new measures on liquidity provision (swap lines), if they can get over potential US reservations, which would provide some limited reassurance to the markets that there’s means to fight stressed market conditions. But nevertheless my take is that the G20 meeting likely won’t fundamentally address market concerns and hence substantially calm market volatility: the market reacts with “tell me something I don’t know”. What is really required to calm market nerves is an improvement in the macro/inflation data and greater clarity/credibility about Chinese policy. And that’s likely to take time to emerge.
In the meantime, the burden seems likely to continue to be borne mainly by central banks increasingly worried about the limits of their policies and so also upping the rhetoric on fiscal policy to share the burden. So market attention will likely swiftly switch to the March round of central bank policy meetings, kicked off by the ECB on 10 March (where it faces a tough challenge to positively surprise the market and needs to overcome internal disagreements, but could prompt SNB and Riksbank reactions) and the Fed’s 15-16 March meeting where the market will be looking to see how much the forecasts and “dot plots” are revised down and whether Yellen becomes more dovish than hitherto.
Backdrop: the policy challenges and market conditions
There’s a wide range of (inter-related) macro-financial worries for the G20 finance ministers and Central Bank governors to mull over in Shanghai 26-27 February:
• Lack of global demand, with G10 data tending to disappoint (including fading hopes of an end to EA underperformance, with even Germany struggling due to its Asian trade exposures, and US manufacturing weakness showing some signs of spilling over into the service sector) while China and especially EMEs have slowed sharply.
• Disappointingly weak inflationary pressures, exacerbated by oil price declines and excess capacity in many EMEs, with growing concerns about second round effects into wage-setting and with market-based inflation expectations flashing warning signs of becoming de-anchored (especially in the EA with 5y5y brekevens hitting fresh record lows of 1.40%).
• Concerns about China’s (narrowing) policy options, given slowing growth and overcapacity/deflationary pressures with the growing fear that continued strong capital outflows will eventually force PBOC’s hand into devaluating CNY (despite official denials).
• Continued oil price fragility, given the disappointment about the lack of supply cuts: Iranian comments that the suggested production freeze is “laughable” sums up the underlying issues. By contrast, some hard commodity prices have bounced more strongly.
• Strong market concerns that monetary policy is losing traction, with indeed negative interest rates increasingly viewed as counterproductive given via their adverse impact on banks’ margins.
• Sharp equity market falls, especially bank stockson worries about the revenue/margin hit from negative rates. While there has been some limited stabilisation in recent days, the situation looks fragile with equities currently taking their direction from oil prices.
• Safe haven demand for high-quality government bonds, causing yields to fall to unprecedented low levels (5-year bunds at -0.34%, thereby currently ineligible for ECB QE purchases, 10-year bunds at a 0.15%) and the yield curve flattening signalling recession fears.
• A sharp uptick in FX volatility, associated with concerns about Chinese FX policy and the pushing back of US rate hike expectations, with Brexit worries being the latest thing for the market to worry about (see here). The Yen has appreciated sharply on safe haven effects, with markets provocatively calling the BoJ’s bluff on negative rates, while the dollar has fallen back on Fed policy concerns and Draghi seems has managed to curtail nascent EUR strength driven by carry trade unwinds.
Important barriers to any substantial agreement or actions
So there are a number of important macro and market developments for the G20 policymakers to mull over, which has encouraged market hopes that some form of updated Plaza accord will be forthcoming. The 1985 Plaza accord reversed an unprecedented mid-1980s USD appreciation, although the 1987 Loure accord represented a u-turn given subsequent Japanese worries and a change of Government. Unfortunately, there are several important barriers to the G20 making any substantive agreements or undertaking significant policy actions.
(a) Not a big enough crisis to provoke G20 action
First, while the situation is clearly strained it’s yet to reach truly crisis proportions. Markets have calmed a little in recent days as the bank stock sell-off have slowed, FX volatility has retraced and oil prices show limited signs of stabilising. That said, inflation breakevens nevertheless continue to grind downwards, suggesting evaporating faith in central bankers (especially the ECB). But the experience of previous G20 policy interventions, such as that of the April 2009 meeting in London, indicates that it takes a genuine crisis to provoke strong G20 coordinated policy actions. The current situation will concern G20 policymakers, but probably not enough yet to stir such a disaparate group of countries into concerted action. Indeed, some may view the recent market turmoil as a natural consequence of the Fed starting the ease the market off extraordinarily loose monetary policy. So they may well take a “things will calm down, financial markets are over-estimating the deterioration in macro prospects” attitude, at least in private. The prospects of further ECB policy actions in a fortnight (10 March, which may well provoke reactions by the SNB and Riksbank) may well also encorage a wait and see attitude with many of the G20 thinking that it’s up to the ECB to sort out their problems.
(b) Unclear which FX interventions would be both helpful and mutually agreeable.
Second, more fundamentally, it’s unclear where any coordinated FX intervention should focus at present (CNY, USD or JPY depreciation?). The Plaza agreement came into being and was effective because it was obvious (given the scale/speed of the USD appreciation, the widening US trade deficit and slowing US growth) that the USD had become detached from “fundamentals”. Plus exerience shows that coordinated interventions are most impactful when they are “working with” the underlying fundamentals rather than pushing against them (when the markets tend to see through things fairly quickly and test the credibility of the actions) and are backed by actual policy changes. The sharp post-Plaza USD fall reflected the unsterilised FX intervention ammounted to policy stimulus in the US but tightening in Germany and Japan (Japan saw this as a quid pro quo for reducing the pressure for US tariffs, but subsequently regretted it leading to the 1987 Louvre accord).
By contrast, it’s not obvious that either such a simple issue faces today’s more complicated and integrated global economy or that policymakers are willing/able to walk the talk to make any coordinated interventions credible. As detailed above, the current overarching global issue is deficient global demand with consequent weak inflationary pressures. But there’s no clarity on what is the appropriate coordinated FX intervention to solve it (for good reason). Different commentators/policymakers have argued that what’s required is either a CNY devaluation, a USD depreciation or a JPY depreciation (with the ECB also wanting a weaker EUR!). But none of those options appear both consistent with macro fundamentals and capable of obtaining widespread G20 support.
Proponents of CNY devaluation argue that this would bail the Chinese authorities out of their substantial issues of slowing growth excess industrial capacity and producer price deflation plus rapidly-falling FX reserves (only a few months away from breaching IMF metrics of adequate reserves). Essentially the Chinese authorities have been wrestling with the “impossible trinity” of a floating exchange rate, independent monetary policy and open capital accounts, as they try to transition to a more market-determined economy with a larger role for services/domestic demand and less reliance on exports and investment. The sharp of the CNY real effective exchange rate appreciation, up a startling 60% since 2005 provides some support for it being overvalued alongside the capital outflows (although the pushback is that China continues to run a substantial and recently-rising $63bn trade surplus as imports have fallen even more sharply than exports). So a devaluation sounds like a potential way out for the Chinese authorities to forestall a potential hard landing which could reverberate unhelpfully around the globe.
But there’s also substantial problems with a sharp CNY depreciation. First, it would represent a further global deflationary shock, effectively exporting Chinese producer price deflation more strongly to a rest of the world already facing a lowflation problem. Second, it would pile further pressure on other excess capacity and indebted AxJ currencies to follow suit and devalue their currencies i.e. escalating the global currency war. So it’s hard to envisage much support for it at the G20 meeting. Indeed, it’s a bit perverse to argue that the solution to recent market turbulence is to crystalise one of the main risks which has generated such volatilty in the first place. But the Chinese authorities don’t seem to support a CNY devaluation, because they realise it would ultimately feed back on them in adverse ways. The Asian regional trading network would be substantially disrupted, their main markets of G10 economies could be pushed into stagflation and capital flight out of China could well accelerate rather than die down (it’s very hard to tie down “equilibrium” exchange rates so it may be difficult to rein in expectations of further moves). That said, PBOC Governor Zhou’s recent statement that there’s “no need to worry” about the decline in Chinese FX reserves and that there was “no basis for continued CNY depreciation” also look Panglossian. Chinese authorities undoubtedly face substantial challenges and indeed a substantial real CNY fall at some point looks close to inevitable. But it would currently be unhelpful at a global level given the global lowflation problem etc. So in the near term the Chinese authorities seem likely to continue trying to shift market focus away from the USDCNY rate and towards the (new) TWI, so that they can achieve a gradual USDCNY rise.
Proponents of the need for coordinated intervention to generate a USD depreciation draw analogies with the Volker-induced 60% USD TWI appreciation 1978-85, which was halted by the Plaza agreement, and the 20% USD TWI rise since mid-2011. And a weaker USD would have several potential benefits: (i) it would indirectly helps out China, by reducing the pressure on USDCNY, and so would likely be supported by the Chinese authorities; (ii) it would support EM countries with substantial USD-denominated debt, thereby supporting global growth; (iii) somewhat more speculatively, it could help stabilise USD-denominated commodity prices, thereby reducing deflationary impulses; (iv) it would support US manufacturing, trade and growth – helping the US once again be the global engine of growth; (v) it would make Fed rate hikes more likely (less tightening of financial conditions) which would be beneficial in giving policy room to handle future downturns, although it obviously also risks raising the probability of such a downturn.
But again there’s a number of important problems here. First, lowflation countries like Japan and the EA won’t support a G20 agreement to weaken the dollar, given that they also want weaker currencies (obviously without trying to actively achieve that!). Second, unlike prior to the Plaza agreement, a substantially weaker USD don’t look appropriate given macro fundamentals: (i) while US growth prospects have dimmed somewhat, they remain stronger than most other countries; (ii) much of the USD strength seems to reflect non-US weakness – evident in US investors repatriating foreign investments (especially out of foreign bonds) and the relatively-close correlation between USD’s rise and the fall in non-US policy expectations (although the 2016 USD fallback has been driven by the dramatic repricing of Fed rate hike expectations). So the policy risks putting the cart before the horse: it’s better to try and strengthen non-US fundamentals (e.g. the weak investment that’s driving the EA current account surplus) rather than arbitrarily try and reverse the symptom. Third, reflecting the above, the international policy changes necessary to provide a credible backdrop to any intervention – looser US monetary and tighter US fiscal combined with tighter EA/Japanese monetary policy and looser EA/Japanese fiscal policies – look like pipe dreams. Fourth, while the USD has appreciated 20% since 2011, unlike prior to the Plaza accord it’s not obvious that this has yet taken USD into substantially-overvalued territory.
The main proponents of a JPY depreciation have been the Japanese authorities. The recent risk-off driven yen rise, despite BoJ moving to (very limited) negative interest rates, as undermining Abenomics’ attempt to get away from the lowflation trap. Like many other central banks, the focus is on raising wage settlements in the crucial Shunto negotiations as the BoJ tries to engineer a virtuous circle via lower yen and higher corporate profits. Hence the frustrations at the yen’s 2016 rise, with the TWI up 9% since mid-December. While BoJ Governor Kuroda has been streadfastly arguing that the BoJ is ready to do more, with there being “ample room” for further rate cuts, the markets have thus far called his bluff in the risk-off world with the tentative negative rate policy seen as a sign of policy impotence especially given that the committee only narrowly agreed the cut (5-4 vote). Indeed, Japanese banks’ equities have recently fallen by similar amounts to EA banks (see above).
The main argument for FX intervention to weaken JPY is that it would reduce the chances of policy failure in the world’s third-largest economy, avoiding a scenario which would be bad for the global economy. But global policymakers have got bigger fish to fry and the recent JPY strength only unwinds a small proportion of the 35% JPY depreciation since 2012. Indeed, JPY currently looks the most undervalued major currency on a real TWI basis. So the G20 seems very unlikely to bail the BoJ out of its dilemma. The best they can hope for is that any G20 measures stabilise risk appetite and hence reduce the safe have JPY bid. But JPY seems unlikely to fall fast any time soon unless the BoJ can regain policy credibility.
G20 FX intervention would be a major shift away from “market determined” .
A further barrier to an updated Plaza agreement over the weekend is that recent communiques have stressed commitments to “market-determined exchange rate systems and exhange rate flexibility to reflect underlying fundamentals, and avoid persistent exchange rate misalignments. We will refrain from competitive devaluations“. So it would be quite a jump to a major form of FX intervention.
Difficult getting agreement among such a large number of disparate countries
A further practical issue is that it will likely ti be difficult to get agreement on major measures amongst such a large group of disparate counties. The halcyon days of the Plaza accord required onlt the agreement of 5 countries (US, Japan, West Germany, France, UK) rather than the current 20. This explains why G20’s can tend to be bland affairs outside true crisis periods (e.g April 2009 London summit). For example, while China and some commodity-producing G20 members could support intervention to try and weaken USD, given that it could boost their terms of trade an support their currencies and hence help get their high inflation rates under control, other EM countries and most of the lowflation G10 would likely resist. But even previous G20 agreements have underwhelmed e.g. the Feburary 2014 deal on reforms has bee under-delivered.
Fiscal stimulus and structural reform focus: don’t expect that much soon
As stressed above, the main underlying issue facing the global economy is deficient demand conditions (although the oil price fall largely reflects supply increases). And there’s likely to be pressure within the G20, most strongly from the US, to adopt the obvious solution of open the fiscal taps (public investment). That’s in line with recent OECD and IMF recommendations, would taking advantage of unprededentedly-low government bond yields and would relieve the pressure on increasingly ineffective/counterproductive monetary polict easing. And as discussed above that would address the fundamental issue rather than try and treat the symptom via coordinated FX intervention. But it would face implementation challenges. Mario Draghi’s appeals to EA fiscal authorities to pull their weight, while of course respecting the fiscal rules, has had little impact. German fiscal policy has been loosened a little to deal with the refugee crisis, but the focus remains on hitting a fiscal surplus. And while the Italian and Portuguese governments have been keen to exploit fiscal flexibility their efforts are constrained by the European Commission and market discipline. The Japanese fiscal authorities seem potentially more open to some fiscal loosening, with Finance Minister Aso not rule out the possibility of compiling a supplementary budget in April. While the Chinese authorities could also eventually fall back on further fiscal measures that might not support market confidence if it stimulated markets concerns about growing debt levels.
The G20 communique will also almost certainly include exhortations about the growth benefits of pursing structural reforms. But they face the challenge that the beneficial effects come with potentially long lags, whereas demand support is required now. Indeed, some reforms can exacerbate deflationary pressures in the near term. The G20 delivery record on structural reforms is also imperfect.