The Dollar Express

February 19, 2010

The dollar is coming off yet another solid week.  While attention continued to be riveted on the high debt and deficits of Euroland’s peripheral countries like Greece, Spain, Portugal and Ireland, the dollar scored its largest advances of the week against the yen, a new development, and sterling, which is an old story.

The yen has outperformed the dollar often over the past two and a half years. Compared to the start of the global financial crisis in early August 2007, the dollar still shows a significant net decline of 22.5% against the Japanese currency.  Japanese real GDP contracted more sharply than the United States, sliding by 1.2% in 2008 and 5.0% last year.  Because Japanese deflation has roared back with a vengeance, the Bank of Japan has much less latitude to normalize policy than does the Fed, even though both economies enjoyed much brisker growth last quarter than did Europe.  Japan has accumulated much more debt than either the U.S. or Europe, but domestic investors keep absorbing the incremental deficit without any sign of distress.  The current 10-year Japanese Government Bond (JGB) yield is 1.34%, practically spot on last year’s average of 1.36%.  The yield had averaged 1.56% in 2004-08, 1.35% in 2000-03 and 3.85% in the 1990s.  Because they were already very depressed by 2007, JGB yields have fallen less sharply since the beginning of the financial crisis than the comparable returns on other G-7 sovereign bonds.  Japan’s location in the world economy’s most dynamic region, and the nation’s current account surplus, which is equal to almost 3% of GDP, provide other sources of yen support.

But the yen has repeatedly failed to sustain upside traction against the dollar beyond the 90 level.  Fourteen months have now passed since it penetrated that psychological barrier in late 2008.  Repeated missions into the 80s got no further than 84.83 in 2009, and dollar/yen has averaged 93.1 since the initial penetration into the 80s.  Japan’s greater historical readiness to use foreign exchange intervention has made an impression on investors, who know that the economy’s keen dependency on exports means that appreciation beyond 90 poses significant risks to the fragile recovery.  The yen seems perhaps overdue to take the lead from the euro in falling against the dollar as the Fed but not the BOJ shifts policy gears.

The same cannot be said about sterling, which is now trading some 24% below its dollar level at the start of the financial crisis.  Financial services made up a comparatively big share of U.K. GDP, priming that economy for a big cyclical and structural hit from the Great Recession.  The U.K. budget deficit is in double digits, and debt has climbed to 60% of GDP from marginally less than 30% in the 2001/2 financial year.  A current account gap of about 1.5% of GDP has developed.  Britain lagged the emergence of other G-7 economies from recession.  In spite of a comparatively high 3.5% rate of CPI inflation, which Bank of England officials blame on the VAT increase and energy price swings, policymakers have signaled repeatedly that a return to quantitative easing would be undertaken if Britain’s economy stumbles anew.  As other central banks start to implement exit strategies, the Bank of England straddled the fence more tenaciously, unsure of which way it will go next.  Elections must be held in about three months, and polls suggest the possibility of a hung parliament with party securing a majority in parliament, which would be the worst outcome of all from sterling’s standpoint.

None of the incumbent Group of Seven governments are in secure positions.  Fiscal gridlock does not have the same currency implication in all instances, however.  Investors are very leery about an unchecked Democrat activist agenda and breathed a sigh of relief when the healthcare bill derailed.  The U.S. government was custom-built for shared power and has functioned decently at such times in the past.  Parliamentary systems, in contrast, combine the legislative and executive branches and were not intended to produce situations where the majority party is unable to implement its policy manifesto.

In Euroland’s case, an even greater problem is the dispersion of fiscal responsibility among sixteen different sovereign fiefdoms.  Even with a separate agreement that would have penalized countries whose deficits exceeded 3%, the euro area never fit textbook conditions for forming a currency union.  Critics of the plan pointed this out repeatedly beforehand.  A further blow to the perceived legitimacy of the project occurred when most governments refused to submit the decision to voters via national referendum, and in those few exceptions such as France in September 1992, the majorities voting affirmatively to endorse a common currency and single monetary policy were razor thin.  A change as profound as the European Monetary Union ought to have been subjected to a much stiffer standard like a minimum two-thirds majority.  The fact is that the main proponents of the project — former French President Mitterrand and German Chancellor Kohl — sought the move mostly for foreign policy reasons, not for economic consequences.  Their thinking was that having a common currency would end the possibility of another big intra-European war.  Their logic appears flawed.  In fact, as we see now, tensions over shared fiscal burdens can be a source of immense friction and resentment and not a promoter of greater brotherhood.  As for the Stability and Growth Pact that would have policed and prevented fiscal excesses, any chance for decent enforcement was dashed when the big members, especially Germany, colluded to make an exception of themselves in the early years of the experiment after recessionary conditions had cut tax revenues.

Fiscal policy issues are weighing on the euro because of the distribution of the imbalances, not its overall size. The whole bloc’s deficit in 2010 will be about 7% of GDP, smaller than Japan’s gap and about half the size the U.S. or British budget shortfalls.  The uncertain resolution of a few situations within the European Monetary Union (EMU) is the source of the euro’s current difficulties, particularly when combined with data that suggest a very tepid and fragile pace of economic growth in the region.  All options look very painful, even a decision to leave the herd.  Greece has been targeted by speculators because it has the worst numbers  — debt up to 125% of GDP, a budget gap exceeding 12% of GDP, an equally large current account imbalance, big maturing loans in the next few months, and powerful unions mindless of the consequences of seeking their parochial interests.  However, Spain is my greater worry because of the sheer size of its economy. 

This whole mess is going to keep festering over the month to Greece’s deadline on March 16, breeding uncertainty and a stream of headlines that may be damaging to the euro.  Recent technical damage in the EUR/USD relationship suggests that a move close to $1.30 is quite plausible.  Considerably beyond that big figure is the euro’s 2009 low of $1.2458.  I expect Greece to stay in EMU.  The Maastricht Treaty upon which EMU is based does not address how members might disengage from EMU, so investors have concluded that defections are unthinkable.  That’s not really so, but the market’s mindset means that financial prices would get badly rocked if Greece were to walk away so soon after the worst global recession in 75 years.  That’s why more than Continental Europe has a stake in avoiding EMU’s breakup.  It really becomes a problem for everybody and grist for G-20 diplomacy.

The Swiss franc should be one beneficiary of the near-term uncertainty surrounding the euro.  The assault on bank secrecy laws removes one of the huge historic appeals of the franc, but others remain.  The Swissy is backed by low and stable Swiss inflation, a current account surplus of nearly 8% of GDP, and a tiny fiscal deficit.  Now emerging from recession and thus with a fading deflationary danger, central bank authorities have made their management of the EUR/CHF cross rate more flexible this year.  The franc is 11% stronger against the dollar than it was at the start of the financial crisis, which is somewhat less than half as much as the yen’s rise over that period.  The franc edged only marginally higher this past week against the euro.  The threat of intervention remains an effective deterrent, but there’s no line in the sand as was the case during much of last year.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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