That’s our takeaway from Credit Suisse’s 12-page report on quantitative easing and currencies.
That relationship having been much publicised of late, with the idea of the UK or US quantitatively “printing money” to escape the credit crunch and causing Zimbabwe-style inflation, seeping into the main-stream media. That’s partly the aim — to inflate your way out of debt and potentially provide a much-needed jump start for the economy. But QE also helps support asset prices and get banks lending by basically flooding the system with liquidity.
Credit Suisse’s Sean Shepley explains:
We believe the reason policymakers are engaging in unconventional monetary policy is that a breakdown in the financial system can very rapidly turn an economic downturn into a powerful debt deflation. In the 1930s, policy choices failed to correct these forces early enough, resulting in a massive destruction of wealth and bank deposits, greatly lengthening the time required for recovery along with the associated costs to the economy.
Although the transmission of today’s shock is very different from the 1930s, the basic concept of a breakdown in the credit mechanism that leaves exposed an indebted economic structure is the same. Left to its own devices, the market ‘clears’ via massive destruction of wealth and a collapse in prices. To prevent this, policymakers must expand monetary creation and replace debt-financing structures where these are broken.
But — QE doesn’t automatically mean a weaker currency, according to CS. There are other things going on. For instance, countries like the UK, US and Australia, with their relatively high dependence on debt portfolio inflows (see table below), may be more at risk of weakened currencies at times like these.
From CS:
Increased competition for debt finance at a time of reduced capital availability and falling interest rates in these economies leave them more exposed to a failure to roll maturing issues. This acts as a structural source of weakness for these countries even without the adoption of unconventional policy measures…
The combination of a large banking system and a Balance of Payments structured around debt inflows explains much of the GBP depreciation without anything more required than the discussion of QE, in our view.
Hence, Credit Suisse thinks focusing solely on the monetary base in periods of quantitative easing is misleading — there are a lot of other factors that could affect currency movements floating (ha) around. It also ignores the fact, as above, that in times of risk aversion there’s increased demand for cash, banks start hoarding and the money multiplier breaks down. In this sort of environment, cash is king and QE-caused weaker currencies won’t happen until that’s reversed:
One conclusion we draw is that expected returns on other financial assets need to begin improving before the effects of quantitative easing on a currency are likely to become significant. This is particularly the case for the dollar, whose role as a ‘capital currency’ means that foreign holders of funded dollar assets become increasingly short dollars as their assets are written down, thereby creating a natural demand for the currency during a period of deleveraging.
Here then, are CS’s conclusions for individual currencies:
EUR: QE is difficult for the euro area, an institutional weakness that has also caused sovereign spreads to widen sharply. Although difficult, it is not impossible, in our view. We believe a resolution of these concerns would be a structural positive for the euro’s role as a reserve currency. Although it would not improve the weak macro backdrop, we think it would allow the euro to participate in a new round of generalized dollar weakness.
CHF: The SNB has indicated its willingness to use QE and has explicitly mentioned FX intervention as a means to achieve its objectives. We suspect that unlimited intervention is unlikely and that intervention is more likely to be used to offset CHF strength than cause weakness.
JPY: QE’s implementation was unsuccessful earlier in the decade and the BoJ is very reluctant to allow rates to return to zero. Following the Fed’s lead, it is now starting to try to improve domestic credit mechanisms, but remains hampered by residual weaknesses in the domestic financial system and appears unwilling at this point to seek to resolve them aggressively. JPY strength through deleveraging comes from its net international surplus of foreign assets. A continuation into accelerated QE elsewhere is possible if monetary expansion proves hard to control.
USD: The early stages of QE haven’t hurt the dollar because deleveraging has increased foreign demand to buy back dollars previously used to fund the accumulation of USD assets, which have now fallen in value. At the same time, the destruction of wealth leads to increased domestic money demand to preserve capital. We expect these forces to wane through the year and for the dollar to weaken as QE is expanded.
GBP: The pound has weakened sharply in anticipation of QE. A Balance of Payments structure that relied on debt inflows to permit a combination of elevated consumption and accumulation of leveraged foreign assets helped create an ‘international ALM mismatch’ that has now been exposed. Even at current valuations, we think GBP is vulnerable to QE because attempting to underpin a leveraged national balance sheet through sovereign debt expansion is inherently unstable given the threat of domestic capital flight. By contrast, GBP could benefit from successful US implementation of a bad bank plan that underpins broad asset price expectations.
The bank’s read-through for Great Britain, incidentally, is:
This means that while the US is still master of its own destiny, in the UK, QE is insufficient to fix the problem.
Related links:
Preparing for QE failure – FT Alphaville
We can collapse our own currency, thank you very much – FT Alphaville