from Follow the Money

Good reading on the dollar’s recent move

December 2, 2006

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I have on occasion been critical of the Economist’s coverage, particularly its emphasis on Chinese consumption growth rather than Chinese export growth.  But I should also give credit where credit is due.   I thought their leader on the dollar was spot on.

Among other things, the leader makes three key points: 

  • Europe has done a lot better recently than most Americans think – think of a US style housing boom that has supported domestic demand combined with a strong export sector.   Germany’s rust belt (a.k.a export machine) is doing a lot better than Ohio, even with a strong euro.
  • The dollar isn’t that weak.   At least not yet.  There is a tendency to equate the dollar with the dollar/ euro.    And no doubt the dollar/ euro matters greatly – for tourists, for the value of US investment abroad and for United States competitiveness in many third party markets.  But the dollar has also moved a lot more against the euro than against other currencies.  On a broad trade-weighted basis, the dollar remains well above its levels in the late 80s/ early 1990s.  See General glut, or compare the major currency index with the other trading partners index. That suggests it needs to fall further.
  • Countries with lots of dollar reserves may not want to see those dollar reserves fall in value, but most countries with large dollar reserves can only protect the value of their existing reserves by continuing to buy more dollars.   That only adds to their exposure to future falls in the dollar (both to falls in the dollar/ euro and to falls in the dollar against their own currencies).  Call it the Amaranth strategy.

The Economist hints that some central banks are likely to conclude that they are better off if they don't keep adding to the dollar holdings.  I have some sympathy for that argument – Nouriel and I made it strongly two years ago.   Central banks have gone on to add $900b (by my estimate) to their dollar reserves over the last two years.  Having been premature once, I am a bit gun shy – I don’t (yet) see strong evidence that there has been much of a change in central banks willingness to accumulate reserves.  More on that in a bit.

I also wanted to laud Steven Weisman’s coverage in the New York Times, which got, I think, the United States dollar policy more or less right -- though the headline should probably say that a weak dollar rather that volatile dollar doesn't scare to Washington.  

The US doesn’t just have a strong dollar policy.   It has a strong dollar policy and a please-intervene-less-to-keep-the-dollar strong policy.    Call it a strong dollar and an-even-stronger RMB policy.

The Treasury certainly isn’t unhappy with the dollar’s recent fall against the euro.  It will help support activity in the US during a housing slump.  But I suspect that they would be even happier if the dollar was falling at a comparable rate against the yen and the RMB.    

What the Treasury should be happy about is strong domestic demand led growth in Europe.   If I were at the Treasury, I would be talking this up big time.    A strong currency is not necessarily a recipe for economic weakness, despite what some in Asia think.

That is why I was disappointed to see Robert Samuelson trot out the old “slow growth in the rest of the world” explanation for the expanding US trade deficit.   

“Faster economic growth in the United States than in many of our major trading partners has stunted our exports and increased our imports.”

That explanation just doesn’t cut it right now.    Global growth has been very strong since 2004 (look at the IMF’s WEO data).   In 2004, you could argue that Europe was lagging.  Not so any more.  Right now both global and European growth are strong.    That is one reason why US export growth has been quite strong since 2004 as well.

So why hasn’t the trade deficit fallen?  I suspect we may need to rethink how strong global growth influences the US trade deficit in a world where there isn’t much slack in the oil market.   The US imports a lot more of its energy than it has in the past.    And with limited spare capacity in the global oil market, strong growth means higher oil prices and a higher oil import bill along with higher exports.    And the US imports a lot of oil relative to its goods and services exports, so in the past few years, the oil import bill has increased along with US exports. 

Back to the $5 trillion question.    Are the world’s central banks tiring of holding depreciating dollars? 

The answer is clearly yes.    Russia has reduced the dollar share of its portfolio, the oil investment funds in the Gulf are looking to increase their investments in Asia  and China is increasingly worried about their dollar exposure.    

Stephen Jen reports (in his most recent note) anecdotal evidence that central banks have sought to reduce their dollar exposure from a couple of fund managers who manage money for central banks.  The Clarida/ Mariappa analysis of PIMCO also emphasizes reduced central bank demand for dollars – and that is a bit of a change for PIMCO.  They previously had pushed the “Bretton Woods is stable and will keep dollar bond yields low” line.   Now they seem to think that there are good alternatives to the dollar (even if they still seem to like dollar bonds).  They may know more than they let on – the UBS chart (presumably derived from the COFER data) in the article isn’t great supporting evidence, not the least because it ends in 2004.  

Christian Menegatti and I also found (modest) evidence of diversification in q4 2005 and q2 2006 (link here but it is behind the RGE firewall).  We compared the IMF’s COFER data to the growth in non-dollar deposits from central banks in the BIS data.  In both q4 2005, the increase in pound deposits exceeded the reported increase in pound reserves in the COFER data, and in q2 2006 the increase in euro deposits exceeded the reported increase in euro reserves in the COFER data.  The most likely explanation?   A shift toward pounds and euros by central banks that don’t report data to the IMF.

So why am I cautious? 

There is a second question – are central banks so tired of holding dollars that they are no longer willing to add to their dollar reserves, especially when the dollar is under pressure.

And on this point, the evidence is mixed.  Despite a bit of portfolio diversification (defined as a fall in the dollar’s share of total reserves), there is little doubt that central banks total dollar holdings are continuing to increase, and to increase rapidly.  Global reserve growth was quite strong in q3.    And I don’t see any evidence that is changing.   

If anything, reserve growth looks likely to pick up, as a group of Asian central banks enter the market to try to keep their currency from appreciating (Singapore has now joined Thailand and Korea).      And it is not just Asia.

  • Brazil’s reserves increased by $4.9b in November.
  • Russia’s reserves were up by nearly $10.9b through November 24.   The dollar’s 2.4% move v. the euro (through the 24th) and its comparable move v. the pound maybe explains $3.5b of that increase.   That still implies underlying reserve growth of around $7.4b in the first three weeks of November.
  • Thailand’s reserves were up about $1.5b through November 24 – also more than likely can be explained by valuation shifts.   And they likely intervened significantly in the last week of November. 

And so on.

If I had to bet, here is what I think is going on.    Most central banks intervene in the first instance in the dollar market.   They clearly bought a fair number of dollars in November.   Similarly, the oil exporters get paid in dollars, so they in the first instance accumulate dollars.     

In normal times, they sell a fraction of those dollars for euros and other reserve assets to maintain a balanced reserve portfolio.     However, in the past, when the dollar has been under pressure, the dollar-peggers generally have reduced their sales of dollars for euros.

One reason: the rise in the euro’s value has increased its share in their portfolio.

Another, possibly more important, reason: selling dollars for euros would add to pressure on the dollar – the last thing a central bank that is intervening to keep its currency from appreciating against the dollar wants. 

So my bet is that a bunch of central banks that already hold more dollars than they really want found themselves obligated to add to the dollar holdings (perhaps significantly) over the past two weeks, as private demand for dollars dried up.  

That is certainly what happened in late 2004.   

But, as Clarida and Mariappa note, rising dollar interest rates triggered a rally in the dollar – something that allowed central banks to lighten up a bit on their dollar holdings in 2005.    

Dollar reserve growth never actually turned negative, there were large euro purchases in the first half of 2005.    Something like 80% of new flows were going into dollars in late 2004, and in early 2005 that fell to around 50%.  (RGE Premium subscribers can see the Menegatti/ Setser paper for details). 

If the US economy rebounds in 2006 and that pulls the dollar up, central banks may get another opportunity to lighten up on dollars.    But a bunch of central banks have to be worried that the US may not rebound quickly, that the Fed may cut and the dollar may remain weak against the key European reserve currencies or even get weaker, forcing them to hold on to the dollars they recently bought.

And that is when things get interesting.  Central banks would either have to put plans for diversification on hold or risk adding to the pressure on the dollar ... and, if they peg to the dollar, adding to the pressures on their own currency.

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