Author: Chris Brown, Gordon Platt

FOREIGN EXCHANGE

missing-picture The dollar faces the prospect of further losses in 2007, particularly if growth in the US economy slows significantly, analysts say. While interest rates are likely to rise in Europe and Japan, where economic growth is picking up, many economists expect the Federal Reserve to cut US rates later this year, sawing away a major prop for the dollar.

Like the Republicans, the dollar took a thumping in November, falling 4% against the euro, with the bulk of the losses coming in the days following Thanksgiving. The decline came after the White House downgraded its economic growth forecasts for 2007 due to a weakening in the housing market.

An impending slowdown in corporate earnings growth due to rising unit labor costs and a slowing economy will undermine foreign appetite for US assets, according to an analysis by Barclays Capital in London. Repercussions of the US midterm elections, including an expected increase in the minimum wage and more-protectionist policies from a Democrat-controlled Congress, will weigh on the dollar, it said in a report by its global foreign exchange strategy team headed by David Woo. Meanwhile, the eurozone is at an early stage of recovery and more-robust domestic demand will help insulate an export slowdown and support the euro, according to Barclays Capital.

The European Central Bank raised its repurchase rate to 3.5% on December 7, to almost no one’s surprise, and the bank’s president, Jean-Claude Trichet, signaled further interest rate hikes are likely in 2007, although probably at a slower pace than in 2006, according to Gabriel Stein, director and chief international economist at London-based Lombard Street Research. The first increase is unlikely to come before March, he says.

Trichet made no attempt to talk down the euro in his press conference following the ECB rate rise in December, in part because such attempts would have been futile in a market that was moving in the opposite direction, Stein notes. What’s more, the eurozone can live with the stronger euro, particularly if it will help unwind global trade and payments imbalances, he says.

Germany’s trade surplus rose to a record $23 billion in October 2006 on a sharp rise in exports outside the EU. Overall exports in Europe’s largest economy rose by 22.6% from the same month a year earlier. Germany’s IFO index of business sentiment rose to a 15-year high in November, and unemployment hit a four-year low.

As Good as It Gets in Europe?
“The risk is that the best of the eurozone’s cyclical recovery is behind it,” says Marc Chandler, global head of currency strategy at Brown Brothers Harriman in New York. A combination of higher taxes, higher interest rates and the stronger euro could undermine growth in the quarters ahead, Chandler says. Meanwhile, European politicians are likely to increasingly voice their objections to further euro appreciation, he says.

missing-picture Already, French prime minister Dominique de Villepin has complained about the rise in the euro and suggested that the currency’s management cannot be left to the ECB alone. “The threat of a politicization of euro policy spooks the market,” Chandler says. Villepin made his comments at a meeting with EADS, the parent of Airbus. He said the strength of the euro penalizes French industry at the expense of the US competition.

“This is similar to US automakers’ complaints about the yen’s weakness,” Chandler says. The ECB is a new central bank, and its relative uniqueness suggests that the eurozone is still in its early years of the bank’s evolving role, he says. In the US, he notes, it took several decades for the Treasury and the Federal Reserve to come to some agreement on the responsibility for currency issues.

Other than a move by speculators to take advantage of thin holiday markets, analysts gave no clear explanation for the sudden plunge of the dollar at the US Thanksgiving. “The dollar has sold off at the end of the last couple of years as well, only to bounce back early in the new year,” Chandler notes. It could happen again, particularly if the Federal Reserve, the stock market, the commodity markets and emerging markets are right and the US economy has a soft landing, he says. “The debt market and the currency market have been trading as if the US economy were poised for a hard landing,” he says.

Still World’s Reserve Currency
Reports of foreign central banks shifting reserves out of the dollar have been around for months. “The dollar is still the world’s reserve currency,” Chandler says, “and there is still no lack of will from the US political elite to rule the world.” There is no clear alternative to the dollar as the anchor for the global currency system, he asserts. “The Europeans are studying their navel and worrying about new countries joining the EU or other countries getting kicked out,” he says. “Japan is too internally looking. China could play a bigger role perhaps one day, but it is only a $2 trillion economy right now, slightly bigger than the economy of the state of California,” he adds.

Meanwhile, Chandler says, the available data continue to suggest that despite the US current account deficit, the foreign appetite for US securities remains strong. Foreign investors increased their US debt holdings by $190 billion and US equity holdings by $116 billion in the third quarter of 2006. The Federal Reserve’s custody holdings, primarily on behalf of foreign central banks, show no evidence of net divestment. The US Treasury data show that China has been buying US securities month in and month out, without fail, he says.

“The lurch in the dollar in recent weeks still seems best explained by the micro-structure of the market rather than some kind of structural shift,” Chandler says. The shift appears to have been among speculators, he says, who were able to engineer a break of the trading ranges and force others to adjust positions as volatility spiked higher.

Interest-Rate Advantage Shrinks
There are some fundamental economic reasons to expect the dollar to continue to weaken in 2007, economists say. The US interest-rate premium against the euro and the British pound is waning, says Carl Weinberg, chief economist at Valhalla, New York-based High Frequency Economics. “We think the dollar does have some medium-term vulnerability,” he says. “If the ECB tightens and the Bank of England hikes rates in 2007, and the Fed cuts, we fear the dollar will cheapen.”

missing-picture The US employment report for November 2006 showed a solid increase of 132,000 in non-farm payrolls, although the unemployment rate rose to 4.5% from 4.4% a month earlier. “This set of employment statistics will give policymakers little reason to panic over the current policy track,” says Steven Wieting, senior economist at Citigroup Global Markets in New York. However, construction employment fell by 29,000 in November, the largest drop since February 2003, and manufacturing employment declined for the fifth month in a row. Current weakness in output suggests that future employment gains should ease, but labor-market conditions overall haven’t turned sharply, he says.

The November employment report showed that average hourly earnings increased 0.2%, slower than the 0.3% increase in October. Fading fears of wage-led inflation pressures will enable the Federal Reserve to explore easing monetary policy in the first quarter of 2007, says Ashraf Laidi, chief foreign exchange analyst at CMC Markets US in New York. The bulk of the increase in services jobs in November may have been the result of holiday-related hiring efforts, which will be temporary, he says. The fact that retail jobs have shown an average monthly decline of 9,000 in the first 10 months of 2006 makes the 20,000-job increase in November an aberration, he says.

Contrasting Growth Outlooks
Meanwhile, the Institute of Supply Management says its US manufacturing index for November fell to 49.5, which was weaker than expected. The index fell for the fourth consecutive month. The sub-50 reading, indicating that manufacturing activity contracted, raised the chances of an interest rate cut in the first quarter of 2007, according to Laidi. Both the UK and eurozone manufacturing purchasing manager indexes remain well above 50, he says, affirming the contrasting growth picture between the US and Europe and hence adding downward pressure on the dollar.

US Treasury secretary Henry Paulson came to the dollar’s defense on December 8 when he reiterated that a strong dollar is in the US interest. Paulson’s remarks gave an immediate lift to the greenback. “While this overused mantra had lost its luster in boosting the dollar when used by former Treasury secretary John Snow, it is regaining credibility and effectiveness as it is uttered by a treasury secretary widely considered as most likely to convince Beijing to further change its foreign exchange system,” Laidi says.

If Paulson succeeds in convincing the Chinese to adopt a more-flexible currency regime and to allow the yuan to rise faster, this will carry negative dollar implications in the long run, according to Laidi. As Global Finance went to press, Paulson was preparing to lead a high-level delegation of Bush administration officials to China in mid-December, including Federal Reserve chairman Ben Bernanke, as part of an effort to persuade Beijing to accelerate its economic reforms to head off growing protectionist pressures.

Global Savings Glut
San Francisco Fed president Janet Yellen said in November that many Asian countries and members of the Organization of Petroleum Exporting Countries have a savings glut. She said these countries are holding dollars to protect their economies from volatile capital flows, such as occurred in the Asian currency crisis of 1997. “There is a mutuality of interest,” she said in reference to the recycling of trade surpluses and petrodollars into US debt. “That doesn’t mean that it won’t change. It could be that countries will decide to channel less of it into dollar assets, and that could have some impact at some stage,” she noted.

It is very clear that the acceleration in China’s export sales to the world is not being matched by an acceleration of its imports, says Weinberg of High Frequency Economics. China’s imports are growing, but at a slower pace. “Let’s face it,” he says. “Most of the consumer goods that the United States produces are aimed at richer consumers than the average Chinese household. No exchange rate in the world is going to boost China’s demand for Chevys, micro-processor-driven convection ovens, high-priced medications or electronic gear,” he says.

Local public utilities in China have no financial incentive to invest in clean-burning coal technologies, nor do they have the funds to do so, Weinberg says. “Beijing can both mandate and finance such investments, which would open the way for a huge market for US technology and equipment in the electricity-generation sector,” he says.

Operational Constraints
As long as China’s trade and capital accounts continue to generate surpluses in transactions that are denominated in dollars, the People’s Bank of China, or PBOC, will continue to see more dollars coming in the door and its international reserves will continue to rise, Weinberg says. Even though the Chinese central bank does not agree with the case for revaluation, he says, it sees some increase of the yuan as a political necessity.

“There are important operational constraints on the amount by which the yuan can be revalued in any given period of time without bankrupting the central bank,” according to Weinberg. For example, a 30% yuan revaluation would mark down the value of its foreign currency reserves by nearly $300 billion, or 15% of China’s gross domestic product.

About one-third of the country’s foreign currency reserve holdings are in cash deposits or vault cash earning no or very little interest, Weinberg says. “So our guess is that the yield on the overall portfolio of foreign exchange reserves is about 2.5%,” he says. “We see this as the maximum rate of yuan revaluation that can be sustained in any given year without impairing the balance sheet of the central bank.”

Weinberg says no one should bet on a massive shift in the value of the yuan or any currency diversification through dollar sales by the PBOC. The central bank controls the exchange market, and it will not tolerate a faster rate of appreciation than 2.5% or 3% a year under any circumstances, he says.

Japan’s Low Interest Rates
Meanwhile, the debate over Japan’s fiscal policy is likely to pick up in the coming months, according to a report by Brown Brothers Harriman. It says the main weight on the Japanese yen stems from the country’s low interest rates. “If domestic demand is not going to improve much from here in the cycle, it means that Japan, and by extension many other countries in East Asia, cannot be realistically expected to decouple from the US economy,” the report says. “This means that the reduction of global imbalances is likely to prove elusive,” it says.

Central bankers from the major industrial countries would like Japan to raise its interest rates to discourage the yen carry trade, whereby global investors borrow in yen and reinvest the proceeds in higher-yielding assets in other countries, helping to inflate the pool of global liquidity. But the Japanese government downgraded its assessment of the economy in late November for the first time in nearly two years. The Japanese economy remains highly dependent on capital spending and exports. In the third quarter, exports accounted for nearly 80% of Japanese growth, according to Brown Brothers Harriman. The strength of the corporate sector has not trickled down to Japanese employees, and this deters consumption, BBH says.

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Gordon Platt