Plaza Accord, exchange rates, trade and monetary policies

Plaza Agreement 1985. Key takeaways:

-The Plaza Agreement was a 1985 agreement between the G-5 countries consisting of France, Germany, the UK, the US and Japan.

-The purpose of the Plaza Agreement was to weaken the US dollar to reduce the growing US trade deficit.

-The Plaza Accord led to a dramatic increase in the value of the yen and Deutsch mark against the dollar. An unintended consequence of the Plaza Accord was that it paved the way for Japan’s “Lost Decade” of slow growth and deflation.

From the beginning of 1980 to its peak in March 1985, the US dollar appreciated more than 47.9% on the way to the Plaza Agreement. The strong dollar has put pressure on the US manufacturing industry as it makes imported goods relatively cheaper. This caused many large companies such as Caterpillar and IBM to lobby Congress to step in, hence the Plaza Agreement.

The US has promised to reduce the federal deficit. Japan and Germany would increase domestic demand through policies such as tax cuts. All parties agreed to intervene directly in the foreign exchange markets when necessary to correct current account imbalances.

The US dollar fell sharply after the Plaza Agreement. The agreement reduced, but did not eliminate, the U.S.-Japan trade deficit, although it significantly reduced the U.S. deficit with Germany. Not all policy objectives were met, but the overall goal of weakening the dollar to ease the U.S. trade deficit worked.

The US current account balance stabilized as a percentage of GDP between 1985 and 1987 and then rose towards a slight surplus by 1991.

-What happened after the goal was achieved?

By 1987, the Plaza Agreement had largely had the desired effect, and the US government did not want the dollar to weaken further. A second agreement, the Louvre Agreement, was signed in 1987 to stem the dollar’s continued decline and stabilize exchange rates.

The Louvre Agreement was implemented to partially reverse the policies carried out under the Plaza Agreement. The United States and Japan have honored their monetary commitments, and five countries have agreed to step in if their currencies fall outside a certain range.

-What happened to Japan?

 But an unintended consequence of the Accord was that Japan increased its trade and investment with East Asia, making it less dependent on the United States.

Still, a rising yen may also have contributed to recession pressures on Japan’s economy. The strong yen caused a major short-term shock to Japanese export-driven industries. To offset the effects of this shock, the Japanese government embarked on an expansionary monetary and fiscal policy campaign to stimulate the local economy.

This massive macroeconomic stimulus, along with other policies, created equally large credit and asset price bubbles in Japan’s financial and real estate markets in the late 1980s. When that bubble burst, Japan experienced a long period of low growth and deflation that continued throughout the 1990s and 2000s. Thus, the Plaza Accord helped spread the “Lost Decade” in Japan.

Success of the Plaza Agreement The graphic starts on the date of the agreement… Source: Bloomberg

-Similarities with today

 The US dollar rose 13.5% against the world’s major currencies this year. It reached parity with the euro in July for the first time in twenty years. It reached 144 yen and 0.93 pounds per dollar, levels not seen since the turn of the century. Such dollar strength could spell trouble for the rest of the global economy, and history shows why.

Time Travel of Dollar (1980s and 2020s) Major Currencies Weak Against Dollar… Source: Bloomberg

 In the past few months, the dollar has reached relative strength that has only been seen once since 1985. In both the early 1980s and early 2020s, large fiscal spending and rapidly tightening monetary policy created conditions that facilitated a surge in the dollar’s value.

In response to the pandemic, President Joe Biden similarly undertook expansionary fiscal policy through the American Recovery Plan. As inflation accelerated, the Fed responded by raising interest rates and applying quantitative tightening. But other central banks lagged behind in the pace and scope of Fed action. The Fed raised rates twice, seventy-five basis points each, while the European Central Bank raised only fifty points, and the Bank of Japan hesitated to change rates.

Higher returns as a result of higher comparative interest rates, as well as the dollar’s safe-haven status amid fears of a global recession, encouraged capital inflows and strengthened the dollar rate.

Stagflation risks and the stance of monetary policies. Global and leading economies are experiencing the heaviest cost inflation of the last 40-45 years. There has been a historical jump in input costs in all of the most critical commodities and intermediates in terms of agriculture and food, energy, metals and mines, which are the production wheels of the world economy. The tightening of monetary policies during the oil crises of the 1970s did not work in slowing down or breaking the inflation trend that continued to rise in terms of cost inflation, and led leading countries, especially the US and European countries, to stagflation.

Fed Chairman Jerome Powell’s statement is clear: “Many things that cause inflation to rise seem beyond the Fed’s control. External factors make it difficult for the Fed to control inflation.” The reason for this is the weak effectiveness of monetary policies in the fight against cost inflation.

Stagflation occurs only when attempts are made to contain the problem of cost inflation-driven hyperinflation by tightening monetary policies, suppressing demand in the economy, household consumption, and private sector investment spending, while at the same time exacerbating the problem of severe economic recession and unemployment.

The World Bank recently released its Global Economic Outlook report. In the report, it was emphasized that the heavy recession caused by the policy measures of some central banks will increase the risk of recession.

The “risk of stagflation”, pointed out by the World Bank in its report, may also hinder the steps to be taken to stop climate change. While some of the world’s leading central banks risk a severe recession with their tightened monetary policies focused on pushing inflation down, they also risk massive unemployment and disrupting investments that will protect the planet.

-The separation between the Fed and the BOJ…

-Fed

 Inflation has been soaring for the past year or more, and the Fed has been aggressively raising interest rates to combat it. In addition to raising interest rates, the Fed is also reducing its bond portfolio and recently doubled its monthly sales to $95 billion in September. As the Fed drains its balance sheet, this move helps drain liquidity from the financial system and slow inflation.

At around 3.6%, the 10-year Treasury bond is now at its highest level since early 2011. After some ups and downs in 2021, the benchmark bond has risen since December 2021, and especially since the beginning of March, i.e., since it was fully seated.

–BoJ

 Despite talk of a physical intervention in the forex markets, analysts all point to another reason behind the yen’s weakening: the Bank of Japan’s yield curve control (YCC) policy – a strategy implemented in 2016 that limited the 10-year Japanese government bond yields to about 0% and buys an unlimited amount of JGB to defend an implicit 0.25% cap around the target.

The yield curve control policy aims to bring inflation in Japan to the 2% target. Japan on Tuesday reported that core inflation rose 2.8% in August from a year ago, the fastest growth in nearly eight years, and the fifth consecutive month that inflation exceeded the BOJ’s target.

Advocating this policy will be the central bank’s priority, rather than a currency intervention that will be decided by the Ministry of Finance and carried out by the Bank of Japan, HSBC’s Senior Asia FX Strategist Joey Chew said.

“The BOJ will theoretically make unlimited bond purchases to maintain its yield curve control policy,” Chew told CNBC last week. He added that such monetary transactions would be somewhat counterproductive to any possible currency movements, given that dollar-yen sales would tighten the liquidity of the Japanese currency.

“At this point, talking about currency intervention may not have a significant impact,” said Chew. “Even real intervention can only lead to a massive but short-lived response.”

 Foreign trade situation

-US

Exports of goods and services (percent of GDP). Source: World Bank, OECD

The U.S. Census Bureau and U.S. Bureau of Economic Analysis announced that the goods and services deficit was revised to $70.6 billion in July, down $10.2 billion from $80.9 billion in June.

Goods and Services Trade Gap (Seasonally Adjusted) Source: U.S. Bureau of Economic Analysis, U.S. Census Bureau

US International Trade in Goods and Services Deficit. Source: U.S. Bureau of Economic Analysis, U.S. Census Bureau

Exports from the United States rose 0.2%, or US$0.5 billion, from the previous month to US$259.3 billion in July 2022, the highest level since the series began in 1950.

Services exports increased by US$ 0.8 billion to US$ 76.3 billion, mainly in travel (US$ 0.6 billion) and other commercial services (US$ 0.3 billion).

On the other hand, exports of goods, mainly industrial materials and materials (-0.9 billion dollars), natural gas (-1.3 billion dollars) and other petroleum products (-1 billion dollars), decreased by 0.3 billion dollars to 183 billion dollars.

In addition, food, feed and beverage sales fell by USD 1.3 billion. Exports of capital goods increased by USD 2.1 billion, while exports of automotive vehicles, components and engines increased by USD 0.9 billion.

US exports by month. Source: US Census Bureau

 -Japan

Exports of goods and services (& GDP) – Japan. Source: World Bank, OECD

Exports from Japan rose 22.1% year-on-year to JPY 8,061.9 billion in August 2022, below market expectation of 23.6% and after a 19% increase in July.

Still, this was the 18th consecutive month in shipments; machine sales rose 17%, driven by semiconductor machines (22.4%) and power generating machines (10.7%);

While the share of transport equipment increased by 30.8%, motor vehicles (39.3%) and automobiles (39.7%) stood out.

In addition, there were increases in electrical machinery sales (12.9%) due to semiconductors (8.9%) and IC (8.9%);

Others (31.5%) were driven mostly by scientific, optical instruments (15%); chemicals associated with plastic materials (3%); and manufactured goods (12.4%) made of iron and steel (11.2%) and non-ferrous metals (12.5%).

Changes in export locations: China (13.5%), US (33.8%), Hong Kong (5.2%), Taiwan (1.1%), South Korea (20.3%), Singapore (44%) .1), Thailand (16.6%), Malaysia (58.2%), Indonesia (48.5%), Germany (11.2%), Australia (80.4%), and the EU (16.7%).

Japan exports by months. Source: Ministry of Finance, Japan

-Germany

Exports of goods and services – Germany. Source: World Bank, OECD

 Exports from Germany increased by 10.8% year on year to 127.6 billion Euros in July 2022. Exports to Russia amounted to 1 billion Euros, and the country ranked 25th among the main target countries for Germany’s exports, up from 14 a year ago.

On a seasonally adjusted basis, exports fell 2.1% from June to €131.3 billion, with shipments to Russia (-15.1%), US (-13.7%), China (-0.3%) and UK (-4.6)

Germany exports by months. Source: Federal Statistical Office

 Risks of increasing the cost of borrowing. The Central Bank usually raises interest rates when inflation is predicted to rise significantly above the inflation target. Higher interest rates increase the cost of borrowing, reduce disposable income and therefore limit growth in consumer spending. Higher interest rates tend to reduce inflationary pressures and cause local currency appreciation.

The impact of high interest rates

 With higher interest rates, the cost of borrowing increases, interest payments on credit cards and loans are now more expensive. This deters people from borrowing and spending. People who already have loans will have less disposable income because they spend more on interest payments. Therefore, other consumption areas will decrease.

Therefore, higher interest rates will tend to reduce consumer spending and investment. This will lead to a decrease in aggregate demand (AD).

If we lower AD, it will tend to cause:

-Lower economic growth (even negative growth – recession)

-Higher unemployment. If production falls, firms will produce fewer goods and therefore demand fewer workers.

-Improvement in current account. Higher rates will reduce spending on imports and lower inflation will help increase the competitiveness of exports.

Faiz oranlarının AD üzerindeki etkisini gösteren AD/AS diyagramı… 

Conclusion? The world economy is in trouble. As stagflation risks increase globally, different measures are taken according to countries. While Japan controls the yield curve to keep inflation down, the US is raising interest rates firmly.

Also, the rise of the USD is a hassle for global trade. A similar situation occurred in the 1980s and led to the Plaza Agreement. However, it seems unlikely that such an agreement will be withdrawn this time, as it does not comply with today’s world conditions both environmentally and economically.

Kaynak: Tera Yatırım- Enver Erkan
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