The complexities of the current global macroeconomic situation are pushing the world economy in many different directions. The US is undertaking a second round of quantitative easing in order to buy protection against a deflationary risk. China is slowly allowing the RMB to appreciate while preparing the next 5 year plan as it transitions from an economy with unlimited resources and limited interactions with the rest to the world into an economy that is starting to feel a deteriorating growth/inflation trade off and is becoming a key player in international trade and markets. The euro area is still struggling with the sovereign debt crisis and the debate on the future governance of the euro area, including the possibility of debt restructuring, has created very negative side effects. Overall, the glass of the global economy looks half full, but with plenty of uncertainty ahead.
The US outlook remains cloudy. Growth has been positive for 5 quarters but the unemployment rate remains high and core inflation is low and has been trending down. Policy seems to be at a dead end, with fiscal policy poised to become contractionary in 2011 and structural policies heavily constrained by the political gridlock. The Fed remains the policy maker of last resort and has just announced a new round of quantitative easing (QE2). There is a strong division of opinions regarding the potential success of QE2, though it is clear that from the standpoint of its impact on asset prices it has already been effective. Financial conditions, including stock prices, the dollar and real interest rates, have eased by the equivalent of a 100bps rate cut in fed funds, and several forecasters have started to upgrade their outlook. Whether this will now translate into higher hiring and investment remains to be seen. There is a clear suspicion among international observers that the US is trying to devalue its way out of the crisis and that, with the housing market in the doldrums, is trying to engineer a large scale search for yield in risky assets that could have very negative side effects in the medium term. With the midterm elections having delivered what looks like a very gridlocked outcome, there is little confidence that the US will be able to adopt a cooperative attitude and fear that this unilateral approach will continue. This non cooperative behavior risks an erosion of the attractiveness of the US dollar as a reserve currency.
China’s outlook remains strong for the near term, even if the medium term outlook is constrained by the aging of the population. Income divergence is a key problem that is being slowly addressed via policies that foster wage growth. The currency remains a key political issue, more than a key policy issue, as it is clear that the currency can only contribute in small measure to the resolution of China’s imbalances. The debate on the undervaluation of the RMB is probably overdone, the IMF estimates that the undervaluation is in the 5-15 percent range, sizable but not critically important. At the same time, China is steadily moving in the direction of making the RMB a trade invoicing currency. The widespread creation of RMB swaps with trading partners demonstrates the desire to tighten trading relationships and put the RMB at their center. In addition, the Chinese authorities are developing a reserve diversification strategy where an increasingly larger share of their reserves are being invested in commodity currencies and real assets. In other words, China is already adopting a multiple reserve currency approach where currencies such as the Australian dollar, the Brazilian real or the Japanese yen are important elements. However, none of this is enough justification to keep the RMB pegged to the USD. An important negative side effect is that it suppresses market signals, and thus delays the adjustment in an economy that should be rebalancing faster towards domestic demand.
The policy debate in the euro area is complex, and dangerously mixes the requirements of near term crisis management with the need for longer term reforms. The EUR has evolved into a solid reserve currency, with a significant increase in the share of total foreign exchange reserves, but the lack of clarity about the institutional framework is creating serious doubts among investors. European policy makers have understood that the crisis had a strong structural component, and that demand management will not be enough. But the politics of institutional reform are difficult and the lack of market savvy across key political players is turning out to be a very costly drawback.
Overall, the outlook for currencies and the post crisis monetary and financial system remain uncertain as the different players continue to focus their efforts on mostly non cooperative solutions that address their near term domestic political needs. Much more effort is necessary in order to arrive at a cooperative solution where the burden of adjustment is shared among the key players.