Playing With Fire

Old men should know that playing with fire is dangerous. Yet that is precisely what they have done. Many have argued that the large US external imbalance was a major risk to the world economy. The previous solution was for the US to boost domestic savings, for Europe and Japan to make structural reforms to boost domestic demand, and for Asia to adopt more flexible capital markets. The lack of political will to implement the strategy led to the more expedient course of signaling that the currency market should be a greater burden of the adjustment and that in turn has sparked a near free fall in the US dollar.

Officials warned that the US trade deficit is not sustainable and that it injects unnecessary into the capital markets, which distorts investment and economic decision making. But the real disruption to the capital markets, with potential negative impact on world growth has been the clumsy attempt by the G7/IMF trying to fix the problem. Global equity markets have sold off. The rise of global interest rates has accelerated. With a sharply falling dollar, the ability to smoothly finance the US current account deficit is called in to question as the lukewarm reception to the Treasury’s recent auctions indirect bidders. The cure seems worse than the disease.

Although a number of officials, including from the ECB’s Trichet, the Fed’s Bernanke, and at least two senior MOF officials from Japan, indicated the G7 did not signal a general dollar sell-off, the market suspects otherwise and understands those comments as half-hearted attempts to maintain an orderly market. Thus far the absence of clear, strongly worded protests to the pace or magnitude of moves in the foreign exchange market is understood by many participants as acquiescence at the very least and possibly even sanctioned. While the euro was motoring ahead, at least two ECB officials indicated without apparently much prompting that more aggressive rate hikes might be needed. The comments seemed to reflect the lack of concern about the euro’s appreciation.

Been There Done That

Political considerations had seemed to argue against a new G7 policy initiative. The governments in Germany, Italy and Canada are new. Japan’s Koizumi is expected to step down in the fall and a new head of the Finance Ministry is likely. Many people suspect that UK Prime Minister Blair may step down before the end of the year as well. The French government is unpopular and there is talk that President Chirac may reshuffle his government to bolster the party’s chances for next year’s election. In the US, there continues to be speculation that Treasury Secretary Snow’s may be replaced shortly. One of the people rumored to be a likely candidate is Harvard’s Martin Feldstein. Although news wires report that senior US Treasury officials have in both public and private requested officials refrain from not only material intervention by verbal commentary as well.

Yet rather than prevent a new initiative, the political weakness of the individual G7 countries has led to a reversion to an earlier and politically expedient strategy: in lieu of the political will for implementing structural reforms, let the currency market bear the adjustment. In effect, the US had abandoned the strong dollar policy, first articulated by Robert Rubin to signal a break from the devaluationist thrust of his predecessor Lloyd Bentsen.

Many observers have portrayed the G7/IMF stance as multilateral. This is deceiving. There have been two other meeting in recent weeks of monetary officials (ASEAN+3 in early May and the Asian and European finance ministers met in late April) and the statements that were issued did not reflect the sense of urgency of the G7/IMF meeting communiqué and the key difference was the absence of the US.

Also, consider that after the 1997-1998 Asian financial crisis, insofar as the IMF essentially pushed for the implementations of the Washington Consensus, it is hardly perceived as an independent actor. US foreign economic policy is a sub-set of US foreign policy. This is another “coalition of the willing”. In addition, while there is official recognition that the voting system of the IMF no longer reflects economic reality and reforms are likely to announced in September, it did not prevent the old IMF in which developing countries, including China, India, South Korea, Brazil and Russia are not fairly represented from taking on a new foreign exchange mandate.

We have been down this road before. The pattern is for European and Japanese officials to “cry uncle” before the US and long before the dollar has fallen to levels that the conventional view says is required to correct global imbalances. With the US Congress approving the renewal of some the Bush Administration tax cuts, the signal being sent is that the US may not be serious about boosting savings and will rely on currency depreciation. As the euro near the psychologically important $1.30 level and the dollar spends more time below JPY110 and global equity and bond markets become more volatile, it will not take long for domestic pressure to build and resistance to dollar depreciation to grow

Politically Expedient but Maybe not Effective

If dollar depreciation would work to reduce the global imbalances, it would arguably be acceptable. However, the problem is that, looking at the actually track-record, rather the sophomoric economic theory, there is little evidence that a decline in the dollar would achieve the goal. The US dollar peaked against the Canadian dollar in 2002. The Canadian dollar has appreciated by about 50% in the past 4-years, which is what some of the more extreme estimates suggest the Chinese currency is undervalued by. The average monthly US trade deficit with Canada has risen from about $4 bln in 2002 to about $6.7 bln. The four years that have passed should be enough to offset the “J-curve” effect that economists speak of to account for a lag between changes in the price of financial variables and changes goods prices.

This experience is not limited to Canada, the US’s biggest trading partner.

Consider Europe. The euro recorded its historic low against the dollar in 2000 near $0.8230. It too has appreciated by 50%+ against the US dollar. The US recorded an average monthly trade deficit with Europe of roughly $5 bln in 2000 and 2001. It stands at $10.4 bln now.

What about Japan ? The dollar’s has been recording low highs against the yen for nearly 20-years. The last major high was in 1998 near JPY147.50. The peak in 2002 was near JPY135. In 1998, the average US monthly bilateral trade deficit was about $5.3 bln. Now the monthly average is closer to $7 bln.

Given that policy makers cannot be sure that even if the Chinese currency appreciates against the US dollar that the bilateral imbalance will improve, the risks of the current strategy seem greater than likely rewards. Sure nearly every one agrees that the US external imbalance is not sustainable, the sense of urgency does not seem justified. There are more urgent issues, for which Chinese cooperation is more critical and with a higher probability of success. Such issues would include Iran, North Korea, Taiwan, the regional arms race and environmental issues.

Feel Mush, Push

In sword fighting, it is said, when you feel mush push; feel steel, retreat. The dollar feels like mush and the market is pushing. While technical indicators and short-term speculative positioning are at extreme levels, warning that a technical correction may be in the offing, until the official pain threshold is reached, the dollar bears will remain in control.

Support for the euro is seen near $1.2830 and $1.2750. Many investment banks have revised down their dollar forecasts based on the recent price action and many are now looking for a test on the $1.30 level. As more observers recognize that the US has abandoned the strong dollar policy in everything but the exact words, the risk is that the euro tests its record high near $1.3660 this year. The dollar faces important resistance near JPY112.00 and while the JPY109 may now offer support, the real objective is closer to JPY105-JPY106.

The dollar’s depreciation is tantamount to a partial default. The risk is that officials will find it increasingly difficult to arrest the greenback’s decline as this becomes more evident. In a world of fiat currencies, confidence in officials is a critically salient factor. Confidence in the US Administration is on shaky ground at best at the moment and it does not seem to realize it.

The combination of low volatility, low interest rates in the advanced industrial countries, plenty of global liquidity and rising commodity markets has fueled a multi-year rally in many emerging markets. These conditions, except commodity prices, have changed. The risk is for a larger unwinding of emerging market investments. Investors in the emerging markets could be among those burned when old men play with fire.