Do you know who the real bankers are?

By Robert Presser on December 3, 2009

This year has been a seesaw for the Canadian Dollar.  Plunging to the 80 cent USD range during the onset of financial crisis of 2008 and retesting those lows in March of this year, our currency has recovered to trade in a relatively tight range of 92 to 97 cents US over the past two months.  The recovery in our dollar has paralleled the recovery in stock markets and commodities, especially oil.  Sadly, Canadians don’t look at the broader currency picture – while our Loonie is stronger against the US greenback, the USD continues to fall to ever deeper lows against a broader index of international currencies.  The US is pursuing a weak dollar policy despite public statements to the contrary and Canada is along for the ride.

Presser_graph_resize.pngThe graph from tells the long term story: the USD has been in decline since the days of Ronald Reagan and the large (for that era, anyway) deficits that his administration unleashed onto the international debt market.   The USD enjoyed a recovery period during the Clinton era when prosperity raised tax revenues and a Republican Congress actually behaved like the conservatives they purported to be and controlled federal spending.  Since the Bush II era, the USD resumed its downward trend as deficits swelled anew and an administration engaged in two overseas wars made matters worse by cutting taxes to sustain consumer spending.

Any Canadians travelling in Europe, for instance, would notice that our Loonie buys you very little on the continent.  Dinner for two in Paris can easily run you 100 Euros, and that’s the price of a nice lunch in London where the British Pound is even stronger than the Euro.  Canadians are caught in a policy bind between a strengthening Canadian Dollar against the USD and declining purchasing power on an international scale.  Because our commodities are in strong demand from our US neighbor and our economy is in better shape, we appear more attractive for those willing to invest on this continent, but against the rest of the world, we are tied to the deteriorating status of the US because they are our greatest trading partner and our economies are integrated through multiple trading agreements.

Ben Bernanke, chairman of the US Federal Reserve is busy showering the US economy with practically free money to re-inflate the banks’ balance sheets, real estate and get consumers spending again.  Regardless of his efforts, consumer credit is still contracting, down approximately 6% over the past year.  Consumers are saving again, trying to pay down debt, and consumer spending as a whole is expected to fall from 70% of US GDP in 2007-8 back to 62%, the long run average of the past fifty years.  That’s 1 trillion dollars of spending that is not coming back, no matter how low interest rates go.  Canada is in a bind since our economy will recover more quickly than the US, but Mark Carney of the Bank of Canada will not raise interest rates since pushing the Loonie over par with the USD will decimate Canadian manufacturing.  So, Canada, meet your real central banker: the Federal Reserve Bank of the United States.

Canada and the US are both nervously watching what China plans to do concerning the value of the Yuan.  It is currently pegged at 6.83 Yuan to the USD, but the Bank of China has sent a signal that is it ready to revalue the Yuan higher, though they will not let the Yuan float freely as has been asked by President Obama as a means to correct serious trade imbalances between the two countries.    The Eurozone has been especially shrill with the Chinese since the strength of the Euro against the falling USD/Yuan has made Chinese goods so inexpensive that European manufacturers are having serious difficulty competing for consumer and industrial capital goods in international markets.  The Europeans are now in the position that the US was in three or four years ago; their consumers are spending billions more Euros on Chinese goods in their home markets and increasing the trade imbalance between the two economic zones, which will prove just as unsustainable for the Europeans as it was for the US.  The US and the Europeans would like to see the Yuan revalued to at least 6 Yuan/USD as a start, and moving to 5 Yuan/USD over several years would be greatly appreciated towards reversing the massive US and Eurozone trade deficits with China.

Jean Claude Trichet, the President of the European Central Bank, is running a currency plagued by internal problems.  Not a single Eurozone nation is respecting the guidelines governing membership in the Euro, notably that annual deficits have to be contained to 3% of that nation’s GDP or less.  Several Eastern European member nations are economic basket-cases seeking new loan packages from the organizations like the IMF to prevent their economies from spiraling into a deflationary and unemployment plagued period that could provoke political instability not seen since the fall of the Eastern Bloc 20 years ago.  Trichet has argued that the time will come to raise European interest rates to combat a resurgence of inflation, but any such move would further strengthen the Euro and provoke further unemployment in all member nations.  There is no way to wean European consumers off cheap Chinese goods unless the Chinese decouple from the US Dollar and allow the Euro to fall against the Yuan, which would provide trade rebalancing and employment relief across the entire Eurozone.  If the Euro stays strong, there will be political unrest in France and Germany calling for the dissolution of the currency to return monetary policy flexibility to the sovereign governments of these nations in place of the European Central Bank.  China is the real banker in charge of the Euro’s future, and the populace living within the Eurozone is growing impatient as they await improvement in their economic fortunes.

China would be smart to allow the Yuan to appreciate in value.  Firstly, pricing for costly commodities like oil, copper, magnesium and the like (quoted in USD) would fall for Chinese buyers and allow local manufacturers to cut prices for domestic consumption.  The Chinese government has made stimulating the domestic consumer economy a critical objective to sustaining economic growth and lowering costs for producers supplying the domestic market is key to achieving that goal.  A rising Yuan would help address the massive trade imbalance between the US, Eurozone and China and allow those economies to begin to experience employment growth.  While a stronger Yuan would devalue the $800 billion in US federal debt (within total foreign reserves of $2.3 trillion USD) that China now holds, it would be a controlled devaluation.  The alternative would be to see an international run on the USD, a spike in gold prices to several thousand dollars an ounce and a much more massive devaluation of China’s USD holdings.  It is not good business policy to run your best clients into bankruptcy, and the Chinese recognize that their trading success of the past 20 years has bred serious financial imbalances that they can address in a controlled fashion, or allow to continue unchecked until an economic earthquake results.

The Chinese may be the ultimate masters in the currency and trading universe at the moment, but they are in no less trouble than the US and the Eurozone when it comes to finding a mutually beneficial outcome to the current crisis.  The solution involves a Yuan that appreciates slowly, a USD that stabilizes as the government gets its deficits and national debt under control and a Eurozone that avoids the collapse of former Eastern Bloc nations and holds together in the face of old political divisions between Western European powerhouses.  This is a fairytale scenario, but all the political actors involved know that they must work towards this end.   Otherwise their nations could still drift into a deflationary depression that would decimate the remaining savings of their middle classes and cause political unrest not seen since the aftermath of the first world war.


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