Dollar to Fall, but Demise Exaggerated

The US dollar is likely to continue to fall as the year winds down, but reports of its demise have been grossly exaggerated.

News reports this week claiming that Brazil’s super-model Gisele Bundchan demanded compensation in euros rather than dollars, hedge fund manager Jim Rogers announcing he was selling all his dollars, buying yuan and moving to China, and an official in China’s largely impotent legislative branch, the National People’s Congress, said China would diversify reserves out of weak currencies and into strong ones dealt the greenback a body blow.

The US dollar fell to record lows against the euro and the legacy currencies and the Canadian dollar, reached multi-decade highs against sterling and the Australian dollar. As the week drew to a close the dollar was sold to new lows for the year against the low-yielding Japanese yen.

One economist was quoted, seemingly to represent the views of many, saying “the dollar is in trouble”. But is it really? Isn’t the news stream reminiscent of the late 1990s when taxi cab drivers would give internet stock tips? The news coverage of Bundchan and Rogers comments make it sound as if they are revealing some kind of state secret, but if truth be told, the euro has been rising since the fall of 2000, the last time the major central banks intervened in the foreign exchange market.

Rogers’ idea of selling all his dollars and buying the yuan clearly is not representative of anything but the “irrational exuberance” of the dollar bears. Surely even for “homo economicus”, Rogers’ calculation attributes no value to political freedom or liberties. While the US will allow Rogers to take his money out, if he were to change his mind, Chinese authorities would be less accommodating.

On November 7, China’s Cheng Siwei was quoted on the news wires saying, “We will favor stronger currencies over weaker ones, and will adjust accordingly.” This suggests China is going to diversify its some $1.4 trillion reserve holdings away from the US dollar and is pre-announcing it to the world. This does not past the smell test. What incentive do they have to tip their hand, even if that is what they intend to do? Instead, we suggest that what China and other central banks may be doing is diversifying the new reserve accumulations not their stock of reserve holdings.

Former Federal Reserve Chairman Alan Greenspan has also commented on the end of the dollar’s dominance. On Oct 1st he noted that the dollar’s status as the preeminent reserve currency was being eroded as the euro and sterling become more attractive.

However, a look at the data tells a different story. The most authoritative source of the currency allocation of reserves is the IMF and BIS. The most recent data covers the second quarter. An important caveat is that not all countries report the allocation of their reserves. The data available indicates that the dollar’s share of reserves slipped to 64.8% from 66.1% at the end of Q2 2006. The euro’s share rose to 25.6% from 24.8%. Together sterling and the yen’s share was 7.5%.

These figures would seem to show only the slightest shift in reserve diversification and even this overstates the case. Why? Valuation. Consider this thought experiment. Suppose you are a central bank. Your reserves are evenly divided between dollars and euros. Now over the past year the euro has risen almost 15%. You are a patient central bank. You have done nothing, yet because of the shifts in valuation, the proportion of your reserves in euros has increased and your proportion of dollars has declined. The shift in currency values would imply a greater shift away from dollars than the IMF reserve figures suggest.

Traditionally, many economists argued that central banks can be thought of as long-term counter-trend speculators. When the US dollar is weak, central banks intervene and buy it. China’s Siwei implied just the opposite; that the People’s Bank of China would be a long-term trend speculator. The last central bank that seemed to engage in such practices reportedly was Bank Negara, Malaysia’s central bank in the 1990s and it suffered sufficient losses for it to abandon the strategy.

Nor is the dollar overhang, which is what economists call what they think is a surplus of dollars in the world, as great as often portrayed. The US economy is about a third of the world’s economy, yet as we noted above, the dollar’s share of currency reserves is almost 65%. The discrepancy between the two figures though is not a fair measure of the dollar overhang because of the countries that are formally or informally tied to the dollar, the de facto size of the dollar-bloc if you will is arguably close to 2/3 of the world economy.

French President Sarkozy, speaking in the US earlier this week, seemed to encourage the US to intervene in the foreign exchange market to arrest the dollar’s slide. Why should it? The decline in the US dollar is not adversely impacting the US economy. If anything, it is helping it substitute foreign demand for the slackening domestic demand. Imported prices, excluding fuels, are not rising faster than domestic prices. Intervention would also confuse the message that US policy makers have been sending to China and other countries. Let the free market determine the value of the currencies.

President Bush appears poised to be the first president not to intervene in the foreign exchange market since the end of Bretton Woods. With the Federal Reserve still in a rate-cutting mode, a weaker dollar is consistent with US monetary policy.

While we should be prepared for a weaker dollar in the near-term, the dollar’s downtrend is getting long in the tooth. In terms of duration and magnitude it does not seem exceptional. Market participants often under-estimate cyclical influences and exaggerate structural influences. We caution against making this error with the dollar. Many foreign currencies, like the euro, sterling, and Canadian dollars are well beyond levels than reasonable valuation models would suggest is appropriate. As Rudi Dornbusch taught us, an overshoot in the foreign exchange market is perfectly rational, but it is still an over-shoot.