Webcast 033 | Losing interest: why negative interest rates present a challenge to global growth

It has been a tough start to 2015: what will be the outcome of persistently low interest rates be? Rebecca Harding and Sarasin & Partners’ Subitha Subramaniam discuss the topic.


Webcast 033 Author  |  Rebecca Harding  |  CEO

Growth, currencies and interest rates

Four trade challenges to monetary policy  |  Short summary:


The Fed needs to be careful about the next monetary steps it takes because:

  1. The growth effects of Quantitative Easing (QE) in Europe are yet to be felt, if indeed they will be
  2. Neither China nor Korea’s trade surplus with the US is the Fed’s biggest concern in emerging Asia
  3. The weak yen is not boosting Japan’s exports to the US and is not responsible for its surplus
  4. Monetary policy is not the answer to trade and growth imbalances, but has unintended consequences



In its bi-annual report to Congress, the US Department of the Treasury, International Affairs, assessed the macroeconomic policies of its major trading partners to see if inappropriate activities are being used to manipulate the balance of trade with the US. It urged the governments of Germany, China, South Korea and Japan to do everything in their power to eliminate global economic imbalances by focusing on reducing their trade surpluses with the US and halting practices of competitive devaluation against the US dollar. Against a backdrop of strong US growth and weaker growth elsewhere, the report argued that addressing these imbalances through structural reform, monetary and fiscal policy was the only way of ensuring that the G20 balanced global growth targets were met.


Four trade reasons why monetary policy alone can’t create real growth:


1  |  The growth effects of QE in Europe are yet to be felt, if indeed they will be

The immediate effect of QE has been to push European equity markets to new highs and push down the value of the euro against the USD. It is unlikely to create real, export-led growth since the correlation of the euro with Europe’s trade is positive (i.e. an increase in the value increases trade). Where it does have an effect on boosting trade, it is likely to be felt most strongly in Germany. This will potentially exacerbate the problem of its trade surplus, particularly with the US (Figure 1).



Figure 1  |  Monthly Value of German Exports to the US (USDm), June 2001 – December 2015 vs. EUR-USD, Last Price Monthly, June 2001 – March 2015
Source  |  DeltaMetrics 2015, Bloomberg


The chart shows a positive correlation (0.67): in other words, as the value of the euro increases, so too do exports. This reflects the relative exchange rate inelasticity of trade between Germany and the US. Growth in exports from Germany to the US has been modest over the past two years and the sharp reduction in the value of the euro does not appear to be likely to make much difference to its trade balance with the US.

The weaker euro is unlikely to impact Europe’s or, more specifically, Germany’s trade surplus with the US. Indeed, it is also unlikely to lead to greater demand without an accompanying non-monetary policy in Europe, such as infrastructural spending and structural reform to boost both demand and competitiveness.


2  |  Neither China nor South Korea’s trade surplus with the US is the Fed’s biggest concern in emerging Asia

The yuan is kept within a 2% peg of the US dollar and, as such, has been increasing its value since the end of 2004 when the currency was first allowed to float. More recently, March 2015, the yuan has appreciated against the US dollar giving rise to speculation that the peg is about to be loosened or removed completely (Figure 2).




Figure 2  |  Monthly Value of Chinese Exports to the US (USDbn) vs. USD-CNY Spot Price, Last Price Monthly, June 2001 – December 2015
Source  |  DeltaMetrics 2015, Bloomberg


The impact of the appreciation of the yuan is to suggest that Chinese exports to the US may flatten slightly during 2015. This provides some cause for optimism around the size of its trade surplus with the US. Of greater concern from a US perspective may be Russia’s decision to price oil and gas deals with China in yuan. This suggests that the yuan’s role as a trade finance currency is growing and that there will be further strengthening of the currency. This is likely to be a result of both a loosening of the peg and the role of the yuan as a trade finance currency. The threat of a stronger yuan and the prospect of a future currency war may be more unpalatable than the trade surplus now.

The won is slightly different in that it is only very weakly correlated with South Korea’s exports to the US at -0.46. In other words, any devaluation by the Korean monetary authorities is unlikely to have much, if any, impact on its trade surplus with the US. Given the speed that the Kospi has picked up since QE in Europe has prompted greater liquidity, the US would do well to look at the consequences of capital outflows and rising dollar-denominated debt as Asia’s slowdown works through. Priced in local currencies, such as the won, the markets look buoyant; priced in dollars, the rises are less substantial and represent both a loss in earning and pose a threat when dollar-denominated debt has to be repaid.


3  |  The weak yen is not boosting Japan’s exports to the US and is not responsible for its surplus

Japan’s QE programme has resulted in a substantial devaluation of the yen against the US dollar. However, this has not had the desired impact of increasing all exports to the world or the US in particular (Figure 3). Export-led growth has not materialised despite substantial QE-induced devaluation since the onset of Abenomics.




Figure 3  |  Monthly Value of Japanese Exports to the US vs. USD-JPY Spot, Last Price Monthly, June 2001 – December 2015
Source  |  DeltaMetrics 2015, Bloomberg


In fact, if anything, exports to the US from Japan have been falling ever since the start of the most recent phase of QE in Japan. Alongside this, Japan’s imports from the US have been increasing and could grow by nearly 5% in 2015 as a result of Japan’s greater external energy dependency after Fukushima.


4  |  Monetary policy is not the answer to trade and growth imbalances, but has unintended consequences

The US Fed is now in a bind: its challenge is not the monetary policy of its trading partners, it is the unforeseen consequences of its next monetary moves. The US dollar is strong and while some of this is because the US economy itself is doing well compared with other economies, its strength is more than partly due to the fact that markets are speculating on when the Fed will put up rates. Fuelled by both QE and uncertainty around the announcement of a rise in rates, it is likely that the USD and the euro will reach parity imminently, if not by the end of April then during May. Similarly, the yen is hitting new lows against the USD.

The euro and the yen’s values are already distorted by the effects of QE. Alongside this, any increase in interest rates will exacerbate the dollar’s strength against the currencies of all its major trade partners except China. While currencies weaken, equity markets including the Dax, Nikkei, the HSI and the Kospi continue bull runs that are the direct result of large amounts of liquidity made cheaper, not just by low interest rates, but also by weaker currencies. The result will undoubtedly be aggravated by a rise in US rates: a strong US dollar is not necessarily the best for the US in the long run if corporate earnings, confidence and exports falter.


Three reasons why the Fed should not raise rates  |  The rampant US dollar went relatively unnoticed until the end of last week as the world’s attention was diverted towards Europe and the start of Quantitative Easing (QE). It gained almost 4% against the so-called “BRICSA” and “MINT” currencies, the South Korean won and the Thai baht in the first two weeks of March. Since these countries have almost $US 870bn in dollar-denominated debt, all of a sudden the dollar’s strength appears to be the world’s weakness in the long term. And as markets are increasingly expecting a small increase in US interest rates in June, the Fed should at least consider the international consequences of that decision.

Quite apart from anything else, it highlights just how integrated the post-crisis world is through the global financial and trading systems and, increasingly, monetary policy as well. At its extreme, there is no such thing as “national” monetary policy: Central Banks, including the Fed, do not set interest rates for a closed economy. Their actions have global repercussions and at no time in recent economic history has this been clearer as June, and therefore the prospect for a hike in Fed rates, gets closer.

Delta Economics is of the view that if the Fed raised interest rates it would be damaging the prospects for long- term economic growth in the US. This is not because the US economy is weak. Rather, it is because the risk of sovereign default on the dollar denominated debt becomes greater as the dollar gets stronger. Beyond the simple cost of repayment, there are three things that make default likelier and therefore the consequences for the US economy more severe.


1. Currency depreciation does not necessarily lead to export growth

First, it cannot be assumed that there is an automatic link between currency depreciation and greater exports. The Thai baht, for example, shows how for some countries there is an inverse relationship between the currency’s value and its trade: as the spot rate decreases (in other words the baht appreciates) trade increases (Figure 1a). This is also the case for some of the other, most indebted, Emerging Market economies: for example, Brazil ($188bn debt), China ($213,7bn), South Korea ($82.3bn) and Thailand ($14.6tn) (Figure 1b ).


2015-03-17_fedUp_fig01a_v03 2015-03-18_fedUp_fig01b_v05


Figure 1a  |  Monthly value of Thailand’s exports versus USDTHB, Last Price Monthly, June 2001-Dec 2015 (forecast)
Source  |  DeltaMetrics 2015, Bloomberg

Figure 1b  |  Selected Emerging Market currencies’ correlation with trade growth, June 2001-March 2015
Source  |  Delta Economics analysis


Conversely, the positive correlations are not as strong as they should be for a country to benefit from a depreciation in its currency. For South Africa and Russia there is a very low correlation indeed, while for Indonesia, India and Turkey the correlations are higher but still moderate. Only Nigeria and Mexico have stronger correlations between the value of their currency and trade. This suggests that they are in highly competitive markets (such as oil and intermediate manufactured goods) where the responsiveness of trade to a change in the value of the currency is likely to be higher.

However small a rise in Fed interest rates may be, the dollar’s value would increase and therefore make emerging market debt more expensive. Because there is not a clear-cut and positive impact on trade, Emerging Market economies are unlikely to have the export-led growth effects that will make that debt affordable.


2. Oil Price Losers

The dominance of oil in the structure of Emerging Market trade is made obvious by the extraordinarily high correlation between oil prices and total trade (Figure 2).




Figure 2  |  Correlation of total trade with oil prices, selected Emerging Market economies, June 2001-March 2015
Source  |  Delta Economics analysis


The lowest correlation of trade with oil price is China at 0.81, but for countries like Indonesia and Mexico the correlation is much higher at 0.90 and 0.89, respectively. What this suggests is that trade will increase as oil prices rise and vice versa. This is simply a reflection of the importance of oil in the structure of trade of Emerging Economies: because of its dominance, its correlation with the price of oil is very strong.

But because of the oil dependency of trade for many Emerging Markets, the fact that trade will drop in real terms means that all nations are potential losers from the fall in oil prices. This is either because their revenues from oil exports have dropped or because their trade overall has dropped. Again, this makes it tougher for any export-led growth to materialise.


3. Over-valued EM equities

The story of Emerging Market equity growth in the period since the financial crisis is one of expectations exceeding outcomes. The extraordinary recovery of trade and economic growth after the crisis pulled capital into Emerging Markets in anticipation of growth in the future. The strong correlation of most Emerging Market equities with trade through the 2001-2015 period illustrates the strength of these expectations manifested in investments in Emerging Market equities.




Figure 3  |  Correlation between emerging market equities and exports, June 2001-March 2015
Source  |  Delta Economics analysis


Interestingly, only China and Nigeria exhibit weaker relationships between their markets and trade. However, China’s trade is 0.94 correlated with the Hang Seng Index and Nigeria’s market is proportionately under-developed through the time period.

What this shows is that if trade falls back, there is a strong likelihood that Emerging Market equities will also fall. Consequently, this will reduce the amount of capital flows into these economies. Again, the net effect is to dampen economic strength but, equally, potentially to create a self-fulfilling prophecy: trade effects feed lower capital flows which in turn lead to a decline in trade because of a lower capital base.


So what does the Fed do?

The Fed should not raise interest rates unless it is prepared to write off the emerging market debt that is denominated in US dollars. Monetary policy has become international as well as national and it may well be that the United States’ long-term interests are not served by a strong US dollar. Emerging Market trade, oil prices and the value of Emerging Market currencies, and over-valued EM equities may seem unorthodox reasons for keeping interest rates on hold. But in the long term, it is the US that will lose if the debts cannot be repaid.