Opening Currency Market Act of 2012

January 5, 2012

The dollar started 2012 on a high note just as it did in the first week of three of the past five years.  Between yearend and January 7, the dollar appreciated against the euro by 3.6% in 2011, 2.5% in 2009 and 1.4% in 2007.  It was unchanged in the first week of 2010 and slid 0.6% in the opening week of 2008.  Going back further, one also finds a statistically significant tendency for the dollar to perform well in early January against the main currency of Europe.  Even though the fundamental economic backdrop has favored U.S. assets, care should be taken in not reading too much into the dollar’s opening strength this year, which saw it climb against the euro to pricier levels than attained at any time during 2011.

In recent years, the United States economy has often resembled the one-eyed man in the land of the blind.  True, real GDP fell 5.1% during the Great Recession from peak to the trough, but Japan and much of Europe suffered worse.  Likewise, the annualized 1.6% pace of U.S. real GDP growth since end-1999 compares unfavorably with growth of 3.6% per annum in the second half of the 20th century but still beats the recent difficulties of other advanced economies.  Unemployment too is high by U.S. standards but less than the jobless rates in Continental Europe.  The U.S. current account deficit of 3.1% of GDP during January-September of 2011 is greater than one would like to see but nonetheless only about half of its pre-crisis peak.  While many European nations suffer to sell government paper, the U.S. enjoys historically low long-term interest rates, and the U.S. stock market has also performed comparatively well next to other bourses.  From many respects, the dollar seems positioned to appreciate.

That’s not a view shared by the U.S. government, however. Referring to IMF empirical studies, a semi-annual Treasury Department report on international economic and exchange rate policies released December 27 observed that “the real effective exchange rates of the Brazilian real and U.S. dollar were estimated as overvalued. No overall estimate was provided for the Canadian dollar, but based on the three models it was close to medium-term fundamentals. The real effective value of the euro, the yen, the Mexican peso, the Swiss franc, and the pound sterling were judged to be in line with medium-term fundamentals. The Korean won and the Chinese renminbi were undervalued.”

The Treasury is supposed to identify any governments that are “currency manipulators,” a designation that would put passage of U.S. sanctions against such countries on the fast track.  Once again, Treasury officials did not place any nation on that list, but clear impatience was expressed about the behavior of China, Japan and South Korea.

China is often the object of such criticism.  The most recent Treasury report opines that “while China’s real exchange rate has appreciated, the process of appreciation remains incomplete. China’s long-standing pattern of reserve accumulation, the persistence of its current account surplus and the incomplete appreciation of the renminbi, especially given rapid productivity growth in the traded goods sector, indicate that the real exchange rate of the renminbi is persistently misaligned and remains substantially undervalued.  It is in China’s interest to allow the exchange rate to continue to appreciate, both against the dollar and against the currencies of its other major trading partners. A lack of continued appreciation by China would prevent the exchange rate from serving as a tool to encourage consumption so as to maintain strong, sustainable growth, further complicate the adjustment needed for broader financial sector reform, and undermine China’s stated goal of strengthening domestic demand.  In light of the persistent misalignment of the RMB at a substantially undervalued level, Treasury assesses that movement of the RMB to date is insufficient and more progress is needed.” 

Chinese currency reserves at the end of September equaled $3.22 trillion, the most by far of any country.  In second place at $1.22 trillion was the reserve total of Japan.  The total grew sharply in 2011 as a result of a few huge currency market interventions by Japanese authorities, the last two of which on August 4 ($59 billion) and October 31 ($116 billion) drew a sharp rebuke from the U.S. Treasury report.

The unilateral Japanese interventions were undertaken when exchange market conditions appeared to be operating in an orderly manner and volatility in the yen-dollar exchange rate was lower than in, for example, the euro-dollar market.  In contrast to the G7 joint post-earthquake intervention in March 2011, the U.S. did not support these interventions.  It is worth noting that these operations took place at a time when foreign exchange market activity and risk aversion were being predominantly influenced by financial developments elsewhere in the global economy that were impacting all of the major currencies.  Rather than reacting to domestic “strong yen” concerns by intervening to try to influence the exchange rate, Japan should take fundamental and thoroughgoing steps to increase the dynamism of the domestic economy, increase the competitiveness of Japanese firms – including those in utilities and services – and raise potential growth.

The government of South Korea is another government with borderline justification for all its intervention.  “The Korean authorities should limit their foreign exchange intervention to the exceptional circumstances of disorderly market conditions and adopt a greater degree of exchange rate flexibility.”

In Switzerland’s case, by contrast, U.S. authorities express their complete sympathy for the central bank’s policy since early September that sets a ceiling of 1.2000 francs per euro, enforced by a willingness to intervene if necessary and increase liquidity in unlimited amounts.  In explaining why that instance should be handled differently than the situations in China, Japan, and Korea, U.S. authorities seem to welcome the opportunity to underline why the latter interventions are inappropriate by pointing to a different example that defines the limited circumstances when currency manipulation is acceptable.

The Swiss franc usually has been a freely floating currency, and the Swiss National Bank sets monetary policy to keep inflation stable at around 2%.  The circumstances prompting the actions by the SNB are unique to Switzerland.  It is a small open economy that has been disproportionately affected by the financial stresses in Europe, resulting in disorderly movements in the exchange rate.

Taken in totality, the Treasury report says more about the currency policy of the United States than of the countries singled out for criticism.  For most of the past forty years, the United States has implemented a policy of benign neglect.  The two exceptions were in the early 1980s when President Reagan interpreted dollar appreciation as living proof that the United States is going in the right direction and the latter 1990s when the government bent over backwards to convince investors that the notion of benign neglect was grossly mistaken and that a strong dollar was instead desired to keep inflation and interest rates low while attracting foreign capital inflows.  Once again, investors believe that both the Fed and the Treasury prefer an undervalued dollar to an overvalued one.  This market sentiment has been an X-factor in recent years, explaining why the dollar has been on offer against the yen and why the euro hasn’t collapsed. 

The table below shows the dollar’s highs and lows in 2009, 2010, and 2011 against selected other currencies including the euro.  Note that the ranges against the euro and sterling were more or less similar each year.  The euro showed more consistent weakness against the euro, shown in the final row of the table.

  2009 2010 2011
EUR/USD 1.5144 – 1.2458 1.4582 – 1.1878 1.4939 – 1.2856
USD/JPY 101.44 – 84.83 94.98 – 80.25 85.54 – 75.31
USD/CHF 1.1967 – 0.9919 1.1730 – 0.9300 0.9785 – 0.7085
GBP/USD 1.7043 – 1.3505 1.6457 – 1.4232 1.6745 – 1.5270
AUD/USD 0.9405 – 0.6250 1.0253 – 0.8068 1.1080 – 0.9386
EUR/JPY 139.22 – 112.06 134.38 – 105.44 123.33 – 99.58

One of the great questions as 2012 lays stretched out ahead is whether this will be the year when the long-awaited substantial drop of the euro occurs against the dollar.  Opinion is mixed.  While many analysts believe it will be so, a separate school sees the euro ending the year about 10% stronger than now.  For more on that contrarian view, see this earlier posting.

Copyright 2012, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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