G20: Accommodating America

new risk

This is a unusual time.  The US has often played a leading role in shaping the global financial architecture.  As a result of last year’s election, the US appears to be defecting from that global system that it helped build, while others, who often seem to chafe under US leadership, are defending it.  

The G20 finance ministers and central bankers meet at the end of next week.  It is the first such meeting for the new US Treasury Secretary Mnuchin, who according to press reports, is struggling to put together his senior team.  Nevertheless, An early draft of the statement has been leaked to the news wires.  There are clear signs that some accommodation is being made to the new US administration.  There are three areas that draw our attention.

First, the draft statement drops the pledge to resist protectionism.  It still endorses “open and fair” international trade, and reaffirms the commitment to reducing the excessive imbalance.

Second, the statement issued last summer called for countries to refrain from competitive devaluations and not use the foreign exchange for competitive purposes.  This is what we have compared with an arms control agreement.  This was dropped in the draft statement, and replaced by “affirming previous foreign exchange commitments.”   It may be a shorthand for the draft.  It will be interesting to see how this evolves in future drafts, and of course, in the final statement.

Third, the G20 do not just call for markets to determine foreign exchange rates, but also argues against excess volatility.  This reference also appears to have been dropped in the draft.

The draft statement is often managed by the host country, in this case, German.  It is not clear how much the US participated in shaping the draft and how much the Sherpas tried anticipating the US administration’s position.

The side meetings around the G20 meeting are often as important, if not more important than the overall meeting.  The difference this time is 1) the new US Treasury Secretary and the need for many to get a better sense of the US administration beyond the rhetoric, and 2) the increased US focus on Germany.  To this end, consider that on March 14, a day before the FOMC meeting and Dutch elections, German Chancellor Merkel meets with US President Trump in Washington.  On March 16, German Finance Minister Schaeuble meets US Treasury Secretary Mnuchin in Germany.

The head of the new US National Trade Council Navarro has called for bilateral negotiations with Germany on reducing the US bilateral trade deficit.  He has complained that Germany was exploiting “a grossly undervalued” euro to take advantage of the US (and others).  That this assessment irks German officials is evident by their vehement denials.

Germany offered a technical defense for rebuffing Navarro’s call for negotiations.  Germany argued that under EU rules, the European Commission handles trade policy and the ECB is responsible for currency policy.   There is substantive defense Germany could offer in addition.  The US-German trade balance is improving already.  The rolling 12-month US merchandise deficit bottomed in July 2015 at a monthly average of $6.34 bln.  By January 2017, the 12-month average had fallen by 15% to $5.43 bln.

It is true that the euro is undervalued by most measures.  The OECD’s measure of purchasing power parity estimates the euro to nearly 27% undervalued.  That is significant.  However, the euro was overvalued by from 2004 through most of 2014.  Purchasing power parity is the level currencies gravitate around in the long-run according to economists, not in the short-run.  The deviation from fair value can be largely explained in cyclical terms, not manipulation.

Some German officials, including the Bundesbank, have argued against many of the unorthodox measures of the European Central Bank.  Germany will like a less accommodative ECB and a stronger euro.  However, nearly the rest of the EMU want the easy monetary policy.  Perhaps it is not adequately appreciated, but Germany’s record demonstrates that its companies can compete with a stronger euro.  In 2008, when the OCE’s measure of the euro’s PPP peaked (more than 20% overvalued), Germany recorded an average monthly trade surplus with the US of $3.675 bln.  Many other countries in the EMU would struggle under a stronger euro.

The strong dollar is not just a function of the weak euro.  It is also partly a function of US monetary policy.  The Fed is raising rates.  The ECB is still engaged in unorthodox monetary policy, even if the downside risks have eased and the threat of deflation has subsided.  Over the past year, the US two-year yield is up nearly 50 bp, while the German yield is off almost 35 bp.

Navarro complained about the German companies’ ability to claim VAT rebate for exports.  He says it is unfair.  Yet it was ruled as fair by the WTO, which is the arbiter of fairness when it comes to trade. The risk is that some US officials want to be both the judge and the jury, or they will not be subject to the WTO rulings.  Lastly, Navarro argues that these trade issues are a matter of national security.  Such claims may reinforce the idea that the new US administration is weaponizing trade.

The bottom line is that the G20 will have to accommodate the Trump Administration without abandoning the main principles and best practices that have evolved (and continue to evolve).  When Japan’s Abe was elected several years ago, the G7 were concerned that his government would seek competitive advantage in the currency market.  They made Abe sign a new agreement and commitment.  It may be too much to expect such a formal response to Trump’s initiatives, but don’t look for a capitulation either.