from Follow the Money

Deja vu all over again (dollar falls v. the euro when Americans are on vacation edition)

November 24, 2006

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Maybe it is just me, but Thankgiving 2006 is starting to feel a bit like the period after Christmas in 2004.   Both periods saw sharp falls in the dollar in thin markets.  1.31 isn’t 1.36.  But, in a (almost) no volatility world, a sudden move to 1.31 certainly generated headlines

I certainly don’t know if the dollar will rebound when more normal market conditions return next week.    Some certainly think so.  But there are no shortage of reasons why the dollar could stabilize below 1.30 – a slowing US economy, smaller growth (and interest rate) differentials between the US and Europe and that large (and still rising) US current account deficit.  BNP Paribas seems to be among the structural dollar bears:

“To dismiss this as a technical correction is to overlook the structural reasons why the U.S. dollar is having a very hard time these days,” said Hans Redeker, global head of currency strategy at BNP Paribas

Some carry traders somewhere must be nervous.   At the Euromoney conference in early November, pretty much everyone on the program seemed to expect that the low volatility environment that makes carry trades attractive would continue.

High carry strategies (at least strategies that involved borrowing low-yielding G-10 currencies to invest in high yielding G-10 currencies) have made money nine of the last ten years.  1998 is the only exception.   That was one thing I learned at the Euromoney conference.

Most expected “high carry” strategies to continue to do very well – not just in 2006, but also in 2007.    I don’t think borrowing euros to buy dollars has been a popular carry trade.  There isn’t much carry relative to the risks – particularly as the euro has rallied against the dollar this year despite somewhat lower eurozone rates.  But borrowing yen to buy dollars certainly has been a reasonably popular high-carry strategy.    And the yen joined the euro in this week's move, even if it doesn't seem to have moved as much on Friday. 

For all the parallels with 2004, though, there are no shortages of differences between the fall of 2004 and the fall of 2006.

Here are the ones that stand out to me. 

  1. China is far more exposed to a big fall in the dollar now.    China has twice as many reserves today as it had two years ago.   It may not quite have twice as many dollar reserves as it had two years ago (I suspect it diversified a bit during the dollar’s rally v. the euro in 2005), it still has a lot more dollars than it had a few years ago.   China’s dollar reserves are almost north of 25% of China’s GDP ($700b v. $2.6 trillion or so).  
  2. There was an active debate inside China about China’s potential (over) exposure to the dollar even before the dollar’s recent slide.   But it isn’t clear to me if that has generated a consensus on what to do.  China has already tried most of the easy options.    Allow a bit more flexibility.   Done that. Keep Chinese interest rates below US rates.  Done that. Make sure the RMB’s appreciation is less than predicted in the forward market.   Done that. Loosen controls on capital outflows.  Done that.  Increasingly allow firms to keep their dollar export proceeds on deposit in the banking system in dollars rather than convert them into RMB.  Done that. Convince the banks to hold the funds raised in their IPOs offshore.  Done that .... despite all these efforts, China’s reserves are still rising by $20b or so a month, and no doubt it dollar holdings are rising fast.   The RMB’s slide v. the euro won’t help China’s efforts to rebalance its economy away from exports either. 
  3. The oil exporters are much more exposed to falls in the dollar than in 2004.    They have stuffed a tremendous number of dollars away over the past few years.   Even those that have shifted their portfolios toward euros (Russia) have more dollars than they did a few years ago – simply because they have a lot more money to invest in international markets.   The Saudis presumably have even more dollar exposure …
  4. GCC has even less need for a weaker currency right now than in 2004.   Back in 2004, I think most of the oil exporters were expecting oil to fall back and budgeting very, very conservatively.   The GCC still has a huge cushion between budgeted spending (inlcuding spending on investment projects) and export revenues.  But there also is a fair amount of additional domestic spending (including spending on ‘investment projects”) in the pipeline.  Indeed rising spending -- including a surge in construction -- led GCC inflation to pick up even before the GCC currencies joined the dollar's most recent slide. 
  5. But if China and the Gulf are more exposed to a fall in the dollar than they used to be, the same cannot really be said of the rest of Asia.  In late 2004, most emerging Asian economies had been intervening almost non-stop for several years.     The dollar’s 2005 rally let them get out of the market (and no doubt helped many diversify).  They were active in the market sporadically in 2006 (including, I would bet, on Thursday and Friday), but they have been intervening on a sustained basis.     
  6. As Stephen Jen notes in revising his euro/ dollar forecast for the end of 2006, Europe’s economy looks healthier now than it did in 2004.  The euro’s rally v. the dollar in late 2004 came in the face of rather sluggish European growth.   Somewhat ironically, the euro area economy picked up in 2005 amid a big bout of euro-pessimism in the currency markets (and all sorts of political angst).    And no doubt some European finance ministers are worried that the euro’s current strength will trigger a renewed bit of sluggishness in the eurozone.    Think the RMB is weak v the dollar?  Look at the RMB/ Euro ...
  7. The US needs rather more financing than it did in 2004.   The US current account deficit in q3 2006 is likely to be around $900b annualized … and unless the US starts cutting rates, I suspect the current account deficit will continue to rise in 2007 even if the trade deficit stabilizes or falls, thanks to a rapidly rising interest bill. 
  8. One thing though probably hasn’t changed much.  The US net international investment position -- the gap between the dollar value of US external liabilities (FDI in the US as well as US borrowing from the world) and US investment abroad (inlcuding US lending to the world).   Stock markets outside the US generally have done well again this year.   And the euro’s slide increase the dollar value of US investment in Europe.   The rising value of US external assets should help to offset all the debt the US is taking on.  Nothing beats borrowing against the rising value of your external assets.

One of the features of the international financial system over the past few years is that any fall in the dollar has been met by both an increase in the overall pace of reserve growth (countries that peg to the dollar have followed the dollar down, and many countries have intervened rather than allow their currencies to move up) and an increase in the share of that reserve growth that is held in dollars.   So a weaker dollar generally has meant more rapid growth in central bank dollar reserves: central banks have financed the US when the markets don’t want to.

At the end of 2004, I suspect some central banks had rather more dollars than they wanted.    Many were able to shift in euros over the course of 2005 – that was one side effect of the Homeland investment act and the (failed) referendum on the new European constitution. 

Other central banks though continued to pile up the dollars.  China and the oil exporters most notably.

If the dollar’s current slide continues, those countries face a set of increasingly difficult choices. 

China’s current (not-a-real basket) peg implies that it would need to pick up its dollar reserve accumulation to keep the RMB from rising against the dollar, even as its central bank talks of diversification.

The GCC countries would be faced with a similar set of choices – their currencies are depreciating in real terms as well.     That will only add to (strong) inflationary pressures in the most rapidly growing GCC countries – and force the GCC countries to choose between more sterilization (which likely means scaling back spending plans), higher inflation (and real appreciation from faster price rises than in the US) or a revaluation (and a real appreciation from a nominal appreciation). 

And emerging Asian economies (from India to Korea) could have to choose between allowing their currencies to appreciate (or, for some, appreciate more) against the dollar and renewed large-scale intervention.

No doubt, there are lots of folks hoping the dollar rebounds on Monday.  So long as the dollar stays in its recent ranges, many key actors can continue to postpone some increasingly difficult choices.  But if the dollar slides, some have to choose whether or not to join the dollar on its way down .. and others have to choose whether or not to join the euro and the pound on the way up.

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