MacroScope

The financial turmoil still dogging Europe is most often described as a debt crisis. But sovereign debt is only part of the problem, according to new research from Jay Shambaugh, economist at Georgetown’s McDonough School of Business. The other two prongs of what he describes as three coexisting crises are the region’s troubled banks and the prospect of an imminent recession.

These problems are mutually reinforcing, and require a more forceful policy response than the authorities have delivered to date. In particular, Shambaugh advocates using tax policy to lower labor costs, fiscal stimulus from those economies strong enough to afford it, and more aggressive action from the European Central Bank:

It is possible that coordinated shifts in payroll and consumption taxes could aid the painful process of internal devaluation. The EFSF could be used to capitalize banks and to help break the sovereign / bank link. Fiscal support in core countries could help spur growth.  Finally, the ECB could provide liquidity to sovereigns and increase nominal GDP growth as well as allow slightly faster inflation to facilitate deleveraging and relative price adjustments across regions.

All these steps, especially if taken together in an attempt to treat the three crises holistically could substantially improve outcomes. At the same time, institutional reforms to create a true financial union and a common risk free asset could help both solve the current problems and reduce the connections of these crises in the future.  Of course, politics, ideology, or additional economic shocks could all hinder improvement.  The euro area is highly vulnerable and without deft policy may continue in crisis for a considerable amount of time.

Maybe it never went away at all. But if the war was dormant, Brazilian President Dilma Rousseff certainly launched what appeared to be an opening salvo for a new round of battles – rhetorical ones for now.

Rousseff reached for some cataclysmic language to describe the recent appreciation of the real, which Brazil worries will crimp exports and hurt the domestic economy. The culprit, according to Rousseff, is an irresponsible “monetary tsunami” resulting from the ultra-loose monetary policies of rich nations like the United States.

Alonso Soto and Tiago Pariz offer some background in this Reuters article out of Brasilia:

China’s importance to the global economy makes it difficult to believe the role of the yuan in foreign exchange will not continue to expand. Will that dominance advance sufficiently to make the Chinese renminbi one of the world’s reserve currencies? A new study from the Brookings Institution suggests that in the long run, the ascendance of the yuan to reserve-currency standing is likely. It notes that of the six largest economies in the world, China is the only one whose currency does not have reserve status. But the road to getting there will be long and tortuous, the study warns, and there will be plenty of potholes.

Getting there will require overcoming two main challenges, according to Eswar Prasad and Lei Ye, who authored the report:

Sequencing of capital account opening with other policies, such as exchange rate flexibility and financial market development, to improve the cost/benefit trade-off.

Currency analysts are divided over whether U.S. criticism of Japan’s forex policy will change Tokyo’s currency stance. While some say it could raise the hurdle for further Japanese intervention, others think it might not have much impact. Rob Ryan, FX strategist at BNP Paribas in Singapore says the effect will be limited given uncertainty about the Japanese economy’s outlook and current levels of dollar/yen and cross/yen pairs.

“I think if they (Japanese authorities) feel they have to intervene, they will intervene,” Ryan says, adding that a dollar drop down to the “low 76s” might be enough to prompt further action from Japan.

The U.S. Treasury Department said in its semi-annual report on international exchange rate policies issued on Tuesday that the U.S. did not support Japan’s recent bouts of solo FX intervention, adding that they took place when volatility in dollar/yen was relatively low. USD/JPY was currently trading at Y77.98, not too far from a record low of Y75.311 hit on Oct. 31, when Japan conducted massive yen-selling intervention.

This time it was going to be different. A make-or-break, comprehensive, grand, “bazooka” solution would draw a line under the euro zone debt crisis.

But the plan agreed by all EU states except Britain to pursue stricter budget rules and a stronger fiscal union did little to soothe bond markets. Ten-year Italian yields rose as far as 6.8 percent, prompting the European Central Bank to intervene in the secondary market, and German Bunds rose more than 100 ticks on the day.

Among the short-falls, the capacity of the euro zone’s bailout fund was capped and it was not granted a banking license. For now, this puts more pressure on the European Central Bank to help contain the crisis by stepping up bond-purchases. The bank however has repeatedly resisted a bigger crisis-fighting role and last week dampened expectations that it could ramp up a program which has tried to keep borrowing costs affordable. The legal basis of a new accord to enforce debt and deficit rules also still needs to be worked out.

A sharp recent drop in the Fed’s holdings of U.S. Treasuries for foreign central banks probably reflects the effort by many developing economies to stem rapid declines in their currencies, not some frightening move by the likes of China out of U.S. bonds. That’s the argument put forth by Marc Chandler at Brown Brothers Harriman, who notes the pullback of recent weeks appears to have been the most dramatic since the Asian financial crisis of the late 1990s.

His reasoning makes sense: a September spike in the U.S. dollar was accompanied by steep plunges in the exchange rates of many emerging economies. Still, Chandler remains puzzled as to why the selling accelerated to a hefty $21 billion even as the dollar reversed course in the last week:

This is the seventh consecutive weekly decline and over this period, custody holdings have fallen an average of about $12-$12.5 billion a week, making this past week quite large relative to trend. It likely reflects foreign central banks’ selling of Treasuries to intervene to support their currencies rather than a dumping of Treasuries to diversify reserves or as a protest to such low interest rates.

Mexico Central Bank Governor Agustin Carstens spoke to Reuters Insider on the sidelines of this year’s IMF/G20 meetings. He said the peso, which like many other emerging market currencies has taken a drubbing with the dollar’s recent rally, is undervalued. But unlike in Brazil, where an even more volatile exchange rate has prompted the monetary authorities to step in, Carstens said Mexico does not see the need to intervene.

As long as the markets continue to work well, I think central bank intervention is not required. If we guide ourselves by fundamentals the peso should appreciate soon.

Asked about the path of monetary policy for Mexico, Carstens said he backs a “neutral” stance for now given all the uncertainty in the global economy. Until recently, analysts were betting the central bank would lower borrowing costs to offset the drag from a global economic slowdown. But the peso’s steep depreciation, with its potentially inflationary implications, has muddled the outlook for Mexican interest rates, currently at 4.5 percent. Mexico is struggling to recover from a deep recession in 2009, with growth seen below 4 percent this year, and is particularly vulnerable to lower U.S. demand.

Greece is in the danger zone. Even as the country’s finance minister sought to reassure his euro zone counterparts at a meeting in Poland, Greek credit default swaps were pricing in a more than 90 percent chance of default, according to Reuters calculations of Markit data. Economists in a Reuters poll see a 65 percent chance of that happening, probably within a year.

Such fears recently sent jitters across financial markets, prompting some words of comfort from German Chancellor Angela Merkel and French President Nicolas Sarkozy that they are determined to keep Greece in the euro zone. But speculation is growing that Greece will default, and that it will be a messy ordeal. Here are some of the potential dangers if it occurs:

* Greece may be seen as setting a precedent for Portugal and Ireland, analysts said. Yields on peripheral euro zone debt could surge rapidly, making funding costs increasingly unsustainable as yields on Italian and Spanish 10-year bonds surge back towards 7 percent. The ECB could have to intervene more aggressively in the secondary bond market to the detriment of its balance sheet.

Amid the storm of Europe’s sovereign debt crisis, investors have found a safe harbor in the Swiss franc. Attracted by its low levels of inflation and stable debt-to-GDP ratio, traders have pushed Switzerland’s currency up 15 percent against the euro in 2010 and 6 percent so far this year. This has been a boon to the Swiss government’s ability to finance its operations — Switzerland’s 10-year benchmark bond is currently yielding just 1.53% — as well as Swiss tourists, who are enjoying huge discounts on trips abroad thanks to their favorable exchange rate.

Swiss exporters, though, are not so thrilled with the franc’s rally. Nearly half of the Swiss corporate executives that the central bank surveyed earlier this year admitted they “experienced negative effects” due to the currency’s strength. But it’s the chairman of the Swiss National Bank, a former hedge-fund manager named Philipp Hildebrand, who may be come out as the biggest loser from these events. In an effort to contain the franc’s upward climb early last year, Hildebrand spent 147 billion francs — nearly 25% of the country’s GDP — buying mostly euros, U.S. dollars, and British pounds sterling. The central bank reported a book loss of nearly $21 billion last year as the franc continued its ascent.

Now Hildebrand, like his American counterpart Ben Bernanke, is facing heat at home for his unorthodox monetary maneuvers. Reuters Zurich bureau chief Emma Thomasson wrote an illuminating profile of Hildebrand last month that nicely captured his opponents’ gripes.