Will dollar be adjusted while the sun shines?
Worries about Asian central banks diversifying their massive reserve holdings out of the dollar and reports of oil-rich Middle Eastern countries boosting their euro holdings have been weighing on the greenback in recent weeks. Hedge-fund managers have been waiting to jump on the weak-dollar trade for a long time, and they have been wrong, as the dollar has held relatively steady, says David Gilmore, economist and partner at FX Analytics, based in Essex, Connecticut. Now, however, the time for the weak-dollar trade to prove right is drawing closer, he says.
Recent economic data from Europe and Japan have been promising, even suggesting that domestic demand is recovering in both of these regions along with business investment, and that the strength is not merely in export-led industries, Gilmore says. Meanwhile, officials of the major industrialized countries are becoming increasingly worried about the US trade and current account deficits, realizing that the longer the adjustment process is delayed, the greater is the risk of a dollar crisis, according to Gilmore.
Central bank governors and finance officials of the Group of 7 nations know that the time to act to encourage a weaker dollar is while the sun is still shining, Gilmore says. US growth is strong, the Federal Reserve is still raising interest rates, and domestic demand is strengthening in Japan and Europe.
“Moreover, waiting for markets to deal with imbalances after it is clear the Fed-tightening cycle has ended, and rate increases are in their early stages in Europe and Japan, would elevate the risk of a disorderly dollar adjustment,” Gilmore says. “Protectionist politics in the United States and the eurozone, in particular, are taking root like weeds,” he says. “This crowd will sooner rather than later hijack the currency issue, so it is high time to beat them to the punch and keep currency politics at the treasury or finance ministry level and out of legislators’ hands.”
There is no need to limit all currency adjustment to the Chinese yuan, Gilmore says. “China may move a bit here and a bit there, but it is not going to unlock the global currency markets to an orderly broad adjustment downward in the dollar,” he says. If European and Japanese officials succeed in keeping foreign exchange policy unchanged and limit pressure for change to China, then the US Treasury should call for an orderly rise in non-dollar currencies and enlist the International Monetary Fund to do the same, he says.
Last month the European Commission backed China’s policy of taking its time in introducing greater exchange-rate flexibility, according to a confidential document that was leaked to the media. The commission, the European Union’s economic watchdog, warned that an abrupt rise in the yuan might result in an excessive downward move in the dollar against the euro if it triggered a sudden reversal of Asian capital flows into the US. As imbalances continue to widen, the likelihood of a disorderly correction increases, it said.
Japanese finance minister Sadakazu Tanigaki was questioned last month about the dollar’s role as the hegemonic reserve currency. “This is a sensitive issue, so I won’t comment on whether there is any change in the use of our foreign exchange reserves,” he said.
The latest data available show that Japan’s holdings of US treasury securities fell 2.4% in January to $668 billion, reaching their lowest level since April 2004. Analysts say Japan is scaling down its large dollar exposure in a very gradual manner to avoid sending signals of panic selling to the market.
Cheng Siwei, one of 10 vice chairmen of China’s National People’s Congress, said last month that China should gradually reduce its holdings of US assets and stop buying dollar-denominated bonds. As of the end of January, China held about $262 billion of US treasury securities. While China officially has no plans to cut its holdings of US assets, if it merely stops buying new US treasuries, this could put upward pressure on long-term US interest rates.
Meanwhile, Qatar followed the UAE last month in indicating that it is considering boosting its euro holdings. The expressed intentions of Arab Gulf nations to shift a portion of their reserves into euros should not be neglected simply because of the small size of their reserves relative to China and Japan, says Ashraf Laidi, chief currency analyst at MG Financial Group in New York.
“The fact that these Gulf nations, which are major producers of the world’s most important commodity, which happens to be priced in dollars, are considering carrying more euros should help the euro against the dollar,” Laidi says. And when the dollar is dragged down against the euro in the most highly traded pair in the foreign exchange market, that tends to destabilize the dollar against other currencies, he says.
Iran has been threatening to create an exchange where oil, gas and petroleum products would be traded in euros.
Oil exporters have sharply reduced their purchases of dollar-denominated long-term securities from the early-2005 peak, according to a report by Jeffrey Young, head of currency research and managing director at Citigroup in New York. However, oil exporters have “parked” a large fraction of their surpluses in dollar bank deposits, he says.
The surge in bank deposits likely is temporary, Young says, and is expected to unwind as US short-term interest rates peak. If oil exporters remain true to their past investment patterns, they probably will shift into non-dollar deposits and securities, Young says.
Meanwhile, the US political pressure on China will likely culminate this month with the US Treasury formally citing China as a manipulator in the currency market, says Marc Chandler, global head of currency strategy at Brown Brothers Harriman in New York. Anticipation of further appreciation of the yuan is expected to help underpin other currencies in the region and help draw investment into Asian equity markets, he says.
“The main weight on the dollar appears to be more psychological than fundamental,” Chandler says. “This is not to say it is any less real,” he says.
The dollar failed to respond on April 17 to US Treasury data showing that capital inflows into the US rebounded sharply in February. Failure of the dollar to advance on positive news was a sign that investors are hesitant to buy dollars, analysts say.