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1. The Global Economy
Monthly letter from Swedbank’s Economic Research Department
by Cecilia Hermansson 19 October 2010
Economic Research Department, Swedbank AB (publ), SE-105 34 Stockholm, tel +46-8-5859 7740
E-mail: ek.sekr@swedbank.se Internet: www.swedbank.com Responsible publisher: Cecilia Hermansson, +46-8-
5859 7720, Magnus Alvesson, +46-8-5859 3341, Jörgen Kennemar, +46-8-5859 7730, ISSN 1103-4897
Currency tensions put the global recovery at risk
• Even though the US economy is no longer shrinking, the recovery is taking time. There
is a risk that unemployment could rise even further, and inflation remains
uncomfortably low. The Federal Reserve is expected to begin another quantitative
easing in November. The dollar is already weakening.
• Currency tensions are growing and will overshadow everything else at the G20 summit
in Seoul in November. A US quantitative easing could create bubbles in emerging
economies when capital seeks out higher returns. China's currency reserves are
growing, and in its attempts to spread currency risks it is buying yen and won, which
are pushing the values of these currencies higher. Japan has already reacted to the US
monetary easing and started intervene to prevent the yen from getting too high. Other
countries are following suit. Currency tensions are growing, and Brazilian finance
Minister Guido Mantega has talked about a currency war.
• It is reasonable that countries with large current account deficits should have a weaker
currency, while those with surpluses have to accept a stronger currency. Compared to
exchange rates before the financial crisis in 2007, few currencies have appreciated
against the dollar. The lack of economic tools in developed countries’ arsenal and an
excessively mercantilist stance in several emerging countries are driving these
currency tensions. The risk is that they could lead to protectionism and a vicious cycle
of deflation and weak growth. It is still possible to prevent this from happening.
US: No quick fix
On September 20 it was announced that the US
recession had ended in June 2009, i.e., the
economy was no longer shrinking. The committee
appointed by the National Bureau of Economic
Research (NBER) to determine when the US goes
in and out of recessions reported that this recession
had been unusually long – 18 months – making it
the longest since World War II.
In our last monthly letter we mentioned it was
important not to draw any hasty conclusions about
the US economy. Labour, housing and credit
markets had not shown any signs of a turnaround.
What the NBER said, however, is that the economy
isn't getting any worse. It is still hard to see any
improvement on the horizon, especially since
unemployment is expected to continue to rise
before eventually tailing off. One reason is that
states are coming under increasing financial
pressure and more of their employees will have to
be laid off. The private sector doesn't seem able to
add many jobs either, as small and midsize
companies struggle with weak domestic demand.
The National Association of Business Economics
(NABE) issued a new forecast at its annual meeting
last weekend in Denver. It expects GDP to grow by
2.6% this year and next, a significant downward
revision from May of this year, when it forecast
3.2% for both years. (Compare Swedbank’s
forecasts from April and September of 2.8% and
2.2% for 2010 and 2011). In addition to lower GDP
growth, the NABE economists now have a more
pessimistic outlook on unemployment, and inflation
is projected to be lower than before. They are not
concerned, though, that the US will enter a period
of deflation. On the contrary, they are more worried
about inflation. Still, neither deflation more inflation
are their biggest concerns. Instead it is weak growth
and the job market – especially the federal debt
situation – that keep them awake at night. Like
other market analysts, they do not expect the
Federal Reserve to raise interest rates until late
next year.

2. The Global Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 7 • 19 October 2010
2
US unemployment (% of labour force)
and core inflation (annual change) 1958-2010
Source: Reuters EcoWin
60 65 70 75 80 85 90 95 00 05 10
Percent
0.0
2.5
5.0
7.5
10.0
12.5
15.0
Annual Core Inflation
Unemployment
The political situation is complicating efforts in the
US to implement effective economic policies.
President Obama’s proposed $50 billion fiscal
stimulus to improve infrastructure and the business
climate has not yet been passed by Congress.
Many US economists are complaining that the
political situation threatens the recovery, as
companies and households are feeling uncertain
which way the country will go in terms of taxes,
spending and economic policies in general. The
healthcare reform could be taken up again by
Congress if the Republicans decide to repeal the
law if they win a Congressional majority in
November (which many people expect).
This means that the ball rests in the court of the US
central bank, the Federal Reserve. In Jackson Hole
in August, Fed Chairman Ben Bernanke signalled
that inflation was below the Fed's comfort zone.
Since then core inflation (excluding energy and
food) has continued to fall, to 0.89, its lowest level
since 1961.
Since the benchmark interest rate has already been
cut to zero, the only thing left for the Fed to do is
crank up the printing presses again to buy bonds.
Its first quantitative easing (QE) in March focused
on mortgage bonds, and to a lesser extent
treasuries. The financial market is expecting a new
period of QE beginning in November that will focus
more on government bond purchases. The goal is
to further reduce interest rates and raise inflation
expectations. In the wake of this anticipated
measure the dollar has already begun to weaken.
Even though the US administration frequently says
it prefers a strong dollar, it isn’t complaining when it
knows that a weaker currency will stimulate exports.
The question is how US monetary policy affects the
rest of the world and in what ways the response
from other countries will impact the US. China in
particular is a key. Irritation is growing over how the
Chinese have dragged their feet in letting the yuan
appreciate. The House of Representatives has
passed legislation imposing a duty on Chinese
goods. (The Senate has yet to take up the measure
and the president hasn't taken action either.) US
rhetoric is heating up. Just last week Nobel prize-
winning economist Paul Krugman accused China of
stealing American jobs.
G20 summit in Seoul: Currencies dominate
the agenda
The G20 summit on November 11-12 in Seoul will
bring together political leaders, finance ministers
and central bank governors as well as a number of
international bodies such as the IMF and the World
Bank. The agenda was supposed to centre on
financial sector regulation, but the currency
tensions in recent months could now overshadow
everything else on the agenda. The risk is that if
these tensions worsen, protectionism and a trade
war won’t be far behind, undermining the global
recovery. In addition, there is the risk that deflation
and weak growth in the West will follow when global
imbalances are no longer shrinking.
Economic policies were coordinated at a previous
G20 summit in connection with the financial crisis
and global recession. Now that economic weapons
are no longer working normally – fiscal policy has to
be tightened due to escalating debts in many
developed countries, at the same time that
monetary policy has already been made expansive
and there isn’t much ammunition left – many
countries are trying to prevent their currencies from
appreciating against the dollar.
It is reasonable that countries with large current
account deficits switch from a growth model driven
by domestic demand, large imports and low savings
to more export-driven growth. A weaker dollar
therefore makes sense to reduce imbalances and in
the US case to strengthen growth, reduce
unemployment and avoid deflation.
In China, where the current account surplus is
again growing after having fallen to about 6% of
GDP last year, and currency reserves rose by 35%
on an annual basis during the second quarter to
$2.65 billion, it is instead reasonable that the
currency, the yuan, be allowed to appreciate
against the dollar. This is after China kept its
exchange rate closely tied to the dollar during the
crisis until last summer, when a slight appreciation

3. The Global Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 7 • 19 October 2010
3
was allowed. There is, of course, great
disappointment in the US and among many
emerging economies that compete with Chinese
products over the slow pace.
Japan: Nominal and real effective exchange rates
(and 30-year trends)
Source: Reuters EcoWin
78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
Index
40
50
60
70
80
90
100
110
120
130
140
150
160
Nominal Effective Exchange Rate Index
Real Effective Exchange Rate Index
The upcoming quantitative easing (QE) in the US
has already set in motion a wave of activity in other
countries. At the same time China’s actions also
make other countries want to stop the rapid
appreciation of their currencies. China’s burgeoning
foreign reserves have to be invested, and to avoid
becoming overly dependent on the dollar China is
also buying yen, won and euro (e.g. Greek
government bonds) to reduce the share of dollars in
its reserves, which are estimated at 65%. Last
spring, when China bought the yen, it rose, and it is
now at a high level in nominal terms (though not yet
in real terms, since Japan has deflation). Even
though China sold the yen in August, there are
analysts who feel that yen purchases in the UK at
the same time were the work of the Chinese trying
to be less transparent about what their currency
portfolio really looked like.
When the financial crisis began in fall 2007, a
number of currencies weakened against the dollar
as investors sought out safe harbours and had to
restore their balance sheets. Since early 2009,
when the crisis eased, most of these currencies
have risen, and in several cases they are now back
at the levels from before the crisis (in nominal
terms).
The Japanese yen and the Swiss franc have
appreciated strongly since the crisis. Both countries
have intervened, but have not been successful in
their unilateral efforts. Expectations are that these
currencies will continue to rise in value. It is not
unreasonable that countries with large current
account surpluses such as Japan, Germany and
Sweden allow their currencies to appreciate. This is
happening all over Europe, but Japan must also
accept a stronger yen and instead do more with
structural reforms.
Various currencies’ nominal values compared with the US
dollar 2003-2010 (Index 9 Aug 2007 = 100)
Source: Reuters EcoWin
03 04 05 06 07 08 09 10
60
70
80
90
100
110
120
130
140
150
160
170
180
190
Yen
Euro
Korean Won
Brazilean Real
Swedish Krona
Yuan
Swiss Franc
If China accepted a faster appreciation, it would
also give other emerging economies’ currencies
some breathing room. An excessive appreciation
should be avoided, however, so that China's
economic development isn't threatened in terms of
its export industry and employment. It is in China’s
interest, however, to allow the yuan to appreciate,
since it would facilitate an easier transition to a
growth model driven by domestic demand at the
same time that any inflation problems can be better
controlled.
At the same time the US quantitative easing
complicates the picture, since it is driving capital to
countries offering higher returns, i.e., emerging
economies. There is a risk that the capital inflows
now “hurting” these countries could lead to new
bubbles, overheating and instability.
Representatives of South Korea, for example, claim
that the main reason for their attempts to prevent
the won from appreciating is to counter volatility. As
indicated in the diagram above, the won is still
weaker than when the crisis broke out in 2007.
Every country is trying to export its way out of the
crisis for a lack of better economic tools. Some are
trying to prevent their currencies from becoming too
strong (South Korea, Japan). Some are trying to
directly or indirectly weaken their currency (US).
Others are doing little to influence their currency
(Eurozone).

4. The Global Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 7 • 19 October 2010
4
This works for certain countries in the Eurozone
(Germany), while the PIIGS countries (Portugal,
Ireland, Italy, Greece and Spain) will have a tougher
time pushing their economies in the right direction
again now that they are weaker competitively. This
means more emphasis on internal devaluations
through lower wages and prices in order to
compete. In the diagram below you can see how
Ireland's competitive strength has been sapped in
the last decade, which can be compared to
Germany's, where the real effective exchange rate
has remained stable for much of the decade.
Japan's improved competitiveness is mainly the
result of the long period of deflation it has endured,
which has brought its cost level down. Even after
the recent appreciation, the yen hasn’t returned to
the 2000 level.
Real effective exchange rate according to BIS for a number
of countries, where the index on 1 January 2000 = 100
Source: Reuters EcoWin
00 01 02 03 04 05 06 07 08 09 10
Index2000-01-01=100
60
70
80
90
100
110
120
130
140
China
Euro Zone
Germany
Japan
US
Ireland
The world has two currency unions:
1) Essentially an involuntary union between China
and the US
2) Another, more voluntary union among euro
countries.
Both currency unions face problems.
The US has to carefully consider how much
difference an additional QE will actually make in
stimulating the economy, i.e., provided the costs
exceed the benefits nationally and globally. The risk
with raising inflation expectations is that it can be
hard to adjust them downward later and the country
could instead face problems with inflation, a weak
dollar and higher interest rates. There is also the
risk of negative global effects that excessive capital
inflows could cause in emerging countries.
China should consider whether it wouldn't benefit
from a faster appreciation of the yuan from a
national perspective and in order to take greater
global responsibility.
The Eurozone and the European Central Bank have
to carefully consider the risks of having certain
countries in the Eurozone under excessive
deflationary pressure, which could spread to the
rest of the region. During the 2000’s the euro
accounted for a larger share of currency
adjustments than the dollar, for example. It is
reasonable that structural reforms now become the
principal economic tool in developed countries, but
it is unreasonable to complicate the process more
than necessary by accepting a considerably
stronger euro when the region as a whole isn’t
reporting any major imbalances.
It is important this time to look beyond averages
and instead focus on countries with large surpluses
(Germany) and those with large deficits (e.g.,
Spain). It is still too early at this point to discuss
whether the ECB should raise its benchmark
interest rate.
The euro isn’t in the same league as the yuan,
where China’s leaders intentionally let the currency
be undervalued, since the euro’s value is
determined by the financial markets. The Eurozone
can hardly be blamed for jeopardising stability at
the global level. On the other hand, is important that
the euro’s currency union address the problems
there, to create new rules that work better and
avoid new periods of divergence and imbalances
within the union. A crisis for the euro countries of
the kind we have seen certainly should make it
easier to come up with such rules. It is a question of
survival!
Cecilia Hermansson
Swedbank
Economic Research Department
SE-105 34 Stockholm, Sweden
Phone +46-8-5859 7740
ek.sekr@swedbank.se
www.swedbank.se
Legally responsible publisher
Cecilia Hermansson, +46-88-5859 7720
Magnus Alvesson, +46-8-5859 3341
Jörgen Kennemar, +46-8-5859 7730
Swedbank’s monthly The Global Economy newsletter is published as a service to our
customers. We believe that we have used reliable sources and methods in the preparation
of the analyses reported in this publication. However, we cannot guarantee the accuracy or
completeness of the report and cannot be held responsible for any error or omission in the
underlying material or its use. Readers are encouraged to base any (investment) decisions
on other material as well. Neither Swedbank nor its employees may be held responsible for
losses or damages, direct or indirect, owing to any errors or omissions in Swedbank’s
monthly The Global Economy newsletter.