Weekly Foreign Exchange Developments: October 9th

October 9, 2009

The Obama Administration’s commitment to promoting a strong dollar has evoked considerable suspicion.  Reactions to this development can range over a very wide spectrum as defined by the following questions:

  1. So what else is new?
  2. This too will pass as it has many times before?
  3. Why has the crescendo of anxiety occurred at this particular time?
  4. Are the dollar’s loses really excessive?
  5. How aggressively will officials in the U.S. and elsewhere counteract the impression that the dollar is being managed neglectfully?

In 1968 before the U.S. currency floated, a dollar could be exchanged for 3.99 marks or 360 yen.  Following two devaluations in the early 1970’s and the introduction of flexible market-determined exchange rates, the dollar posted average values of DEM 2.246 and JPY 198.9 in the 1980s and DEM 1.639 and JPY 118.8 in the 1990’s.  The dollar’s average DEM-translation value in the present decade of 1.708 was actually 4.2% stronger than the 1990’s mean, and its current implied price of DEM 1.326 today is 19.1% weaker than its 1990’s mean versus a drop of 58.9% between 1968 and the 1990s average.  Against the yen, the dollar lost 44.8% from 1968 to the 1980s mean and a further 40.3% from its 1980s average to its 1990’s average.  The drop from the 1990s mean to the average value in the present decade was a small 5.3%, by comparison, and even the 24.7% drop from the 1990s mean to the present spot level represents a slower rate of depreciation.  The dollar has fallen since August, but we’ve seen a much worse performance in the past.

This is not an easy time to discern long-term currency market trends from cyclical noise.  Very wide swings in dollar rates have occurred during the twenty-six months since the onset of the global financial crisis in August 2007, with high-low range widths of 67.7% against the kiwi, 63.8% against the Australian dollar, 56.7% versus sterling, 44.2% against the Canadian dollar, 37.6% against the yen, 30.1% against the euro, and 27.7% against the Swiss franc.  Since the period began, the dollar has lost 26.4% against the yen, a considerably smaller 6.2% against the euro, and 3.3% relative to the Australian dollar.  Net appreciations of 27.7% against sterling and 0.7% against the Canadian dollar were recorded.

The backdrop to the hysteria over a slip-sliding dollar is the worst global recession since the depression, the stalled momentum toward freer world trade that preceded the recession, and the reliance on export-led expansion in many economies as the world haltingly emerges from recession.  Currency manipulation is the most powerful form of trade protectionism because it affects all traded goods prices, not just a few industries.  U.S. government officials from both Democratic Party and Republican administrations have been mouthing the mantra since 1995 that “a strong dollar is in the interest of the United States” and have signed repeated international agreements that “excess volatility and disorderly movements in exchange rates have adverse implications for economic and financial stability.”  However the last time the United States bought or sold dollars against foreign currencies and called such intervention was in the second half of 2000, a time of dollar strength and euro weakness.  The Fed meanwhile issues regular statements defending its ultra-easy monetary policy without mentioning the dollar.  These actions speak louder than words in shaping market investor impressions.

China’s emergence as key economic and financial player in the world economy makes present worries about the dollar more acute in many ways than in earlier bouts of dollar weakness.  China holds dollar-denominated assets of an unprecedented magnitude.  China’s currency is very tightly managed by Beijing officials and has been frozen against the weakening dollar since July 2008.  Other Asian governments fear a loss of competitiveness vis-a-vis China, and several intervened heavily this past week to limit further appreciation of their currencies against the U.S. dollar.  The history of currency diplomacy with China over the past ten years is that demands by other governments have very small influence.  Changes are made when deemed beneficial from a domestic point of view, and the internal debate in Beijing on what yuan policy is best for the economy is not settled.  The exchange rate will be allowed to climb only when the internal pros and cons are sorted out.  Predicting the timing of such an essentially political decision reduces to a role of the dice. 

Officials from other regions are uneasily watching the faltering dollar.  Europeans are speaking out more frequently about the necessity of a strong dollar.  Commodity-intensive economies like Canada, Australia, South Africa and New Zealand are at particular risks.  From post Labor Day lows, the kiwi and Aussie dollar have each risen about 10% against their U.S. counterpart, while the Canadian dollar is up over 6%. Well-bid commodities have caused some economies, notably Norway and Australia, to be ahead of the global norm in escaping from recession.  Without a well-designed plan to cap dollar weakness, their currencies are likely to remain among the world’s strongest.

For a general turnaround in the dollar’s fortunes, the main impetus has to come from Washington.  Investors in the past relied on the potential for imported inflation, upward pressures on interest rates, and capital outflows to discipline U.S. governments into rescuing the dollar from excessively sharp downswings.  This time the dollar hasn’t dropped in a disorderly way.  The biggest indication that something may be seriously amiss is coming from record high gold prices. While other metals also have advanced sharply, oil remains at less than half the 2008 peak.  U.S. interest rates haven’t climbed despite the economy’s transition into recovery, and stock values are bubbling upward.  The impact of lip service is unlikely to be sustained without concrete U.S. policy changes or a credible reason to fear the imminence of changes.

The motivation for the Obama Administration to support the dollar with action as well as words needn’t be limited to the above tangibles, however. A rising currency is a symbol of power and respect that can infuse America’s image as a superpower economically and in foreign policy.  The United States is badly in need of each.  So is the Obama Administration, which aside from averting a financial meltdown and economic catastrophe has few accomplishments as Election Day approaches.  Some of the president’s advisors will argue that “it’s the labor market, stupid” and that dollar depreciation, not appreciation, promotes that goal.  But others will caution that risks mustn’t be taken that jeopardize the dollar’s status as king of reserve currency portfolios.  Renown Harvard economist Ken Rogoff was quoted in Thursday’s FT saying that “the financial crisis probably has brought forward the day when the dollar is no longer dominant — but maybe from 75 years to 40 years.”  That’s too cavalier.  It’s been 41 years since 1968, and the dollar would be worth Y 22.1 and 4.44 per euro in 2050 if it replicated its 1968 to 2009 losses in the coming four decades.  Can anyone imagine that happening and the dollar remaining the most favored reserve currency?

There is a another way for the dollar to climb sharply in the next six months or so, but it’s not a nice scenario to contemplate.  The structural shortcomings that led to the global recession remain largely unrepaired, and asset bubbles have returned.  A complete relapse in financial markets and the global business cycle remains possible.  The first round of such proved very supportive for the U.
S. currency.  History might repeat.

Copyright Larry Greenberg 2009.  All rights reserved.  No secondary distribution without express permission.


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