Cheap currency, inflation, economy - UK's case

The UK is diving into stagflation - Is that so?

The UK's GDP unexpectedly shrank 0.5% in the last quarter, the first-time decline in five quarters since the Lehman crisis in the third quarter of 2009. The hardest hit was the construction sector which decreased 3.3% from the previous quarter, followed by the service sector which lost 0.5%. What caused it? According to the ONS,

The change in GDP in Q4 was clearly affected by the extremely bad weather in December last year. The disruption caused by the bad weather in December is likely to have contributed to most of the 0.5 per cent decline.

So, it's the bad weather to be blamed. Along with it, they also admit that

if there had been no disruption, GDP would be showing a flattish picture rather than declining by 0.5 per cent.

GDP wouldn't grow at all in the fourth quarter last year even without the bad weather.

Meanwhile, a cheap currency has contributed to the rise of the UK's inflation. In real terms, sterling fell more than 20% in four years, now one of the cheapest among major currencies. It's no doubt that weak sterling has pushed up the inflation rate through imports, and helped survive manufacturing industry in the midst of crisis which hit the UK's once-touted financial sector the hardest.

The problem is: Is a cheap currency enough to help float the UK economy?

Given the current trend of declining manufacturing and surging services in the UK economy, it's an open question whether a weak currency keeps on underpinning the economy through exports, ignoring rising inflation.

Decoupling of stock markets

It looks like Asia (Asia ex-Japan, of course) has been heading into a cycle of rate hike these days. The Bank of Korea, South Korea's central bank, raised its policy interest rate last week by 25bp to 2.75%, third rate hike since last year. In the same week, the Bank of Thailand, Thailand's central bank, also tightened monetary policy by venturing into the fourth increase of its benchmark interest rate by 25bp to 2.25% in a year.

What everybody is now watching very closely is, however, China, the second largest economy in the world. The country raised its reserve requirement ratio by 50bp last week, the seventh in a year. Fear of economic slowdown due to the rate hike dived the Shanghai composite, a benchmark index of China's stock, to a nearly three-month low of 2677.65 on Thursday.

Will China's economy slow down so soon this year? At least for now, it seems that the world markets read it as only China's problem, not themselves.

First, let's look at how China is big in the current world economy. China's contribution to the world growth has been increasing dramatically for the last ten years. Though it plunged in 2008 because of the recession after the Lehman crisis, the country's growth amounted one-third of the world growth in the same year. In addition, China's economy GREW more than 9% in 2009, whereas the world economy LOST 2%. It appears that China is now a sole locomotive driving the global economy.

Nonetheless, the world stock markets haven't responded to the decline of China's stock.

In fact, the S&P500 gained 6% since early December, while the Shanghai composite declined 5% in the same period. Does this mean a "decoupling" of China from outside world? Given that China's stock market is intrinsically different from other markets in the sense that it's driven more by politics than economics, it seems that a contrasting move of stock markets between two countries isn't surprising at all.

I have no definitive answer yet to why the world isn't responding to China's stock market slump, even though China's influence in the global economy is increasing exponentially. More time is needed to scrutinize it.

From deflation to inflation?

The world has recently seen rising prices which are not only a concern for economic stability but also causing deadly riots in North Africa, where Tunisia's Ben Ali was forced into exile after 23 years in dictatorship.

Inflation has been creeping into advanced nations, too. The UK's consumer price index in December increased 3.7% from the previous year, the highest since April 2010. The largest contributor to December's rise was transport which claimed nearly 30% of total increase. Food was the second largest contributor, and restaurants the third.

Likewise, Germany's Harmonised Index of Consumer Prices (HICP) rose 1.9% in December, the biggest since October 2008. About 40% of rise came from energy, which was the largest contributor to nearly two-year high. Traffic and food followed.

Meanwhile, the US is also feeling the rise of inflation, albeit very slowly, even though deflation was perceived as the biggest risk for a little while back. A 1.5% growth of CPI in December is lower than the UK and Germany, but it's the highest in 8 months, nonetheless. Transportation was the largest driver of the increase, beating medical care and food and beverages.

The common factor behind the latest inflation in those three countries is the rise of energy and food price. Transportation is the prime sector that passes through soaring energy costs on fares. Restaurants are also vulnerable to the swing of food prices, and have little choice but to raise retail prices in face of escalating food prices.

The fear of inflation is gradually appearing on a radar screen of European authorities' mind. In the recent interview, ECB President Jean-Claude Trichet brought inflation fighting back to the agenda.

European Central Bank President Jean-Claude Trichet said policy makers are monitoring price developments "very closely" after euro-area inflation breached the ECB's limit in December, Germany's Bild newspaper reported.

"We are always concerned if inflation rises and are following developments very closely," Trichet told the newspaper in an interview. "But the figures for December can be accounted for, above all, by rising energy prices."

Reuters poll indicates that some analysts are anticipating the Bank of England's rate hike in as early as the third quarter of this year, though a majority forecasts a rise in the fourth quarter.

This is all happening when economic activity around the world is still and will be fragile for a while, at least this year. It should be dubious that inflation persists with considerable resources still in slack mode, but the world might have to recall how to tackle and tame stagflation in the 1970's.

Why Japan buys euro bonds?

The news that Japan is going to buy eurozone bonds has so far had little to solve the problems facing the eurozone countries, though the euro gained a little bit and the eurozone peripheral bonds also climbed a bit in favor of the news.

Japan will purchase euro zone bonds to bolster confidence in the European Financial Stability Facility as the euro zone struggles with a prolonged debt crisis, Japan's finance minister said on Tuesday, boosting the euro.

Tokyo is considering buying about 20 percent of euro zone bonds to be jointly issued later this month to raise funds to support Ireland, using euros in its foreign reserves, Finance Minister Yoshihiko Noda told a news conference.

"I think it's appropriate for Japan to purchase a certain amount of bonds to boost confidence in the EFSF and make a contribution as a major country," he said.

China last week reaffirmed a commitment to buying Spanish bonds and last year offered to buy Greek bonds after Athens had to seek an international bailout.

Noda's comments came after Japan's top currency diplomat, Rintaro Tamaki, said on Monday that Tokyo could consider buying euro zone bonds to support the bloc as it struggles with a debt crisis.

Japan's foreign reserves, the world's second-biggest after China's, stood at $1.10 trillion at the end of December last year, after authorities spent 2.1249 trillion yen ($25.69 billion) on currency intervention in the month to Sept. 28, Ministry of Finance data showed on Tuesday.

The euro rose as far as $1.2992 on trading platform EBS from around $1.2925 after Noda's comments, pulling further away from a four-month low hit on Monday, although it later moved back to $1.2961. Against the yen, the euro rose as high as 107.86 yen.

"I don't think these comments change the backdrop for the euro at all," said Todd Elmer, currency strategist for Citi in Singapore.

"Despite the fact that we're seeing this groundswell of international support, it doesn't really change or address the underlying problem and that's not going to change until the European authorities themselves come up with a more comprehensive solution to mitigate the fallout from the debt crisis."

Though Japan's purchase is unlikely to be a comprehensive solution to European problems, the timing of announcement is perfect. The yield spread between German and the eurozone peripheral bonds has been widening again since the start of this year. In fact, the yield of 10-year Spanish government bonds is now around 270bp above that of 10-year German Bunds, the biggest since late November last year.

What made Japan to decide to buy euro bonds? Japan's move is too timely in the midst of widening spreads that it might be a cooperative action to tame the concern for worsening euro crisis between Japan, EU, and probably the US-IMF.

For Japan, purchasing euro bonds has two merits. First, it could diversify from the dollar assets which would lose its values due to the Fed's ultra-loose monetary policy. Second, buying euro would depreciate yen which is now traded at a historically high level against the dollar. Depreciating yen would help exporters revive in the fierce competition against South Korea and China, both of whose currencies are considered to be undervalued.

Likewise, Europe has some merits for Japan's purchase: Japan's money is thought to be "clean" relative to China's, and it could prevent one country (China, for example) from investing too much in euro bonds.

Still, Europe's prospect is so bleak that it's increasingly difficult to find an easy way out from the mess.

Manufacturing is too concentrated in China

It looks like Brazil is gaining an expertise of creating new rhetoric. According to a BBC report, Brazil's Finance minister Guido Mantega stepped up its warning on currency manipulation, saying, "This is a currency war which is turning into a trade war." Mantega went further to express a jittering voice against China's currency, yuan, adding that "China's 'undervalued currency' was also distorting world trade."

As my last post shows, Brazil's concern would be justifiable given the rapid appreciation of its currency, real. In the last two years, real has risen more than 30% in real terms, one of the biggest gains of all. Brazil's exports are only 13% of GDP, but it could still put a considerable pressure on exporters. On the other hand, yuan lost 4.5% of its value despite a double-digit growth of China's economy which has led the country to the world's largest exporter. Who could say that Brazil is overreacting?

China surpassed Germany as the world's largest exporter in 2009, which undervalued yuan probably had huge effects. Then, what is China exporting? Of course, it should be manufactured products. China is making a gigantic effort to be the world's factory, and estimated to replace the US as the world's largest manufacturer in as early as 2010. China's manufacturing claimed mere 1% among the world's total in 1970, one-twenty-fifth of the US. But now it's more than 17%, and close to the US's 20%. This is an amazing concentration of industrial power given not only developed economies but also emerging countries like Brazil and Russia are transforming themselves to service economies.

An important question should then arise: What if China goes bust? China is going to be the world's factory, but what would happen if the world's factory loses its motion and stops producing? It seems that the world has recently forgotten or is afraid to ask about the demise of China's economy, but the risk remains as to the excessive concentration of manufacturing on one country.

Brazil to curb currency speculation

Brazil is set to impose another measure to curb the appreciation of its currency real against the dollar, thus preventing speculative money from flooding into the economy. According to a Bloomberg report,

The new rules have the potential to reduce short positions in the dollar to $10 billion from $16.8 billion in December as banks seek to avoid paying reserve requirements on currency operations, Aldo Mendes, the central bank's director of monetary policy told reporters in Brasilia.

Starting April 4, Brazilian banks will need to deposit in cash at the central bank 60 percent of their short positions in U.S. dollars above $3 billion or their capital base, whichever is smaller. The reserves will not earn interest, Mendes said.

Brazil's move is quite understandable given the recent steep rise of the currency. In fact, according to the BIS, Brazil's real exchange rates have increased 33% in the last two years, the third biggest gain among all 58 countries which the BIS covers in the broad effective exchange rates data.

It's excessively odd that China, the fastest growing economy in the world, has one of the weakest currencies of all.

Food prices and income level

According to the latest report of the Food and Agriculture Organization, UN's organ, food prices jumped to the all-time high in December last year, beating the previous high in June 2008 that "sparked deadly riots from Haiti to Egypt." As the current rise of food prices, coupled with high unemployment, has already provoked riots among Algerian youths, the likelihood is increasing that riots over high living costs spread to other countries. In fact, neighboring Tunisia has seen unrest over unemployment these days, claiming three deaths.

The Food Price Index compiled by the FAO started at the initial value of 110.3 in 1990. From then on, the index has gained more than 100% and hit 214.7 last month, surpassing the previous all-time high of 213.5 in June 2008. But the recession after the Lehman crisis plunged the index to a 22-month low of 139.0 in February 2009. It means that the latest figure has climbed more than 50% since a 22-month low in February 2009 and reached the new high in the same 22 months.

Setting the value in February 2009 at 100, two groups can be observed in the composition of the index. First, sugar has risen the most among five categories since February 2009, and oils and dairy follow. Sugar and oils are gaining more than 100% in nearly two years. On the other hand, cereals and meat have increased only around 30%, though the former rose starkly after losing nearly 15% in June last year.

What's interesting is the relation between consumer price index by country income and food prices. First, if looking at a level of consumer price index and food prices, all countries, irrespective of income levels, have recently strengthened the relationship between them. In fact, every income-level country, high, middle, and low, has more than 0.9 of correlation coefficient in 2000 to 2009, while a negative coefficient is observed in all three in 1991 to 1999.

However, if looking at the correlation between the growth rate of consumer price index and food prices, a different picture arises. The most striking is that the CPI growth rate of high income countries has increased its correlation with that of food prices in the recent decade. In fact, the correlation coefficient of high income countries has jumped from 0.11 in 1991 to 1999 to 0.72 in 2000 to 2009.

It's not clear why the correlation is going up in high income countries. It would be against the intuition that food has a larger part in low-income countries, which is expected to lead to a higher correlation in low income countries. It would, at least, mean that commodities including food have recently pushed overall prices higher in high income countries, although correlation has no clue on which leads which.