Signalling cycle as explanatory of the financial crisis



Why G20 Summits should begin to signal a managed exchange rate regime to control the financial crisis.

Patrick McNutt



Abstract: If it is unlikely that China moves first on its exchange rate to revalue to allow more imports and help in the fight to control domestic inflation then will the US move on a real depreciation of the US dollar to realise a long-term economic growth through a reliance on export growth. Who will prevail as the US needs to export more and China needs to fight inflation? It may require a G20 initiative on managing exchange rates as global imbalances continue to hamper a world economic recovery.

Background

Developing ideas introduced initially at an Union Bancaire Privee (UBP) hosted Hedge Fund Conference in Geneva, May 28-29 2008 and developed later on live interview discussion with Martin Koong on cnbc Asia Squawk Box October 23 2008, and at Alumni events at Singapore and Hong Kong in October 2008, in this presentation Professor Patrick McNutt of Patrick McNutt & Associates, Dublin, and Visiting Fellow at Manchester Business School, elaborates further on the need for a managed exchange rate regime as an agenda item at the G20 Summit meetings during 2009 and into 2010.

$$ Game On: China and US

In the Financial Times Letters in July 2009, Patrick had suggested that the issue of exchange rate volatility should be part of a coordinated solution to our world financial crisis Commentary on the financial crisis seldom addresses the significance of exchange rate volatility. But it may change soon. Both the WTO and the World Bank have warned about the rise in protectionism. China continues to hold firm in its belief that currency issues should be discussed at the world meetings; at London in April 2009, Italy, July and Pittsburg September 2009. In the interim, China and US are in a non cooperative signalling game and we can observe the signals from both sides on the role of the US$. Check the critical time line chart accompanying this presentation and also available on .

Note: China has signalled that fighting inflation is a number one priority and People’s Bank of China (PBOC) has signalled this during 2009 and followed with action on reserve requirements. They are a key policy tool at PBOC in reaction to problems from the exchange rates. China has in effect a quasi-fixed exchange rate with US dollar and this compromises their ability to use monetary policy like interest rates to control inflation. Any rise in Chinese rates could lead to significant capital inflows putting more upward pressure on China’s currency.

The history point in this China-US game, the start point, began with by the comment from Chinese central bank Governor, Zhou Xiachuan, on Monday 23rd March 2009 ahead of G20 meetings in London. The comment was a signal on the role of the US dollar as reserve currency. During 2009 China and the US are reacting to each other’s signal as players in a classic non cooperative game. In such a game, the Prisoners’ dilemma solution is inefficient in the sense that the world economy would potentially be better off by a coordinated equilibrium. As the value of US dollar reserves fluctuate, big holders of dollar reserves may switch to (say) the Euro - already fluctuating in a signalling cycle - and the dollar could be replaced as the world’s main reserve currency unit over the next few years

Signalling Cycle

During 2008, Patrick argued then that a signalling cycle may have begun March 12th 2007 with the suspension of shares in New Century Financial Corp., subsequent filing for Chapter 11 bankruptcy protection. Panic ensued as the SEC investigated some Bear Sterns’ hedge funds in the summer of 2007 and asymmetry in information spread through the financial markets as the international financial community observed ‘nationalisation’ and the socialisation of banks losses becoming the norm in 2008 and 2009. The year 2007 was time period t, the beginning of a cycle in which the IMF predicts a global growth rate falling to 0.5% in 2009 - lowest level in sixty years [ 5% in 2007] – in which corporate earnings fall below target because of exchange rate exposure and in which the socialising of world bank’s losses has raised the spectre of more government and beggar-my-neighbour protectionist policies.

When will it end?

When will it end? We need to find time period t+1. Time period t+1, a possible end date to this cycle can only be assessed in terms of two catalysts viz (i) a paradigm shift in macroeconomics with less of a reliance on consumption as the determinant of GDP growth but more of an emphasis on exports and FDI and (ii) understanding of a signalling cycle. In term of the former, Patrick notes that in the past across many economies consumption (domestic demand) and exports increasingly explained GDP growth but today ASLEEP economics {acronym: Asia, Latin America, Eastern Europe and the Pacific Rim} have expanded in terms of their macroeconomic significance to the world economy. As they decouple themselves from the US and to a lesser extent the EU, the ASLEEP economies will account for 30% of world exports and 50% of world growth by 2011.

Why manage exchange rates?

At this crucial time in the world economy Patrick is advocating the importance of understanding a paradigm shift in economics, a shift away from the inbuilt Keynesian taxonomy that underpins the econometric models of policymakers. There is a greater emphasis on signalling = a world economy where financial and economic variables relate to different periods of time and acquire links with the past and the future. Consequently an economic system becomes dynamic: interest rates, inflation rates, and growth rates oscillate around some particular level but in the evolving cycle either demand drives income or output drives demand.

He argues that in a signalling cycle output drives demand as equilibrium prices fall as demand becomes more elastic. Traditionally, expenditures increases and household debt matches the government surplus. But in a signalling cycle output cycles can be influenced by exchange rate movements. Output is curtailed and companies restructure to minimise operating losses. Household income falls. The exchange rate is the one variable in the new paradigm that should be managed for a period of time. Devaluation encourages more exports while a revaluation can encourage domestic demand if domestic prices remain low due to lower (imported) supply costs. Corporate earnings today are global and thus are more intricately linked to exchange rate fluctuations.

In terms of a signalling cycle, for example devaluation can be triggered by interest rates and once this becomes common knowledge exchange rates begin to move. Corporations are posting earnings losses. Apart from falling domestic demand, exchange rate are influencing profits. For example, the FT has predicted that for every 1Yen rise against the Euro, Sony’s operating profits will fall by Yen 7.5b. This requires of global companies to restructure in order to balance the exchange rate induced operating losses, and thus exacerbating the signalling cycle.

Beggar-my-neighbour policies

There is a danger that national governments may trigger beggar-my-neighbour policies (for example, devaluation) and FX signals are based on the beggar-thy-neighbour outcome of the signalling game; in other words, we can all easily observe that any outcome via a weak/strong US dollar has led to an increase/decrease in US export competitiveness. But how far will the dollar fall/rise? The answer: until a point of equilibrium (Nash Equilibrium) can be achieved - as explained in the slideshow. Such an equilibrium, can be expressed in terms of the best outcome that the (say) US Fed can hope to obtain given the likely reaction of the ECB and of the BoE or the Bank of Japan or China..

Working on the assumption that a trade deficit of 2% of US GDP is sustainable for the dollar as a reserve currency then a falling dollar can help to restore the US trade deficit to that sustainable level. That in part is what is happening during 2009-2009 as the dollar fluctuates. However, if the US trade deficit currently stands at approx 6.5%, so working some back-of-the-envelope numbers, McNutt argues that reaching a sustainable level of US trade deficit may require a dollar fall against Sterling to within the $2.20-$2.40 range in 2008-2011 in the absence of managed exchange rates. The last time that happened was when Harold Wilson was PM in the late 1960s.

Escape clauses and ‘what ifs’?

Alternatively, he continues to advocate the option first addressed in 2008, of a coordinated equilibrium, a managed exchange rates regime across the Euro, Sterling, US $, Yen and the Chinese Yuan. That is, a possible pegging of FX rates similar to the Louvre Accord and Paris Accord in late 1980s when the issue back then was a weak dollar and a strong Yen. In early 2009 the FX noise is in terms of a weakening US dollar and a strong Euro, weakening Sterling and constant Chinese Yuan. With a managed exchange rate escape clauses are necessary to ensure that governments will still be able to set interest rates and national money supply.

But the ‘what ifs’ include: what if ASLEEP and EMs economies substitute export-led growth by growth in domestic government expenditures? What if the ASLEEP economies continue to recycle funds into Euros to trade, and thus strengthening the Euro, and undermining national competitiveness in Euroland? What if China imports less US exports? What if the US adopts a protectionist beggar-my-neighbour economic policy? What about the PBOC signals on fighting domestic inflation in China.

Conclusion

A recognition that the world economy is in a signalling cycle can in and of itself help to correct it as the international investment community begin to react to information and not to idiosyncratic noise. A managed exchange rate regime should be signalled to avert an escalation of the world financial crisis. The period for management should also be signalled: suggestion of a period from 2009 to 2011, a two-year period to coincide with world corporate and banking mergers and consolidations that will evolve out of the socialising of banks’ losses – allowing banks time to earn to repay preference dividends to Uncle Sam and raising capital, and thus lending again - and settle so that the world does have truly global banks and not regional banks selling global products and services.

A wider perspective on the emergence of a new international economic order in the 21st century focusing on the redistribution of world resources and world trade and income to ASLEEP economies, will then have to be embraced for future world prosperity and growth..

If it is unlikely that China moves first on its exchange rate to revalue to allow more imports and help in the fight to control domestic inflation then will the US move on a real depreciation of the US dollar to realise a long-term economic growth through a reliance on export growth. Who will prevail as the US needs to export more and China needs to fight inflation? It may require a G20 initiative on managing exchange rates as global imbalances continue to hamper a world economic recovery.

Abridged@ Sept 2009: Ends © Patrick McNutt

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