Currency Leaders Still Playing With Fire

Despite economic proof to the contrary, the G7 and IMF attempt currency-based rebalancing.
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Old men should know that playing with fire is dangerous. Yet that is precisely what the old men in the G7 and IMF are doing with regards to the U.S. trade deficit.

Many have argued, for some time, that the large U.S. external imbalance was a major risk to the world economy. The previous solution was for the U.S. to boost domestic savings, for Europe and Japan to make structural reforms to boost domestic demand and for Asia to adopt more flexible capital markets. But the current leaders' lack of political will to implement the strategy led to the more expedient course of signaling that the currency market should bear a greater burden of the adjustment. That in turn has sparked a near freefall in the U.S. dollar.

Officials warned that the U.S. trade deficit is not sustainable and that it injects unnecessary volatility into the capital markets, which distorts investment and economic decision making. But the real disruption to the capital markets, with potentially negative impact on world growth, has been the clumsy attempt by the G7 and IMF to try to fix the problem.

Global equity markets have sold off, and the rise of global interest rates has accelerated. And with a sharply falling dollar, the ability to smoothly finance the U.S. current account deficit is called in to question, as evidenced by the lukewarm reception to the Treasury's recent auctions by indirect bidders.

In sum, the cure seems worse than the disease.

Although a number of officials, including the ECB's Trichet, the


Bernanke and at least two senior officials from Japan's Ministry of Finance, indicated the G7 did not signal a general dollar selloff, the market suspects otherwise and understands those comments as half-hearted attempts to maintain an orderly market.

Thus far, the absence of clear, strongly worded protests to the pace or magnitude of moves in the foreign exchange market is understood by many participants as acquiescence at the very least, and possibly even sanction. While the euro was motoring ahead, at least two ECB officials indicated, without much apparent prompting, that more aggressive rate hikes might be needed. The comments seemed to reflect the lack of concern about the euro's appreciation.

Been There Done That

Political considerations had seemed to argue against a new G7 policy initiative.

The governments in Germany, Italy and Canada are new.

Japan's Koizumi is expected to step down in the fall and a new head of the Finance Ministry is likely.

Many people suspect that British Prime Minister Tony Blair may step down before the end of the year as well.

The French government is unpopular, and there is talk that President Chirac may reshuffle his government to bolster the party's chances for next year's election.

And in the U.S., there continues to be speculation that Treasury Secretary Snow may be replaced shortly. (One of the people rumored to be a likely candidate is Harvard's Martin Feldstein.)

Yet rather than prevent a new initiative, the political weakness of the individual G7 countries has led to a reversion to an earlier and politically expedient strategy. In lieu of the political will for structural reforms, the countries have opted to let the currency market bear the adjustment. In effect, the U.S. had abandoned the strong-dollar policy, first articulated by Robert Rubin to signal a break from the devaluationist thrust of his predecessor Lloyd Bentsen.

Many observers have portrayed the G7/IMF stance as multilateral. This is deceiving.

In recent weeks there have been two other meetings of monetary officials (ASEAN+3 in early May and the Asian and European finance ministers met in late April), and the statements that were issued did not reflect the sense of urgency of the G7/IMF meeting communique. The key difference was the absence of the U.S. Also, remember that after the 1997-1998 Asian financial crisis, when the IMF essentially pushed for the implementations of the Washington Consensus, it is hardly perceived as an independent actor.

U.S. foreign economic policy is a subset of U.S. foreign policy. This is another "coalition of the willing." In addition, while there is official recognition that the voting system of the IMF no longer reflects economic reality and reforms are likely to be announced in September, it did not prevent the old IMF -- in which developing countries including China, India, South Korea, Brazil and Russia are not fairly represented -- from taking on a new foreign-exchange mandate.

We have been down this road before. The pattern is for European and Japanese officials to "cry uncle" before the U.S. and long before the dollar has fallen to levels that the conventional view says is required to correct global imbalances. With the U.S. Congress approving the renewal of some the Bush Administration tax cuts, the signal being sent is that the U.S. may not be serious about boosting savings and will rely on currency depreciation. As the euro nears the psychologically important $1.30 level and the dollar spends more time below JPY110 and global equity and bond markets become more volatile, it will not take long for domestic pressure to build and resistance to dollar depreciation to grow.

Politically Expedient May Not Be Effective

If dollar depreciation would work to reduce the global imbalances, it would arguably be acceptable.

But the problem is that by looking at the actually track record, rather than the sophomoric economic theory, there is little evidence that a decline in the dollar would achieve the goal.

Consider Canada, the U.S.' biggest trading partner. The U.S. dollar peaked against the Canadian dollar in 2002. The Canadian dollar has appreciated by about 50% in the past four years, which is what some of the more extreme estimates suggest the Chinese currency is undervalued by. Yet, the average monthly U.S. trade deficit with Canada has risen to about $6.7 billion today from about $4 billion in 2002. The four years that have passed should be enough to offset the "J-curve" effect that economists speak of to account for a lag between changes in the price of financial variables and changes in the price of goods.

And this experience is not limited to Canada. The euro recorded its historic low against the dollar in 2000, around $0.8230. It has appreciated by more than 50% against the U.S. dollar since. The U.S. recorded an average monthly trade deficit with Europe of roughly $5 billion in 2000 and 2001. It stands at $10.4 billion now.

What about Japan? The dollar has been recording lower highs against the yen for nearly 20 years. The last major high was in 1998 near JPY147.50. The peak in 2002 was near JPY135. In 1998, the average U.S. monthly bilateral trade deficit was about $5.3 billion. Now the monthly average is closer to $7 billion.

Given that policy makers cannot be sure that the bilateral imbalance will improve even if the Chinese currency appreciates against the U.S. dollar, the risks of the current strategy seem greater than likely rewards. Nearly every one agrees that the U.S. external imbalance is not sustainable, but the sense of urgency does not seem justified. There are more urgent issues, for which Chinese cooperation is more critical and with a higher probability of success. Such issues would include Iran, North Korea, Taiwan, the regional arms race and environmental issues.

Feel Mush, Push

In sword fighting, it is said, when you feel mush push; when you feel steel, retreat. The dollar feels like mush and the market is pushing.

While technical indicators and short-term speculative positioning are at extreme levels, warning that a technical correction may be in the offing, the dollar bears will remain in control until the official pain threshold is reached.

Support for the euro is seen near $1.2830 and $1.2750. Many investment banks have revised their dollar forecasts down, based on the recent price action, and many are now looking for a test on the $1.30 level. As more observers recognize that the U.S. has abandoned the strong dollar policy in everything but the exact words, the risk is that the euro will test its record high near $1.3660 this year.

On the yen front, the dollar faces important resistance near JPY112.00, and while the JPY109 may now offer support, the real objective is closer to JPY105-JPY106.

The dollar's depreciation is tantamount to a partial default. The risk is that officials will find it increasingly difficult to arrest the greenback's decline as this becomes more evident. In a world of fiat currencies, confidence in officials is a critically salient factor. Confidence in the U.S. administration is on shaky ground at best at the moment, and the administration does not seem to realize it.

The combination of low volatility and low interest rates in the advanced industrial countries, plenty of global liquidity and rising commodity markets has fueled a multiyear rally in many emerging markets. These conditions, except commodity prices, have changed. The risk now is for a larger unwinding of emerging market investments. Investors in the emerging markets could be among those burned by these old men playing with fire.

At the time of publication, Chandler was long yen vs. USD and long Swiss francs vs. euros, although holdings can change at any time.

Marc Chandler has been covering the global capital markets in one fashion or another for nearly 20 years, working at economic consulting firms and global investment banks. Currently, he is the chief foreign exchange strategist at Brown Brothers Harriman. Recently, Chandler was the chief currency strategist for HSBC Bank USA. He is a prolific writer and speaker and appears regularly on CNBC. In addition to being quoted in the financial press, Chandler is often a guest writer for the Financial Times. He also teaches at New York University, where he is an associate professor in the School of Continuing and Professional Studies. While Chandler cannot provide investment advice or recommendations, he appreciates your feedback;

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