from Follow the Money

2006, The year of the euro (and pound)

November 30, 2006

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Like many others, I expected that Asian currencies – notably emerging Asian currencies – would appreciate against both the euro and the dollar this year.    That hasn’t happened. 

Sure, the RMB has moved up a bit against the dollar, but not as much as euro.   Or the pound.  Both the euro and its high-carry cousin on the other side of the Channel are on course to end the year stronger against China and India (and flat v. Korea and Thailand, both of which have allowed their currencies to appreciate) as well as Japan and the US.  

The euro’s strong performance against the dollar in 2006 can be chalked up to shifts in the relative pace of European and US growth (and shifts in expectations about the path of European rates).   Per capita Eurozone growth is likely to exceed US growth this year.  

But it is hard too see how growth differentials explain the Euro’s appreciation against the RMB …  

Since China now exports about as much to Europe as to the US, I rather suspect the RMB will end up depreciating this year on a trade weighted basis.   That is hardly what China needs to wean its economy off exports.

Four other observations: 

One. The dollar’s slide against the euro looks to be a consequence of slower US growth, not the cause of it.   A weaker dollar combined with falling US long-term rates is not recipe for a hard landing driven by the unwillingness of foreigners to finance the US.   For that to happen, a falling dollar needs to be combined with rising US long-term rates.

Two.  The dollar’s slide v. the euro and pound, combined with the relatively strong performance of foreign equity markets, means that the US net international investment position (to simplify a bit, the difference between the dollar value of US investment abroad and foreign lending to the US) won’t deteriorate by much again this year.   The dollar value of US assets in Europe continues to rise.   

The counterpoint is that the US hasn’t been a great place for foreigners to invest.  Rather than letting the US borrow against the rising (dollar) value of US equity investment in Europe, the rest of the world would have been better off if they had forced the US to sell its European assets to finance its current account deficit.  (For more on valuation effects, see this new paper from Philip Lane and Gian Maria Milesi-Ferretti) 

Three.  In the past, stronger euro has generally been associated with a big pick up in (valuation-adjusted) reserve growth in emerging Asian economies not named China.   That is one reason potential why a falling dollar hasn’t led to higher US rates: Asian central banks have been willing to finance the US at relatively low rates when private markets don’t want to.  I will be watching the data on Asia's end November reserves with interest.

Four.  There are a lot British expatriates who don’t like a strong pound.   At least there are a lot of British expats in Dubai who don’t like a strong pound.    They may not pay taxes in Dubai, they do get paid in a currency linked to the US dollar.     Moving to Hong  Kong doesn’t solve that particular problem. 

The British tourists who flock to Dubai presumably have a rather different view. 

Update: The Economist seems to have put the dollar, not the euro on its cover -- perhaps allowing the euro to avoid the dreaded cover jinx on a technicality.

Hat tip: to wcw for his comment on the euro/ baht/ won.  My initial post was a bit sinocentric.

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