One market truism is that the markets are usually ahead of the official sector.
Often that’s true. Think about the way the market now trades credit risk.
Sometimes it is not. The argument that the harsh discipline of the market would prevent major imbalances for ever developing took a bit of a beating last year, when the market financed anyone offering a bit of carry, no matter how big their external deficit. Think Iceland, Turkey, New Zealand and yes, the United States. The G-7 communique can be thought of as a response to the absence of market pressures for adjustment.
And sometimes both the market and the official sector lag.
Consider the official and the market infrastructure around the dollar.
The institutional structure for currency coordination is the G-7, more or less. The IMF stopped playing a role back when Bretton Woods 1 collapsed. And the G-7 has rightly been criticized for bringing the wrong set of actors around the table. Too many Europeans, not enough Asians. And no BRICs. All fair points. I think the wheels are in motion to gradually address this problem … but at the glacial official sector pace.
The leading market index of the dollar’s value, the DX, is every bit as dated as the G-7. It basically is the G-7 currencies. Actually the G-10 currencies. It includes the Swiss franc and the Swedish krona. But no Chinese RMB, Indian rupee, Brazilian real, Russian ruble, Saudi riyal or Korean won.
That makes sense for some purposes – cross border investment between the US and most emerging economies remains tiny relative to cross border investment between the US and Europe. But it means the DX offers a distorted view of the dollar’s strength, and weakness.
The chart over at the Big Picture, for example, looks to be a picture of the dollar against other major currencies, not a picture of the dollar against a broader index that includes emerging economies.
Basically, the DX includes all the currencies that have depreciated against the dollar, and only one of the currencies that hasn’t (the Japanese yen).
Consider the following graph, which plots the Fed’s index of major currencies (in red) against the Fed’s index of other currencies (in blue). The major currencies index is a reasonable proxy for the DX (and it is easier for me to download). I made January 2001 100 for both indexes. The chart is clear. The dollar is down about 20% against the major currencies – and would be down more but for Japan. But it is unchanged against the key currencies of the rest of the world.
Yet, as we all know, the BRICS account for growing share of world trade and of world manufacturing production. So the dollar overall isn’t all that weak.
Remember, I set the index at 100 in 2001, when the dollar was very, very strong against pretty much everyone. It is still strong v. most non-European currencies.
That is relevant because Stephen Jen – in his most recent note – argues that there is no need for the dollar to fall because the dollar, judging by the G-7 dollar index, isn’t overvalued. 2006 isn’t 1985.
"In 1985, the USD index was over-valued by more than two standard deviations. In fact, it was close to being at the most over-valued point in the past 32 years, according to our valuation measures. A weak dollar policy then was appropriate, and ‘fair’, from the global perspective. Now, the G7 dollar index is fairly valued, according to our calculations."
I think Jen misses the point. The dollar may – or may not – be fairly valued against the currencies in the DX. The dollar has fallen significantly since 2001, when it clearly was overvalued. Personally, I think it may need to fall outside traditional measures of fair value, given the size of the US trade deficit and the small size of the US tradables sector. But that debate doesn't matter. The dollar is rather clearly overvalued against the currencies that are not part of Morgan Stanley's G-7 index, or the DX.
Jen argues that the US cannot argue for the RMB to be revalued because China has never devalued the RMB against the dollar. At least not since the early 1990s.
That too misses the point.
China’s strong productivity growth suggests the need for a real appreciation against the dollar.
And, more importantly, the RMB has fallen significantly against most European currencies over the past few years. It is not an accident that the acceleration in China’s export growth that pushed Chinese exports up as a share of Chinese GDP started in 2003. That is when the impact of RMB weakness against the world kicked in. See exhibit 2 in this Wachovia report.
Look, China has – according to the IMF’s Asian Regional outlook (see p. 11) – a surplus of nearly 15% of its GDP in its non-oil current account. 15%! By linking to dollar, the RMB has depreciated against a broad range of currencies this year. That doesn't help.
China isn’t the only culprit. The IMF’s regional economic outlook for the Middle East nicely shows (see Table 17) that the currencies of the major Gulf countries have depreciated in real terms since 2002. Because they too peg to the dollar. And they control domestic gasoline prices, removing a key source of inflation.
They have current account surpluses (including oil, bien sur) of over 20%, according to the IMF (table 18 of the IMF regional economic outlook). And their currencies too have depreciated this year , because they too peg to the dollar.
Just as the exchange rate that made sense for china when it exported $10-20b a month doesn’t make sense now that China exports $80b a month (and is moving up the value-added chain), so the exchange rate that made sense for Saudi Arabia with oil at $15-20 doesn’t make sense with oil at $70.
At least to me. Apparently it makes sense to Dr. Jen.
I just don’t quite see how Jen thinks that the absence of any move in the currency against the dollar is evidence that a currency is fairly valued … Particularly when the dollar is depreciating against much of the world. Depreciation is still depreciation, even if it will be gradual, as Stephen Roach now believes (hopes?). And right now, a bunch of surplus countries are depreciating alongside the US.