The European Central Bank’s launch of its €1.1 trillion quantitative easing program last week has sent shockwaves through global currency markets and triggered a wave of cuts to official interest rates around the world. There’s now intense speculation that the Reserve Bank will also respond with a rate cut when it meets next week.
The market has already pre-empted any move, with the Australian dollar breaking down sharply against the US dollar after the Herald Sun’s Terry McCrann foreshadowed a rate reduction. It’s now trading below US78c.
Whether or not McCrann is right, the RBA will inevitably have to factor into its considerations the ECB’s move and the flood of euros that will pour into global financial markets in pursuit of positive returns.
The risk is that Europe’s QE program, like the US and Japanese programs, could reverse the depreciation of the dollar that has been occurring since the US Federal Reserve Board ended its bond and mortgage-buying last October and markets began to focus on a likely rise in US official interest rates sometime this year.
That increase might be delayed if the Fed believes the ECB action might see the US dollar, which has been steadily appreciating, strengthen even further and undermine US competitiveness and the rate of recovery in its economy.
The RBA, of course, has made no secret of its desire to see the Australian dollar trading around US75c. With other central banks in the region reducing rates -- South Korea cut its rates twice in the second half of last year, India reduced its official rates earlier this month and Singapore only this week -- the pressure is mounting.
Canada reduced its rates largely in response to the plunge in oil prices but Switzerland (pre-emptively) and Denmark have both reduced rates because of the ECB’s program.
There’s also real pressure mounting on China, which has a managed float, or 'dirty' peg against the US dollar, to do something about the renmimbi, which has appreciated almost 10 per cent against the euro over the past six weeks and has been soaring against the yen.
China, south-east Asia and Australia are being caught in the crossfire of what are effectively currency wars between the US, Japan and Europe, even though the explicit objectives of those programs is to stave off deflation rather than to use exchange rates to improve their competitiveness.
China is struggling to maintain its growth rate and manage its internal financial imbalances. While it is trying to rebalance its economy away from an over-reliance on exports and towards greater domestic consumption, its appreciating currency is threatening the competitiveness of its still vital exports -- and not just the price but the volume of Australia’s exports of the raw materials that feed Chinese production. Europe and Japan happen to be two of China's biggest export markets.
China faces some delicate policy decisions, given that the increasing internationalisation of the renminbi has recently see it emerge as one of the five most actively traded currencies in the world. Too aggressive a policy might risk capital flight, while too passive a policy could see euro-funded carry trades join their yen-funded counterparts to exacerbate the impact on the renminbi.
Competitive devaluations (or currency wars) generate volatility and unintended adverse consequences, some of them potentially large and destructive for the innocent bystanders caught in the crossfires.
The ECB action, if it were to delay US rate rises or negatively impact the recovery underway in the US economy, could actually be counter-productive for Europe, given the importance of a growing US economy to the global economy now that China is slowing and the eurozone and Japan are in recession.
If China and other countries, like Australia, join the lengthening list of countries to reduce their interest rates, the effectiveness (which is questionable anyway given the experience of the US and Japanese programs) of the ECB action would also be reduced.
If they don’t, there is a risk of lost competitiveness and an increased risk of financial imbalances and excesses as the carry trades target the markets where there are real returns. The short-term fate of the Australian dollar is very exposed to the decision the RBA makes next Tuesday.