from Follow the Money

Can the dollar block survive another bout of dollar weakness?

April 30, 2006

Blog Post

In case you haven't noticed, the dollar is now closer to 1.30 (v. the euro) than 1.20 - or even 1.15.  Carry is no longer king.   There is talk of a "regime change" in the fx market.  Or at least an attitude change.    If the G-7 takes imbalances seriously, the fx market will too ...   

It isn't just the euro either.    The pound generally seems to move in tandem with the euro (Sorry, Maggie).  And Canada has a strong dollar policy even if the US doesn't.   The loonie, like oil, is testing multi-year highs.  

It sort of feels a bit like 2004 all over again.  At around $1.26 for euro, the dollar is about where it started 2004 - and about where in started in the fourth quarter of 2004 as well.   Korea is back in the market as well, fighting won appreciation.   Steve Johnson of the FT:

Furthermore, the final communique from last weekend's G7 meeting, which called for greater currency flexibility in emerging Asia to help reduce global imbalances ... also led to expectations that the dollar might finally weaken against Asian currencies.

Indeed this happened - for an entire 24 hours - before Japan started complaining about the speed of the move and South Korea backed up its own complaints with a wall of intervention to stop the won from strengthening.

I feel for the Koreans.   The Bank of Korea seems to want to run an independent monetary policy.   They don't want to be part of the dollar block.   But it is hard out there for a won ...   when the rest of North Asia sits out the dollar move.  Japan's Vice Minister is working hard to keep the yen very, very weak in real terms. And China decided not to operate a basket peg last week. The won isn't just strong v. the dollar.  It is also strong v. its etymological cousins the yen and the yuan.   

The US may - or may not - have a weak (strike weak; insert competitive) dollar policy.    Tim Adams certainly would like China to have a strong RMB policy.  Bernanke denied the G-7 statement signaled any intent to manage the dollar down, but he also said the G-7 wants market determined exchange rates.   Bloomberg:

Bernanke today also said it is ``not correct'' that the G-7 sought to weaken the dollar. The group ``supports a market- determined dollar,'' he said.

In the first quarter, countries outside the G-7 spent about $180b (by my calculations) resisting market pressures for their currencies to appreciate.   A market exchange rate for the dollar right now means a weaker dollar ...   Just ask Korea's central bank.


And even if the US doesn't have a weak dollar policy, the Saudis clearly have a weak riyal policy.   The Saudis - along with the GCC - have intervened heavily this year to drive the purchasing power of their currencies down.   That's right.  The Saudis and the rest of the Gulf buys European, not American - at least when they purchase goods rather than financial assets.   And even as oil has soared (in both euro and dollar terms), the external purchasing power of the Gulf currencies has fallen.  

The fall in the real value of the currencies of the oil rich states in the gulf over the past few years is an immensely underreported story.  Since 2002, oil has gone from $20 to $75 - and the purchasing power of the Gulf currencies in places like Europe has gone way, way down.   Look at the real exchange rate graph on p. 29 of the WEO, then skip to the analysis on p. 81 (in the second chapter).  The real depreciation of the Gulf currencies is one big reason why very little of the Gulf's oil windfall - only 15% according to the IMF -- has been spent on imports. 

China clearly has a weak RMB policy.  It intervened actively last week to drive the RMB down against the euro.  Forget about a basket peg.   A basket peg requires that the RMB appreciate against the dollar when the dollar falls v. the euro to keep the RMB from falling too much v. the euro.   That would have meant letting the RMB go through 8.   China refused.    Maybe they didn't want to reward Dubya for his snub summit.  Or maybe they never really stopped pegging to the dollar.   No matter.   In real terms, the RMB is weaker now than it was at the beginning of the year.

You know that old canard that China is just taking market share from the rest of Asia.  It ain't true.   US imports from East Asia (the Pacific Rim category in the US data) are on track to rise from 3.75% of US GDP in 2002 to 4.75% in 2006.   And Eurozone imports from Asia rose from 3.6% of Eurozone GDP in 2002 to 4.6% of Eurozone GDP in 2005, as imports from China nearly doubled (rising from 62b euros to 118b euros) in three years   Fact-based economics should trump anecdote-based economics: electronics assembly has shifted to China from elsewhere in East Asia, but that isn't the only thing that has shifted. 

I mention this because in a world where the two key surplus regions - a block in emerging Asia centered around China and a block in the middle east centered around the Gulf --  tie their currencies to the dollar, global adjustment works a bit differently.

Dollar depreciation can lead to a surge in dollar zone exports to countries outside the dollar zone.   Look at Chinese exports to Europe.  They grew at an average annual pace of 24% from 2003- 2005, in euro terms. 

Over the same time period, US exports to Europe actually fell slightly in euro - though not in dollar -- terms.  

In the past repeats itself, the current bout of dollar (and RMB) weakness could lead to a bigger Chinese current account surplus and more Chinese financing of the US - particularly if it if creates expectations of RMB appreciation and stronger inflows fuel much stronger reserve growth. 

Or dollar depreciation can slow the increase in imports in the Gulf, so more of the $75 a barrel oil windfall is saved and thus sent back to the US.  It is easy to be a Saudi prince these days ... 8 mbd of exports at $75 brings in $220b, or about $10,000 for every Saudi ...

Both Chinese export growth and restrained import growth in the Gulf - relative to the surge in oil revenues -- may have a bigger impact on the overall current account deficit of the dollar zone than any impact a depreciating dollar has on the US current account. 

I do think the dollar matters.   The fall in the dollar since 2002 is a big reason why US export growth has been very robust in 2004, 05 and so far in 06.    But the US export sector is - sadly - tiny.  Goods exports are only ½ goods imports.  That means exports have to grow really, really, really fast to offset rising imports from China and the oil states.

It is far easier if rising surpluses in China and the Gulf offset the still (rapidly) growing US deficit, keeping the dollar zone's overall deficit from rising too much.  Plus, so long as China attracts inflows of capital from outside the dollar zone and channels them to the US, it can help finance the overall deficit of the dollar zone (read the United States deficit). 

Of course, all this has a price.  Global adjustment is a lot harder is the currencies of big surplus countries are tied to the dollar (this is where I disagree with Stephen Roach).   The dollar right now is depreciating against another deficit region (the eurozone) rather than against surplus regions ...  the natural adjustment process has been thwarted.

Moreover, private actors inside the dollar zone are not, by and large, willing to finance the US.   Chinese savers don't want to buy (over-priced) US assets at the current exchange rate (look at the pattern of hot money flows).    And no one really knows who private savers in the gulf want to finance since the oil sheiks don't distribute the oil surplus directly to their people, but rather stock it away - whether in government deposits at the central bank (Saudi Arabia), an oil fund held at the central bank (Russia) or various government run investment authorities (Abu Dhabi, Kuwait, the Emirates ... ).    Saudi central bank foreign assets rose $24.6b in the first quarter,  Russia's reserves rose $23.65b over the same time.  And Russia added another $11b in the first three weeks of April alone ... 

Central banks in the dollar zone's surplus countries have to finance the dollar zone's deficit country.    That as Dr. Roubini and I have long argued means that the central banks will lose money over time.  Yu Yongding and his colleagues at the PBoC are aware of this too.

And following the dollar down has other costs as well.  China's economy is on the verge of overheating, if you haven't noticed.   The last thing China needs is an even weaker currency, more stimulus for its export sector, more capital inflows, more funds for the banking system to play with, and more investment.   Andy Xie is right.    

Sun Bae Kim of Goldman framed the issue well.   In early 2004, China was in a similar position.  And it opted to restrain domestic demand by curbing bank lending while keeping the RMB constant.   The result was a big rise in its trade surplus.   It could do the same thing this time around; restraining domestic demand growth without letting the RMB move, slowing imports and pushing up China's trade surplus.   That would help generate the financing the US needs ... 

Or it could start to let the RMB rise, let a stronger RMB help the central bank out and begin to move out of Stephen Jen's dollar block ... 

Far be it from me to predict what course China will choose - or what course the GCC will choose.    I am confident though that dollar-block weakness will put more strain on the central banks in the surplus countries of the dollar block.    Some decisions that could be postponed back when the dollar block was rising will come back to the fore.  But I certainly don't know when the world's central banks will say "enough."

They haven't yet.  Faced with renewed pressure, Korea and India have both stepped into the market and bought more reserves rather than let their currencies move.   Russia's reserve growth in April should be kind of impressive.  Saudi Arabia's non-reserve foreign assets should grow fast too. 

In the first quarter, I suspect that the world's central banks - including Japan -- added nearly $200b to their reserves.   China, Russia and Saudi Arabia combined for over $100b.  Annualized, that is $800b.   Most of that came from central banks in the dollar block.  And that was with a relatively stable dollar.   With a weaker dollar, the amount of intervention needed to sustain the current (not entirely market-determined) equilibrium might be $250b, or a $1 trillion annual pace.  

I know that is a big number.  But I am not joking.  If carry is no longer king, sustaining a $1 trillion US current account deficit may take $1 trillion in reserve accumulation ...    Along with the continued willingness of all private investors - American and non-American alike - to continue to hold their existing dollar assets ...

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