from Follow the Money

Is the dollar’s decline over?

November 30, 2007

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The Economist put the dollar on its cover this week.   The Economist’s cover is usually a lagging, not a leading, indicator:  it signals that the dollar already has fallen significantly, and sometimes indicates that it is poised for a rebound.

Perhaps more importantly, a long-standing dollar bear – Goldman’s Jim O’Neill – now expects that dollar to rebound against the euro.    Bo Nielsen of Bloomberg reports

"It's fallen a long, long way … I personally think that a year from today the dollar will be quite a bit stronger."

Morgan Stanley’s Stephen Jen presumably has a similar view -- Morgan Stanley’s forecast for the dollar at the end 2008 is 1.35. 

And – as Felix hints – I am also starting to wonder if the dollar has already fallen by as much as it is going to fall against the euro.   

I have long believed that a fall in the dollar’s real value was a necessary part of a broader adjustment needed to bring the United States’ trade deficit – and the United States need for external financing -- down.     And I have long argued that unprecedented intervention to support the dollar (in order to keep other currencies from rising) by the world’s central banks has impeded this correction, storing up problems for the future. 

Those basic views haven’t changed.   But it also hard to deny that the dollar already has moved substantially against the euro.    At 1.45-1.50, the US trade deficit with Europe should fall quite quickly, especially if Europe continues to grow even as the US slows.    The US bilateral balance with Europe has already started to improve in a rather big way.

There is even evidence of a bit of a J-curve effect in the q3 data – the rise in US imports from Europe in dollar terms likely reflects a rise in the dollar price of US imports  far more than an increase in the volume of imported goods.  

The dollar’s fall v the euro also gives US manufactures an advantage over European producers in third party markets.   Ask Airbus.    US airlines aren’t buying many planes period, so Boeing’s recent success has come entirely from exports.    If currently under-employed American financial engineers can retool – and if US firms start to invest more in production in the US – the US might even be able to challenge Germany in some segments of the high-end engineering market.  

Bottom line: the dollar has fallen enough against the euro to encourage a needed adjustment.   The “structural” argument for the dollar to fall v the euro is gone.  With time, the US deficit with Europe should disappear.     The argument for further falls in the dollar is now in large part cyclical -- a slowing US economy and falling US rates.  A loss of confidence in US financial engineering and the risk that some big holders of dollars may stop buying and start selling also plays a part.    

 That said, reserve managers should at least pause before buying into euros at current levels.  Russia had the right idea – it increased its euro allocation back in early 2006.    But anyone trying to follow Russia’s example has to ask if they are going to be buying euros at the euro’s peak.  The dollar probably won’t retain its current dominance in central bank reserves, but now may not be the right time for long-term investors to buy European currencies.

But too much of the talk about the dollar focuses entirely on the dollar-euro.  The dollar-euro is important, but it isn't the only currency pair that matters.  The US has a lot more investment in Europe than Asia, but it imports far more from Asia than from Europe.    

And while the dollar has fallen significantly v a range of European currencies over the past several year, it has yet to fall by much against most Asian currencies.   A lot of emerging Asian currencies have sat out (thanks in large part to central bank intervention) the dollar’s recent slide.    If you compare the cumulative depreciation of the dollar against the euro since the end of say 2000 v the cumulative depreciation of the dollar v. the yuan since 2000, there is no comparison. 

My conclusion: the dollar’s fall isn’t over even if the dollar’s fall v. the euro may be.

It seems a bit churlish to pick up on one small item that I disagreed with in the Economist’s extensive analysis of the dollar this week, especially when I agree with nearly all of the leader.    But one aside in the article analyzing the dollar’s slide jumped out at me:

“As a rule, central banks cannot intervene to determine exchange rates.” 

That seems a bit too strong.   

The GCC central banks clearly set their exchange rate by pegging to the dollar. I would argue that a central bank – the People’s Bank of China – determines one of the most important exchange rates in the world: the dollar –RMB.  Indeed, absent the rather herculean efforts by the PBoC to hold its pace of reserve growth down (the October number -- a roughly $20b increase, with around $10b coming from valuation gains -- is too low to be credible), China's central bank would need to buy around $40b in the market to keep the RMB from rising.    The Ruble-dollar sure seems to be set by the Bank of Russia, and the Reserve Bank of India keeps a close watch on the rupee-dollar (especially when there is pressure for rupee appreciation).    Brazil seems to be intervening again as well – though Brazil’s central bank isn’t as obviously defending a certain level as the other three.   

The BRICs are kind of important.   They are going to add $800b to their combined reserves this year.  And presumably they are doing so to determine the value of their exchange rates against the dollar, and influence the value of exchange rates against the euro.    I would consequently argue that the exchange rate between the BRICs and the US and Europe is primarily determined by central banks.

The argument in the Economist's analysis article – in context -- was referring to the euro/dollar not the BRIC-dollar exchange rate.  

And the conventional wisdom among central banks is that limited intervention by the ECB and the Fed has at best a marginal impact on the value of a generally floating exchange rate.   If the US Fed sells euro-denominated bonds to buy dollars, the general argument would be that this would have no real effect on either the price of euro-denominated bonds or the euro-dollar.   Private agents would sell some of their dollar-denominated bonds to buy the euro-denominated bonds the Fed is selling.

The same logic also applies to the sale of dollars for euros by emerging market central banks.  The increased bid for euros and euro-denominated bonds should be offset by an increase in private sales of euros and euro-denominated bonds, as private actors shift into dollars.   This is why Alan Greenspan argues in his book that a huge swing in the composition of say China’s reserves would have a modest impact on both the euro-dollar exchange rate and the price of US bonds.     (For a primer on the economics literature, see Menzie Chinn at Econbrowser)

I am not sure I fully believe this argument in its strongest form.  

Nor is it obvious that many in the market believe it.   There is a strong sense that increased central bank buying of euros – whether because they are “diversifying” or because they have to sell more dollars and buy more euros just to keep the euro’s share in their portfolio constant as their reserves grow at an exceptional rate – is one cause of the euro’s strength and dollar’s weakness.  See Dr. Jen a few weeks ago.

Indeed the Economist’s leader hints that big swings in the composition of the emerging world’s reserves could matter.    That presumably is why the Economist’s leader calls on emerging market central bankers to hold on to their existing dollars even as they allow their currencies to appreciate at a faster rate against the dollar.

These economies [those now pegging to the dollar] need to allow their currencies to rise, both to curb inflation and encourage the rebalancing of the global economy. Appreciation would mean that these countries accumulated new dollar reserves at a slower pace. That in turn would lead to a loss of the dollar's pre-eminence and the emergence of other reserve currencies: there is no rule to say you can have only one reserve currency. But this need not—and in today's febrile environment must not—mean dumping existing dollar reserves. That would impose a far higher cost on everyone, including the dumpers.

The history of international co-operation on currencies is patchy. But China and the oil-rich Gulf states have ample reason to play their part in an orderly decline of the dollar's dominance. Despite the opprobrium heaped on them, the Chinese do not want to see the Fed's hands tied by a dollar crisis; nor do they want to see the euro zone, one of their best markets, slow sharply; and they have little interest in the external value of their existing dollar reserves plunging.

Indeed, the Economist's analysis article makes a similar point a few lines before arguing that central bank intervention has little impact.

“A crash might be averted if China holds fast too, because it recognises how self-defeating dumping dollars would be to such a large owner of American assets.”

If central banks intervention – including a large portfolio reallocation by a large central bank – didn’t matter, there would be little need to call on China and others not to dump their dollar reserves.  The market would happily sell euros for dollars and the adjustment in central banks portfolio would have little enduring impact …

I think most people would agree that the BRIC central banks do determine their own exchange rates.    And there is at least a possibility that their portfolio choices also influence euro-dollar exchange rate.   I personally would bet that the portfolio choices of a set of actors whose assets are growing at a $1 trillion annual pace has at least some impact on a range of financial variables.   

One line in an Economist article – particularly one line in an article embedded in an issue that includes a leader that I quite liked – hardly merits this kind of attention.  

But I wanted to draw out a tension between two different views, both of which are commonly expressed. 

One view holds that in today’s huge global markets, central banks are too small to matter much – and that all central bank intervention can do is send a signal to the market.  

Another view argues that central banks have now become so big that their actions now can dominate even big markets ….

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