from Follow the Money

Has the dollar peaked?

December 12, 2008

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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For much of the most recent phase of the rolling global crisis, the dollar and the yen rose against the euro, the pound and most emerging market currencies.

Some of that was a reaction to the euro’s extreme strength going in to the crisis; a $1.55 euro amid a European recession would have made life very uncomfortable for many European manufacturers.

But some of the dollar’s rise also reflected a global scramble for dollar liquidity, whether as a safe have (compared say to the ruble, the dollar looks good .. ) or to repay dollar-denominated debts. John Authers of the FT:

On a trade-weighted basis, the dollar rose 22.7 per cent from July until its peak last month. This was not, evidently, due to any great strength in the US economy. Instead it was largely a perverse phenomenon – as traders sold assets to pay down debts (deleveraging), they often had to buy dollars. So as the crisis intensified, so the dollar strengthened. The only exception to this was the yen, which does even better than the dollar when investors are anxious.

Over the past two days, though, the dollar has fallen against both the euro and the yen.

The US trade data surprised on the downside -- and while it is far too soon for the dollar’s recent rise to really have an impact on the trade data, the rise in the deficit perhaps did remind the market that over time a rising dollar would tend to maintain the still large trade deficit not bring it down. Macro man was far more surprised by the rise in the non-oil deficit than I was; it was always going to be race down between imports and exports. And last month exports fell by more ...

The collapse of Madoff’s investment fund presumably hasn’t done wonders for the United States image as a financial safe haven either. His stable, predictable returns turned proved too good to be true. See Cassandra (hat tip Naked Capitalism).

And the apparent collapse of Detroit’s bailout hasn’t helped.

The risk that the much of the US auto sector might be pushed not just into Chapter 11 (I sure hope they have contingency plans ... so any restructuring is fast) but could spiral into liquidation cannot be good for the dollar. Ford, GM and Chrysler still do make significant numbers of vehicles for sale in the US. If a couple of them end up liquidating, the US will either end up buying fewer cars or importing more cars. And over the longer-term, a weaker dollar would be needed to induce European and Japanese manufacturers (or any new electric car start-up) to produce vehicles for the US market in the US -- or to generate the additional exports the US would need to pay for additional automobile imports.

Many emerging market currencies have slid too. But at least one emerging currency also did reasonably well this week: Korea’s won.

Korea has secured $48 billion in swap lines from Japan and China, adding to the $30 billion swap line it now has with the US.

I rather suspect that when the network of Asian swap lines was first created, Korea viewed itself as a likely lender to weaker Asian economies not a likely borrower. But times have changed. Korea has managed to secure more cash through swaps this time around than it got from the IMF last time.

China and Japan weren’t acting entirely altruistically though. The large northeast Asian economies don’t trade among themselves to the same degree that the large European economies do. But they do compete against each other in global markets. Won weakness wasn’t good for either Chinese or Japanese exporters. Pulling the won back up consequently will help reduce the yuan and the yen’s effective strength.

The fact that Korea was able to obtain large quantities of dollars from others in Asia -- and that it did so with having to turn to the IMF -- illustrates how much the world has changed.

At the same time, it is striking to me that the US provided more than either China or Japan and, well, the US doesn’t have many formal foreign currency reserves. So long as the world needs dollars in pinch, the US doesn’t need to hold all that many foreign currency reserves. The Fed has an unlimited ability to provide dollars against won (or other) collateral if it decides too.

And that has meant that the US has played a far more central role managing the global aspects of this crisis than I would have expected six months ago --

At the same time, the US isn’t the world’s only large source of dollar liquidity. Korea has obtained almost $50 billion -- far more than it ever actually borrowed from the IMF and the World Bank in 1997 and 1998 -- without going to Washington. And that is an important change.

UPDATE: The Treasury isn’t going to let Detroit fail, at least not just yet. The TARP will undergo yet another incarnation.

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