Outlook: Currency impasse as G7 heads for Florida

Bond bubble
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The Independent Online

As G7 finance ministers and central bankers gather in the resort town of Boca Raton, in Florida, this weekend, the battle lines are already clearly drawn. The Europeans want to talk about the strong euro-weak dollar, which they see as very much a US problem caused by America's twin budget and current account deficits, while the Americans want to talk about structural reform in Europe, which they see as the chief barrier to decent levels of eurozone growth.

As G7 finance ministers and central bankers gather in the resort town of Boca Raton, in Florida, this weekend, the battle lines are already clearly drawn. The Europeans want to talk about the strong euro-weak dollar, which they see as very much a US problem caused by America's twin budget and current account deficits, while the Americans want to talk about structural reform in Europe, which they see as the chief barrier to decent levels of eurozone growth.

The Japanese too want to talk about the weak dollar, which they are attempting to counter with massive currency intervention, while the Chinese, largely in the same position, would go along with anyone in return for a seat at the table. The British Chancellor, meanwhile, floats enigmatically somewhere in between but, if pushed, would side more with the American position than the European one. As can readily be seen, the chances of getting a meaningful statement out of the G7 this weekend on currency misalignment is close to zero. Yet the markets are on tenterhooks of anticipation. The belief that something, somewhere has to give if the world is to return to a more normalised and equally spread pattern of growth has gathered pace since the last G7 in September.

Extreme currency movements always produce distortions in trade. The European and the Japanese recoveries are export led, and both are threatened by the weakening dollar, which makes their exports less competitive. A weak dollar is, on the other hand, proving highly beneficial to the US, where it is helping to support a strong rebound in growth. So although John Snow, the US Treasury Secretary, and other US policy makers continue to claim allegiance to the old, strong dollar policy, they speak with forked tongue. Actually, they very much like the weak dollar and don't care two hoots that the eurozone is being forced to bear the brunt of the consequent adjustment to trade.

For although the dollar has declined precipitously against the euro since its cyclical peak two years ago, its trade weighted fall against other major currencies is more modest. Against the Japanese yen and other Far Eastern currencies the depreciation is less extreme. This is not as it should be. America has a trade imbalance with almost everywhere, but the real problem lies with China and Japan. The curiosity of the dollar's adjustment, then, is not that it has declined too far, but that it hasn't yet declined by as much as it should, particularly against the currencies of its major trading partners.

The reasons are well rehearsed. Both the Japanese and Chinese authorities support their currencies at artificially depressed levels against the dollar through massive currency intervention. The scale of the intervention was underlined by new figures from the Japan Ministry of Finance yesterday showing that Japan spent ¥5.8755 trillion ($55.55bn) on currency intervention in the final quarter of last year. China is spending on a similar scale to support the renminbi's dollar peg.

Nor is there any sign of a change in tack. The Chinese leadership has set itself the long-term goal of currency reform, but a full float is plainly years away.

On his way to the G7 yesterday, the Japanese Finance Minister, Sadakazu Tanigaki, repeated his determination to stop the yen appreciating against the dollar with as much intervention as necessary. Japan faces potentially catastrophic losses on these transactions if the dollar continues to fall, but this doesn't seem to bother Mr Tanigaki. For him, currency intervention is just a form of government subsidy to Japanese exporters.

Furthermore, it's not real money. Japanese price deflation allows him to print yen to buy dollars without any of the inflationary consequences that would normally accompany such abandon, so far at least.

Most of the intervention goes into buying US Treasury bonds, which in turn helps keep US interest rates low, despite the ever-growing budget and current account deficits. The relationship between America on the one hand, and Japan and China on the other, has thus become a deeply symbiotic one.

Asian central bankers are in effect lending the US the money it needs to buy their exports. Moreover, they are doing it without regard for normal credit risks and at rates of interest quite out of kilter with economic reality. Common sense dictates that there must eventually be a reckoning. The only reason for believing otherwise lies in the idea that the US can eventually grow its way to salvation.

Can the G7 help to untangle this mess? I doubt it. There is too much vested interest to make a common response possible. But one thing I am certain of: Europe should stop looking to America for solutions and start thinking positively about how it might address these issues itself. US profligacy is a large part of the problem, but if it were fully recognised by currency markets, the dollar might be even lower. Meanwhile, necessary structural reform in Europe proceeds at a glacial pace.

Europe cannot beat the unholy alliance of low interest rates and currency intervention that unites the strong growth stories of America and Eastern Asia, so it might as well join it. The European Central Bank again passed over the opportunity to cut interest rates this week. It must not do so again, and, if necessary, it should support currency realignment with intervention as bold as that of China and Japan. But don't hold your breath.

Bond bubble

I've thought shares a better bet than the bond markets for some while now and, as if to prove the point, along comes the always informative Credit Suisse First Boston "Annual Equity Gilt Study". Credit Suisse is the proud keeper of records dating back to 1869 on gilt and equity returns. To the uninitiated, the bare statistics make startling reading. An investment of £100 in equities in 1869 would today be worth £14.9m, whereas a similar amount invested in British Government bonds would be worth only £45,747, or about the same as the cash equivalent. Even adjusting for inflation, the findings are equally eye opening. £100 invested in equities in 1869 becomes worth £331,826, against just £1,018 for gilts.

On any kind of a long-term basis then, equities always far and away outperform gilts, if only because companies are much better adapted to prolonged bouts of inflation - they can raise their prices - than bonds, whose value is destroyed by them.

However, no one alive today could have invested as far back as 1869, and as most of us have discovered to our cost in the past four years, over shorter time scales equities are a lot less reliable. The uncertainty of corporate earnings make equities inherently more risky and volatile than gilts, which at least always repay the initial capital. If you thought the bear market of 2000-2003 was bad, be warned. All it did was return equities to their long-run trend for real rates of return. With the recovery in equity prices over the past year, they are once more running a little above trend.

Yet this doesn't necessarily make them poor value. According to the CSFB study, equities are showing a 20 per cent deviation from trend right now, but gilts are way up there at 60 per cent. At the height of the bull market, equities were 80 per cent above trend, so the overvaluation in gilts may not seem as extreme as was achieved for equities. But long run returns for gilts are also much flatter than equities, or looked at another way, if there were no return on gilts at all in future, they would take 72 years to return to their long-run trend, whereas from the peak of the market for shares, the same adjustment for equities would have taken only 15 years.

All this may sound like a complicated way of stating the obvious, yet it is sometimes reassuring to have the obvious confirmed by the analysis. For gilts to go much higher from current levels requires another fall in already low, inflationary expectations. That doesn't to me look like the way to bet. The present profligacy in Government spending around the world will eventually be paid for by printing more money, which will lift inflation and interest rates. The message is: steer clear of debt, even forms of it as reliable as gilts.

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