from Follow the Money

At least London is affordable again

October 24, 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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When the pound falls more in a week than it did during the week of Black Wednesday, the week when Soros famously "broke the Bank of England," you know big changes are afoot. Bloomberg reports:

Today’s drop in the pound brought the decline this week to 10.1 percent, the most since at least 1971 .... The currency lost 9.8 percent in the week when U.K. Prime Minister John Major pulled the pound out of the Exchange Rate Mechanism on Sept. 16, 1992 in what became known as Black Wednesday.

``These moves are absolutely without precedent,’’ said David Watt, a Toronto-based currency strategist at Royal Bank of Canada Ltd. ``The 1970s are pretty much the extent of the data you’re going to get because currencies didn’t even float that far back.’’

The dollar is rising against everything except the yen -- which just hit a 13 year high against the dollar. The Indian rupee hit a new low against the dollar -- which implies that the yen has really shot up against say the rupee, and pretty much everything else.

That tells you all that you need to know. This is much more of an unwinding of carry trades than a flight to quality -- though there is an aspect of that too. Some Russians for example, seem to have rediscovered the joy of holdings dollars rather than rubles.

The dollar’s rally has a silver lining. It has pulled the RMB up too -- and the RMB needed to appreciate against most European and emerging market currencies. The real appreciation of the RMB over the last few days and weeks has been far larger than the real appreciation associated with the RMB’s 20% nominal appreciation against the dollar.

That is good. China is the major oil-importing economy with the fastest growth, the biggest current account surplus and the lowest fiscal deficit (a surplus actually) going into the current crisis. It has the most capacity to use counter-cyclical fiscal policy to support its growth. Its currency should be appreciating in real terms right now.

It is harder to see the fundamental case for dollar appreciation though.

The dollar clearly was a "funding" currency for a lot of bets on the emerging world -- the dollar not only had fairly low interest rates, but it was tending to depreciate over time v. many emerging market currencies. Companies in the emerging world -- and high octane leveraged investors in the advanced economies -- bet that this trend would continue. Those bets have gone sour fast.

But the US still has a significant trade and current account deficit -- and setting the dollar aside, the currencies of most countries with trade and current account deficits have depreciated not appreciated recently. The dollar’s recent appreciation certainly won’t help to close the trade deficit. The US trades a lot with Korea, Mexico and Europe. If the current trend is sustained, US export growth will slow -- perhaps sharply. That cuts into one of the current bright spots in the US economy.

The fall in oil prices and fall in domestic demand will tend to reduce the deficit -- but the benign adjustment scenario, one driven by rising global demand for US goods and services seems off the table for the moment.

The net effect, I suspect, is that the US will still run a significant -- though smaller -- deficit. And once the deleveraging process is over and the US deficit cannot be financed by the sale of US foreign assets, China’s government will continue to finance a large share of the US deficit.

The dollar block will be in balance: The oil exporters that peg to the dollar will be in rough current account balance, and the US deficit will roughly match China’s surplus.

That at least is my best current guess.

It is hard enough to guess what the global financial system will look like next week, let alone next year. The only safe bet is that the IMF, the US Treasury, the Fed, and nearly every other government will be very busy.

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