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Paola Subacchi -- In the world of currencies, wait-and-see is the best action

Propping up economic growth without undermining financial stability has kept policy makers around the world busy since the beginning of the year. The global economy lacks luster and is expected to grow at a relatively modest rate. The IMF forecasts 3.2% real gross domestic product growth this year, a bit better than the 3.1% in 2015 -- the lowest rate since 2009. The slowdown in China's growth is having a global impact, both on advanced economies and emerging markets. In the U.S., business investment and net exports remain sluggish, reflecting weaker external demand, and growth has been driven mainly by consumer spending and housing activity.

Europe has been on hold for weeks while companies and investors have been waiting to see the outcome of the referendum on Britain's membership of the European Union. As a result, the U.K. economy is expected to slow down sharply this year. In its report on the U.K. published on June 17, the IMF says it expects real GDP to grow by 1.9% this year -- down from 2.3% in 2015. In the euro area, even if underlying growth prospects have improved, low growth and/or high unemployment in southern countries (notably Italy) continues to act as a drag. Real GDP is expected to grow at around 1.5-1.6%; the rate was 1.6% in 2015.

As for Japan, growth and inflation remain elusive. The economy is expected to grow at around 0.5-0.7% this year, as in 2015. The policy of negative interest rates and large purchases of long-dated sovereign bonds that the Bank of Japan embraced at the end of January in order to hit its inflation target, after the initial impact on the yen and the rise in equities, seems to have exhausted its effect. Inflation expectations are currently very depressed. Inflation is stuck at around zero, while forward inflation is priced to be below core inflation. In the meantime, the yen has appreciated by 16% since early February, outstripping all other Asian currencies and putting further downward pressure on inflation expectations and raising the probability of more monetary stimulus in coming months.

Abenomics effects

Does the yen's strength cause problems with Abenomics, the integrated approach to monetary, fiscal and supply-side policies that Prime Minister Shinzo Abe unveiled and then implemented in 2013?

In its original formulation Abenomics should have used ultra-accommodative monetary policy to stimulate the economy -- and in particular consumer demand -- and put consumer prices back on a trend of moderate growth. Stronger growth and higher inflation would have helped rein in public spending and eventually reverse the expansion of the very large public debt -- currently almost 250% of GDP. Instead, inflation expectations remain entrenched while economic activity continues to be sluggish. The strength of the yen further complicates an already difficult situation as it depresses growth prospects and consumer prices.

As monetary policy seems to have reached its limits and an expansionary fiscal policy remains problematic, would intervention to weaken the yen be an advisable course of action? So far the Japanese government has stayed away from yen intervention, allegedly to avoid stir up volatility in the global economy and adversely affect the currency market. But this is only part of the story. The reality is that market interventions risk being self-defeating in the current context. The yen has become a safe haven because of political uncertainty in both America and Europe. Currency intervention would thus mean going against the current market sentiment; therefore it would need to be large, well-funded and sustained without any ex ante guarantee of success. Furthermore it will have an adverse impact on the yuan, with the risk of sparking a "currency war" in Asia.

Managing the exchange rate through currency interventions is a key feature of China's economic policy even if the renminbi has become a more flexible currency with, in theory, less scope for intervention. However, among the currencies that form the IMF SDR basket -- the renminbi was admitted at the end of 2015 -- the Chinese currency is the only one that is actively managed although with a higher degree of flexibility. For the People's Bank of China, China's central bank, currency stability is a critical feature of a key international currency as the renminbi aspires to become. The value of the renminbi is therefore anchored to that of a basket of currencies where both the dollar and the yen feature.

The Chinese monetary authorities are concerned about the possible risks to domestic financial stability that can arise from currency volatility. Surely they do not want to see a rerun of what happened in August 2015 even if, with approximately 3.20 trillion dollars in reserves, they are in a strong position to continue to intervene in the currency market and support the currency, if necessary. At the same time, they can still use monetary policy to weaken the renminbi should they need to ensure that China's exports stay competitive. China is also finding difficult to manage economic growth while it is rebalancing its economy, juggling with excess capacity and addressing vulnerabilities in its financial system.

Against this background there isn't much Japanese policymakers can do to avoid the adverse impact of the yen appreciation on both growth and inflation. Wait and see seems the best course of action at the moment. Too many uncertainties are clouding the economic and political outlook and the risks of embracing the wrong policy and triggering adverse effects are difficult to assess. Besides the political events -- notably the U.S. election -- economic indicators, in particular the fact that the U.S. activity is expanding at a trend place, suggest that the long-term value for the dollar is currently too low and a dollar "normalization" may not be too far way.

Paola Subacchi is director of economic research at Chatham House (the Royal Institute of International Affairs) in London.

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