The impossible trinity

February 216 The impossible trinity China is learning, the hard way, about the impossible trinity. You just cannot have free capital flows, a fixed exchange rate and independent monetary policy all at same time. The People s Bank of China can either continue to run down its currency reserves or allow the yuan to float freely which would give back control of monetary policy to the central bank. A more yuan-friendly option perhaps is to temporarily impose capital controls, at least until investor confidence returns. With its inflation forecasts slated to be revised down yet again, the European Central Bank is poised to add stimulus at its March meeting, something that could weigh on the euro over the near term. The Bank of Japan, also struggling to hit its inflation target, took a page from the ECB s book in January by pushing the deposit rate on excess cash balances held by financial institutions at the central bank into negative territory. Given the above, the USD is in a strong position to add to last year s gains. But we remain hopeful the Fed will be as concerned as we are about the situation. Not only is a strengthening greenback hurting growth and keeping inflation low in the US, but it s also raising risks of disorderly deleveraging in emerging markets considering the massive amount for USD-denominated debt in those economies. The threat of a global financial crisis and recession may be enough to convince the Fed to back down and tone down its tightening bias, something that could help take some steam out of the USD. We have lowered our forecasts for oil prices this year, expecting WTI to hit $ by year-end ($5 previous forecast) and have accordingly downgraded our Canadian GDP growth forecast and C$ targets. Our call for USDCAD to hit 1.36 by year-end hinges not only on rising oil prices but also on a large enough fiscal stimulus from the federal government which would negate the need for the Bank of Canada to cut interest rates. Stéfane Marion/Krishen Rangasamy NBF Currency Outlook* Current 216Q1 216Q2 216Q3 216Q 217Q1 29-Jan-16 USDCAD 1. 1. 1.38 1.38 1.36 1.35 US cents per CAD.72.72.72.73.73.7 EURUSD 1.8 1.7 1.8 1.9 1.1 1.11 USDJPY 122 123 123 12 125 125 AUDUSD.71.71.72.73.7.75 GBPUSD 1.3 1.2 1.3 1. 1.5 1.6 USDCNY 6.58 6.57 6.56 6.55 6.5 6.5 AUDCAD.99.99 1. 1. 1.1 1.1 * forecasts for end of period Source: NBF Economics and Strategy

Fed hindered by slowing economy The Fed s decision to stand pat on monetary policy in January was no surprise. The FOMC s cautious approach is warranted given the massive uncertainty surrounding the outlook for growth and inflation. Besides worries about China and emerging markets in general, there are also concerns at home. The US economy stalled in Q according to the Bureau of Economic Analysis advance estimate of just.7% annualized growth. And not surprisingly, because of the dollar s surge, one of the main sources of drag on the economy was trade. The Q results mirrored the performance of the US economy for 215 as a whole with trade subtracting from growth. U.S.: Trade was the major drag on growth last year Contributions to real GDP growth % 3. 2.5 2. 1..5. -.5-1. Government Real GDP growth Investment Consumption Trade 21 215 Government We expect a similar dynamic for 216 with trade acting as a drag on the economy. The persistence of USD strength had us trim our 216 growth forecast to 2.%, or 2.2% Q/Q (see February s Monthly Economic Monitor). That s lower than the Fed s central tendency forecast of 2.3-2.5% Q/Q growth for 216. Besides the deceleration of the economy, the FOMC will also be concerned about low inflation. The annual core PCE deflator has remained well below the Fed s 2% target for three years in a row and that timeline is likely to be extended due to persistently low wages and a strong dollar. The USD surge is responsible for the fact that import prices are now contracting at the fastest pace since 29. If, as we expect, the Fed finds itself forced to tone down its tightening bias in light of softer growth than it expects and rising threats of disinflation, the USD could struggle this year. U.S.: Strong USD makes it harder for Fed to hit its inflation target 2.5 2. 2.3 2.2 2.1 2. 1.9 1.8 1.7 1.6 1. 1.3 1.2 1.1 1..9 y/y % chg. Core PCE deflator Fed has now failed to hit its inflation target for three straight years Fed target 25 26 27 28 29 21 211 212 213 21 215 Non-petroleum import price index versus Trade-weighted USD Reverse axis 8 y/y % chg. y/y % chg. -2 Import price index, excluding -16 petroleum (L) ECB hints at more stimulus After seeing the worst two-year depreciation on records down 27% versus the USD over 21/15 the euro seems to have found some stability. Consensus-topping economic data has helped the common currency this year, in sharp contrast with disappointing data on the other side of the Atlantic. There are indeed signs the European Central Bank s stimulus is starting to work. Credit channels are slowly being unblocked as evidenced by improving household credit and business loans, the latter even growing on a year-on-year basis for the first time in years. There is also hope that increases in expenditures to address the migrant crisis, e.g. on housing and social services, will provide an extra lift to growth. That said, the Eurozone is not out of the woods. Emerging markets, the Eurozone s main customers, are not growing as much as they used to and that is already hurting the zone s exports. But the ECB will be 7 6 5 3 2 1-1 -2-3 - -5-6 -7-8 and that timeline is about to get longer thanks to the USD s appreciation World: Positive economic surprises in the eurozone Economic surprise indices in OECD 7 6 5 3 2 1-1 -2-3 - -5-6 -7-8 Index Trade-weighted 16 USD (R) 2 25 26 27 28 29 21 211 212 213 21 215 215q1 215q2 215q3 215q 216q1 NBF Economics and Strategy (data via Bloomberg) Eurozone OECD total US -12-8 - 8 12 2

most concerned about not being able to hit its 2% inflation target. The central bank is struggling to assess inflation as evidenced by continuing downgrades to its forecasts. Based on President Draghi s comments in January, odds are there will be another downward revision to inflation forecasts at the March meeting at which time more stimulus could be provided to boost growth and hence prices. The upcoming extra stimulus from the ECB should weigh on the euro over the near term. Longer-term, however, the common currency has room to make a comeback as an improving economy allows the ECB to dial back the extraordinary stimulus it provided. And if, as we expect the USD loses steam, EURUSD could again head past 1.1. Negative interest rates in Japan The Bank of Japan, also struggling to hit its inflation target, took a page from the ECB s book by pushing interest rates into negative territory in January while continuing with its QE program. The deposit rate is now -.1% on excess cash balances held by financial institutions at the central bank. The stimulus has been rebranded as Quantitative and Qualitative Monetary Easing with a Negative Interest rate. By lowering the entire yield curve, the BoJ feels more confident it can achieve the price stability target of 2% at the earliest possible time. While negative for the yen, BoJ stimulus could be blunted if, as we expect, the Fed tones down its tightening bias. We are leaving our endof-year forecast for USDJPY at 125. China and the impossible trinity China has seen better days. The economy grew less than 7% last year, the worst performance in a quarter century. The stock market continues to plunge not just because of anemic growth but also in light of diminished confidence by foreign investors about the future outlook. By the looks of massive capital outflows, it seems foreign investors are not all that confident China s policymakers will be able to properly manage the transition to a services/consumption oriented economy. After all, policy hasn t been reassuring so far, including the yuan s devaluations and then some back pedalling to support the currency, as well as intervention in the stock market. Poor communications with markets haven t helped either. Besides the rebalancing of the economy, China s woes has a lot to do with a very simple concept in Economics called the impossible trinity. It is not possible to have free capital flows, a fixed exchange rate and independent monetary policy all at same time. By opening its borders to foreign investment and keeping a currency peg with the US dollar, China has effectively surrendered monetary policy independence. The massive amounts of capital inflows during the boom years propped up asset prices including real estate. With the latter, and more generally the economy as a whole, now treading water those flows are reversing fast. To prevent the yuan from depreciating in synch with those outflows, the People s Bank of China has two options. Either it sells USD on the market to support the yuan (i.e. run down its currency reserves) or impose capital controls. Neither of those options are sustainable. While China s reserves are large, they are coming down fast they dropped about half a trillion dollars last year alone. As for capital controls, they are the exact opposite of what China is trying to achieve, i.e. integration with global financial markets. China: Dealing with the impossible trinity Fixed exchange rate The impossible trinity Free capital flows Central bankers can pick at most two of the three options Independent monetary policy A third option is to allow the yuan to float freely (i.e. allow a sharp depreciation) which would give back control of monetary policy to the central bank and eliminate the necessity of running down reserves to support the currency. The concern, however, is that left to markets, there is a possibility the yuan could sink too much too fast, thereby hurting confidence in the currency and creating a death spiral. So, what s the PBoC to do? Perhaps it could impose capital controls but make it clear that those are temporary. Not only would that measure stem the yuan s descent and hence severely punish those shorting the currency, but it would also allow China some time to come up with a strategy to address underlying weakness in its economy, e.g. enact capital controls until an ambitious and aggressive 5-year plan is made public in March.. 3.5 3. 2.5 2. 1..5. US$ trillion China s foreign exchange reserves Unless China imposes capital controls, it will continue to see capital outflows, the latter raising the odds it will have to devalue its currency as to restore FX reserves FX reserves (L) US$ trillion y/y change (R) 1985 199 1995 2 25 21 215.6..2. -.2 -. -.6 3

USDCAD FOREX Loonie hobbles back After seemingly spiralling out of control, the Canadian dollar managed to regain its footing thanks in part to the apparent stabilization of oil prices and the Bank of Canada s decision in January not to cut interest rates. For fear of seeing the loonie turn into a deadbeat currency, we had implored the central bank to abstain from cutting interest rates in January see Special Report dated January 18 th : The BoC needs to avoid weakening the CAD further. True, economic growth is weak. But why erode confidence in an already battered currency? And as we asked in the last Forex, why cut interest rates again when you know fiscal stimulus is coming and conditions are already the most stimulative in more than a decade? The Bank of Canada s Monetary Conditions Index a weighted sum of the changes in the short-term interest rate and the exchange rate is indeed at its lowest point in nearly 13 years thanks to the loonie s earlier decline. Canada: Highly stimulative conditions thanks to C$ plunge Monetary Conditions Index (MCI) versus Trade-weighted Canadian dollar (CERI) 8 6 2-2 - -6-8 Index -1 MCI (L) -12 22 2 26 28 21 212 21 NBF Economics and Strategy (data via Bank of Canada) CERI (R) Jan216 average is the lowest in almost 13 years We are glad the Bank of Canada stayed put. While the central bank acknowledged that the decline in commodity prices represented a setback for the Canadian economy it accordingly downgraded its 216 growth forecast to just 1.% (from 2%) it decided to stand pat on monetary policy expressing its confidence about a turnaround in fortunes: The protracted process of reorientation towards nonresource activity is underway, helped by stronger U.S. demand, the lower Canadian dollar, and accommodative monetary and financial conditions. The BoC also made clear its new forecasts did not include the upcoming fiscal measures which it says should be positive for growth. Index 125 12 115 11 15 1 95 9 85 8 75 We have a slightly less optimistic take on Canada s outlook as evidenced by our freshly downgraded 216 growth forecast of just.9% see Special Report dated January 22 nd : Sub-1% growth for Canada. That reflects our lower forecasts for WTI oil prices which we now expect to hit $ by year-end ($5 previous forecast). With lower projections for oil, we have accordingly downgraded our C$ targets. CNDOLL$2 Canadian dollar and oil prices at the end of each year 1.65 1.6 5 1.5 1. 1.35 1.3 1.25 1.2 1.15 1.1 1.5 1. 215 216F 217F.95 1 15 2 25 3 35 5 5 55 6 65 7 75 8 85 9 95 1 WTI oil price US$/barrel But weaker economic growth needs not translate into more monetary stimulus. The major source of expected weakness, namely investment spending, is unlikely to bounce back no matter how many times the BoC cuts interest rates. Investment decisions depend on the outlook for growth and profits which are both dull at best. Moreover, the loonie s slump has made it more expensive for firms to import machinery and equipment, something that will discourage investment particularly with enhanced uncertainties about both the domestic and international outlook. Fiscal policy is arguably the best available option for combatting underlying economic vulnerabilities. Canada needs (and can afford) a more forceful and timely fiscal policy response in the upcoming federal budget. Our call for USDCAD to hit 1.36 by year-end hinges not only on rising oil prices but also on a large enough fiscal stimulus from the federal government which would negate the need for the Bank of Canada to cut interest rates. The major downside risk to our USDCAD forecasts besides oil prices is potential disappointment on the fiscal front, in which case the onus for supporting growth would once again fall squarely back to the central bank. NCLC.1 Previous 217F NBF Economics and Strategy (data via Datastream, NBF forecasts)

Annex Euro 1.7 1.6 1. 1.3 1.2 1.1 1..9.8 Japanese yen 15 15 1 135 13 125 12 115 11 15 1 95 9 85 8 75 British pound 2.2 2.1 2. 1.9 1.8 1.7 1.6 1. 1.3 1.65 1.6 5 1.5 1. 1.35 1.3 1.25 1.2 1.15 1.1 1.5 1..95 Canadian dollar.9 1.15 1.1 1.5 1..95.9.85.8.75.7.65.6.55.5 Australian dollar.5 Chinese yuan 8.8 8.6 8. 8.2 8. 7.8 7.6 7. 7.2 7. 6.8 6.6 6. 6.2 6. 5.8 5.6 5

ECONOMICS AND STRATEGY Montreal Office Toronto Office 51-879-2529 16-869-8598 Stéfane Marion Marc Pinsonneault Warren Lovely Chief Economist & Strategist Senior Economist MD, Public Sector Research and Strategy stefane.marion@nbc.ca marc.pinsonneault@nbc.ca warren.lovely@nbc.ca Paul-André Pinsonnault Senior Fixed Income Economist paulandre.pinsonnault@nbc.ca Krishen Rangasamy Senior Economist krishen.rangasamy@nbc.ca Matthieu Arseneau Senior Economist matthieu.arseneau@nbc.ca Angelo Katsoras Geopolitical Associate Analyst angelo.katsoras@nbc.ca General: National Bank Financial Markets is a business undertaken by National Bank Financial Inc. ( NBF ), an indirect wholly owned subsidiary of National Bank of Canada, and a division of National Bank of Canada. This research has been produced by NBF. National Bank of Canada is a public company listed on Canadian stock exchanges. 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