November 08, 2004

It's a Little Bit More Complicated...

Daniel Drezner writes:

danieldrezner.com :: Daniel W. Drezner :: It begins....: The reason the dollar has managed to stay as strong as it has -- despite the combination of large trade deficits and low interest rates -- is that Asian central banks have been buying up greenbacks. The big question that watchers of global finance have been asking in recent years is: what happens when the Asian central banks stop buying dollars? Steve Johnson and Andrew Balls of the Financial Times suggest that we're about to find out...

It's a little more complicated. The strength of the dollar has been produced by (a) the willingness of someone (mostly Asian central banks) to buy and hold the flow of new dollar-denominated assets held abroad generated by our trade deficit, and (b) the unwillingness of private hedge funds, investment banks, and other investors to place large leveraged bets that the dollar decline has started for real. If the private market--which knows that the dollar is going down someday--decides that that someday has come and that the dollar is going down NOW, then all the Asian central banks in the world cannot stop it. You need both (a) and (b) to keep the dollar up. Just one of them won't do.

Posted by DeLong at November 8, 2004 09:53 AM | TrackBack
Comments

Since a lot of people already hate Soros for no good reason, maybe he should give them a reason.

I really think that if he did, the Protocols, the Rothschilds, and Shylock would reappear, and Soros would be unmasked as a lifelong KGB agent.

What bothers me (praktike said it recently too) is that at some point China can play their trump card and get political concessions out of us.

Not to be paleo or anything, but it seems that our powerful nation cannot afford to offend either China or Saudi Arabia. What's up with that?

Posted by: Zizka at November 8, 2004 10:22 AM

so private hedge fund investors are unwilling to place large bets against the dollar, what expectations are propping their confidence in a stronger dollar?

GDP growth?
no more tax cuts?
reduction of the trade deficit?

just wondering.

Posted by: jeet at November 8, 2004 10:26 AM

Yes, but...

It is often domestic investors fleeing their own currencies that have made the difference betweeen pressure on a currency and an outright crisis. Holders of Mexican and Thai and Argentine assets are never far from the assumption that they will someday have to send their savings overseas. Some US investors may feel that way, but are there enough to make a US$ dive a really spectacular event - one which central banks can't stem? Are hedge funds the proxies for US investors, able to drive the dollar south in a big way, in a way their investors would not do, in aggregate, if they were investing for themselves?

Posted by: kharris at November 8, 2004 10:40 AM

Note that some speculate Europe may start buying US debt to keep the Euro from continuing to overextending its value relative to the Dollar. If that happens tommorow gets put off a bit further.

Also, check out Steven Roach today on an assortment of China issues. Note in particular the leaderships restated resolve to keep the Yuan peg in place for the near term.

http://www.morganstanley.com/GEFdata/digests/20041108-mon.html#anchor0

Regarding Brad's (b) I don't think these hedge fund guys are crazy.. We aren't talking about Sterling or the Peso here. A successful attack on the dollar will screw up the global economy VERY badly. Strictly speaking it may be a case of irrational market behaviour but these guys are probably willing to be more than patient to let things balance out smoothly rather than trigger a big calamity that puts a long list of other investments at risk.

Posted by: Michael Carroll at November 8, 2004 10:52 AM

> It is often domestic investors fleeing their own currencies that
> have made the difference betweeen pressure on a currency and

If they're not doing that now, they should. The 200 euros I cached in my bag, forgetting to exchange on return, made more percent return on investment than anything else I did in the past year.

Posted by: anonymous at November 8, 2004 10:54 AM

Honestly, I wish Kerry had won, but it is so nice to be reading about economics instead of politics here.

Posted by: Michael Carroll at November 8, 2004 10:58 AM

Ziska - I've been saying the same thing (including a post on this site a week or so ago) - the day may very well come when the Chinese say to us, "Lay off us when we invade Taiwan, or watch your interest rates head to the moon." You think the Bushmaster is gonna let a few million Taiwanese interfere with his master plan for Republican domination of the U.S. political system? Not on your nelly....

And, KHarris, you're absolutely correct - some time ago I saw an interview with Jeremy ("Stocks for the Long Run") Siegel of Wharton and Robert ("Irrational Exhuberance") Shiller of Yale. In response to the interviewer's question about where their own personal assets were invested, both replied "Outside the U.S." Do you think they, and other academics who are advising hedge funds, pension funds, etc., are giving their clients advice that's any different?

On the brighter side, I've always wondered what it would be like to work for a foreign company. Maybe now I can find out without having to move out of the U.S.

Posted by: Uncle Jeffy at November 8, 2004 11:03 AM

This is from early September (WSJ):

"The Treasury auction had mixed results...  

Moreover, foreign demand, which has been a strong support for the market, was weak by recent standards. The category of indirect competitive bidders, which includes foreign central banks, represented just 13.3% of competitive bids and was awarded just 24.6% of today's issue. Last month, indirect competitive bidders received 41.7% of the offering. It received 38.2% of July's issue and a stunning 56.0% of June's. "

 "On Sept. 9, as it must frequently do, the U.S. government turned to Wall Street to raise a little cash, and Paul Calvetti bet that demand for $9 billion worth of long-term Treasury bonds would be "huge."

But at 1 p.m., as the auction opened and the numbers began streaming across his flat-panel screens, the head of Treasury trading at Barclays Capital Inc. slumped in his chair. Foreign investors, who had been voraciously buying Treasury bonds, failed to show up. Bond prices cascaded downward, interest rates rose, and in five minutes, Calvetti, 38, who makes money by bidding on bonds at one price and hoping market demand lets him quickly resell them at a profit, had lost $1.5 million.

"It's amazing," he gasped, after the Treasury Department announced that Wall Street traders, not foreigners, had been left to buy virtually the entire auction. "I don't think I've ever seen this before."

The most recent auction of 10-year Treasury notes may have been a fluke, a momentary downturn in one aspect of the massive world market for U.S. government and private-sector bonds, stocks and other securities -- a market so large and diverse that it has long been the world's safe haven. But a rash of new data, including Treasury Department figures released yesterday showing a net sell-off by foreigners of U.S. bonds in August, has stoked debate over whether overseas investors -- private individuals, institutions and government central banks -- are growing dangerously bearish on the U.S. economy. " 

Posted by: steve at November 8, 2004 11:17 AM

I think d2 is right. (b) flowed from (a). E.g. on the yen, the BOJ was huge in its intervention, basically limitless. Hedge funds realized they were facing the casino, so they didn't try.

It's up to the BOJ to decide it has to stop - when it has no more space to put those useless green bills. When it does, the dollar sinks.

To put it another way, if the BOJ wants to keep on printing yen to buy dollars, whats to stop it ? It's the reverse situation - supporting one's own currency - where the central bank tends to lose to the markets.


Posted by: Andrew Boucher at November 8, 2004 11:24 AM

kharris writes about the need for domestic investors to be involved in a currency crisis:
> Some US investors may feel that way, but are there enough to
> make a US$ dive a really spectacular event - one which central
> banks can't stem?

I think the real problem is that it could be very, very difficult to tell. While no hedge fund might be taking an explicit bet against the dollar, isn't it somewhat (and increasingly) likely that some sharp currency shock could cause what *should* be a solid position to unwind quite suddenly? So suppose you've got a position that's fine as long as you don't see a one-day 15% change in the Euro (which you can't defend against in time). This isn't very likely, but it could happen, and if it did, then I'm not sure anybody knows how it would play out. Central banks might be able to stabilize (by force of will) a hedge fund that melted down suddenly in this way, but as soon as you get people thinking that the currency dive really could happen, then that becomes the way to bet, and I think we know that it is almost impossible to defend a currency against anything like a concerted attack.

The problem with the US dollar going down another 50% against the Euro or even less than that against the yuan is pretty clear: the recession we would have almost instantaneously would be devastating in the US, and the sudden lack of an export market would tank the rest of the world, too. Not very much fun in that.

I guess there is some comfort in the possibility that if we had an "everything goes to hell" scenario that was viable, that exceptional measures could be taken to blunt the effect, but I cannot now generate any alternative scenario for the dollar going down by a significant amount in the next year that doesn't involve a major war and the almost inevitable flight to the currency of the country or countries that have all the guns.

Please feel free to make me feel better about this. :-)

Posted by: Jonathan King at November 8, 2004 11:24 AM


Why should a 10% or 20% decline in the value of the dollar against the a basket of currencies be a problem? The trade effect of the decline in dollar value will emerge slowly. Japan and Germany can shift some production to America. Loss of export demand from Germany can be made up with a European stimulus. The fall in dollar value will make energy imports less costly in Japan or Germany. Interest rates are low in America and need not be raised. Why should we worry if the dollar loses value?

Posted by: anne at November 8, 2004 11:31 AM

Many investors believe that relative real growth drives currency moves and for most of the time that appears to be a reasonable position.

But if you look at Bush statements since the election it is obvious that he believes the defict is not a problem and is going to follow policies that expand the deficit -- privatization of SS mainly. This implies that both the federal deficit and current account defict will have to expand and interest rattes spreads are not expanding, so the dollar has to fall. You do not need a conspiracy theory or
anything but econ 101 to see that a falling dollar is a logical consequences of federal policy. Moreover, Bush make it clear in his first press conference that no one is ever going to confuse him with the facts ever again.

Posted by: spencer at November 8, 2004 11:37 AM

Why should a decline in the value of the dollar result in a recession? I do not see why? After the Plaza Accord of September 1985, there was no recession. I simply have trouble worrying about a loss in value of the dollar from the perspective of thinking growth would quickly slow. What am I missing?

Posted by: anne at November 8, 2004 11:41 AM

anne writes:
>
> Why should a 10% or 20% decline in the value of the dollar
> against the a basket of currencies be a problem?

I'm not sure this was a reply to me, but the thing that worries me most is a very fast and sudden decline, even if it is only a transient spike, that could turf any hedge fund that had only bet on a relatively slow decline. The unwinding of big illiquid positions is generally a mess, and I'm not even sure anybody knows what the effects would be at this moment.

In other words, the possibility of *any* sudden move at the moment is potentially a problem just for trading reasons. Anything that improves the likelihood of such a spike (e.g., the fact that everybody now expects the dollar to fall (say) 50% against the basket over the year) is potentially quite a problem beyond what the currency effect is.

Posted by: Jonathan King at November 8, 2004 11:43 AM

Anne I don't think energy costs will ever come down much now.

Posted by: Big Al at November 8, 2004 11:49 AM

anne, i agree with jonathan: engineering a slow, steady decline wouldn't be the end of the world (although either inflation would ratchet up or profitability would ratchet down, 'cause there ain't no free lunch), but a sudden currency move would also lead to sudden bond market moves, and a sudden sodden mess.

as you know, i don't expect that, although it's a not unreasonable fear, i expect a decline in the dollar and an increase in rates to lead to a sluggish, mild stagflationary economy....

Posted by: howard at November 8, 2004 11:51 AM

Anne,

An orderly decline (like Plaza) would not necessarily harm the economy. You might argue that revaluation of the dollar relative to the Yuan is a natural and inevitable consequence of productivity or economic growth in China.

But, a nonlinear event would cause problems. To keep financing our debt, the Treasury has to keep selling bonds, and the yields would have to spike in order to keep foreign buyers interested. This would lead to higher interest rates in the US and likely lead to a recession.

Posted by: steve at November 8, 2004 11:56 AM

I think that Prof. DeLong is forgetting (c) the willingness of oil exporting countries to denominate their sales of oil only in dollars. You need (c) to get (a), otherwise the Asian central banks would hold more than just dollars as their primary reserve.

A change in petrocurrency could create the type of non-linear spike that Steve is worried about. Does anyone here have any idea what portion of the value of the dollar is a result of its status as international petrocurrency?

Posted by: Ed at November 8, 2004 12:11 PM

I know this has been asked before...

But for a regular investor (ie someone not legaly allowed to put money in a hedge fund) what are some methodes that could be used hedge against a steep dollar decline. Is there a swiss bond fund (insert other ideas here) that regular folks can invest in?

Posted by: Rob Sperry at November 8, 2004 12:13 PM

"The willingness of the oil exporting countries to demoninate their sales of oil only in dollars"? I think you are too optimistic. They are willing to put the $ symbol on the price tag, to be sure (and I suppose that means bearing some short term risk), but, IIRC oil prices have spiked noticeably in $ and been basically flat in Euros. Kind of makes you wonder...

Posted by: Ravi at November 8, 2004 12:26 PM

Robert Rubin would ever repeat "a strong dollar is in America's interest." What we thought he meant was that when the dollar was strong it reflected a strong economy. Then, set policies to keep the economy strong and the dollar will reflect the strength.

Policies now have led to a budget deficit that is large and growing faster than the economy can grow. Private saving is too low to make up for the government deficit, so there will be balances of payments deficits as far as I can see. The dollar, then, will decline. The weakness in economic policy and in the economy will be reflected by a weak dollar.

The prospects of a subtly weakening economy are not at all pleasing, but moderate growth could be sustained as long as the Fed allowed for low interest rates. Even in 1987, after the stock market break, the Fed was able to immediately reverse a cycle of tighening and keep the economy growing.

Yes, I am puzzling. Also, I think posing investment questions was a useful exercise. We are increasingly our own retirement insurers, and we have better understand the consequences.

Posted by: anne at November 8, 2004 12:28 PM

From the early 80's until early 2004 the international price of oil and the fed funds rate moved in lockstep. This connection has ended with the fed funds rate standing still or slightly climbing as the price of oil climbs by leaps and bounds.

The fact that oil is spiking in dollars and staying flat in euro's means that the switch away from dollars as petrocurrency is well underway. IMHO the actual announcement that dollars are no longer the de jure petrocurrency will be the catalyst that unwinds the current international monetary system.

Ever since Reagan the international monetary system has been based on petrodollars. Asian central banks bought up dollars to buy oil. They made sure that their currency was pegged (cheaply) to the dollar so that they could be sure of dollar surpluses to pay for the oil that they would need to industrialize their economies. This system led to huge American trade defecits and capital account surpluses. The trade deficits gave the world dollars to buy oil.

As the dollar ends its role as petrocurrency, it will also end its role as reserve currency.

Posted by: Ed at November 8, 2004 12:42 PM

The speculators (aka "investors") bet against the Bank of Japan in 2003 and in early 2004 and lost both times. No wonder they are gun shy.

Why can't Japan buy an infinite number of dollars?

1. While in deflation, it can with minimal if any costs.
2. By showing resolve in the past as well as today to support the dollar, the Bank of Japan scares off speculators and thus it doesn't need to buy an infinite number.

We talk about this stuff all the time at General Glut's Globblog. You should stop by.

Posted by: General Glut at November 8, 2004 01:03 PM

Rob Sperry wrote, "But for a regular investor (ie someone not legaly allowed to put money in a hedge fund) what are some methodes that could be used hedge against a steep dollar decline. Is there a swiss bond fund (insert other ideas here) that regular folks can invest in?"

I like BEBGX, Am Cent Intl Bond. Mostly European govt bonds of intermediate duration. Key thing is that they mostly do not hedge back into dollars. Disclaimer: no conflict of interest on my part, though I do own a good chunk of it.

Posted by: liberal at November 8, 2004 01:04 PM

I have an ignorant question--why are Chinese banks buying US Treasury bonds, that is, why is this the best thing for them to do with a huge amount of money? And where does this pile of cash come from? China is big but not a rich country. Eh, I guess it's two questions.

Posted by: Jim Lund at November 8, 2004 01:06 PM

China has a thriving trade with America, and it is in her interest to finance the trade. Also, China buys dollar denominated securities to maintain to Yuan peg, and uses such securities to secure bank reserves and infrastructure development projects.

China is growing rapidly, and when a country with 1.4 billion people grows rapidly for 5 and 10 and 15 and 20 years, the country shows an astonishing development.

Also, China is a remarkably competitive trader and readily builds foreign exchange reserves. When you go to Vietnam you can buy Honda Motor Bikes, but you can also buy identical looking Honka Motor Bikes. Honka is made in China.

Posted by: anne at November 8, 2004 01:31 PM

Jim,

The PRC runs a big trade surplus with us, so they have a lot of dollars. It is in their interests to keep the RMB cheap (to keep exports competitive) and stable (to encourage futher foreign direct investment).

The policy is definitely mercantilist in nature - businesses have concluded that China is the only scalable manufacturing base in the world: close to a huge pool of inexpensive but skilled labor and also close to fast growing markets (in China and the rest of Asia). The PRC government does not want to do anything to alter these beliefs, which led to $60B in FDI last year. Perhaps more important than the dollar investment figure, there is a huge transfer of technological and business knowledge in progress.

Once it is too late for Western companies to turn back, and domestic demand has grown enough that the economy is not wholly dependent on exports, they will definitely let the currency float.

This is essentially what happened with Japan: export driven growth on the back of a cheap currency, followed by eventual appreciation of the currency. It is hard for us to remember that the Yen used to be cheap in the 60s and 70s.

Another related point, the size of the PRC economy is very different when measured by nominal FX rates vs. PPP. It is clear that this differential will eventually go away as the country becomes fully integrated with the world economy. (Perhaps one could define "integration" in terms of no large discrepancy between PPP and nominal FX rate, since the same bundle of goods should cost roughly the same in China as in the US, if trade is working properly.) This will only happen if the RMB goes up substantially in value (just as the Yen did).

Posted by: steve at November 8, 2004 01:46 PM

http://www.nytimes.com/2004/11/05/business/05hedge.html?position=&pagewanted=print&position=

Hedge Funds' Glitter Fades (but Not for Investors)
By RIVA D. ATLAS

Barton M. Biggs, the well-known stock strategist who left Morgan Stanley last year to set up a $2 billion hedge fund, has been writing a book, "Diary of a Hedge Hog,'' that promises to "describe the agonies and ecstasies of creating and running a new hedge fund."

So far this year, the experience for Mr. Biggs's investors has been agonizing.

After rising 16 percent last year, Mr. Biggs's fund, called Traxis Partners, is down 8.3 percent as of the end of October, according to a person briefed on the results. Earlier this year, Mr. Biggs made an aggressive bet that the price of oil would fall. Instead, it hit record highs, recently peaking at more than $55 a barrel.

In the meantime, Mr. Biggs has postponed the release of his book, which was scheduled for next month, his publisher, John Wiley, said. Mr. Biggs could not be reached for comment.

Investors in Traxis are not the only ones to experience disappointment this year. These days, lots of funds are failing to meet expectations. Some smaller hedge fund managers are quitting the business. More established managers are generally hanging on, but their reputations have taken big hits.

Despite this weak performance, record sums are pouring into hedge funds and many on Wall Street see managing a hedge fund as the most promising route to real riches.

Hedge funds are aggressive privately managed investment partnerships for wealthy individuals and institutions, including pension funds and university endowments. Assets in these elite partnerships were $488 billion in 2000 and have nearly doubled since then, to $890 billion as of the third quarter of 2004, according to Hedge Fund Research.

The flow of capital into the industry has enticed some of Wall Street's biggest names.

Posted by: anne at November 8, 2004 01:47 PM

For additional discussion:

http://www.tacitus.org/?op=displaystory;sid=2004/11/8/115059/258

Posted by: Bernard Guerrero at November 8, 2004 01:53 PM

For additional discussion:

http://www.tacitus.org/?op=displaystory;sid=2004/11/8/115059/258

Posted by: Bernard Guerrero at November 8, 2004 01:54 PM

Jim,

The PRC runs a big trade surplus with us, so they have a lot of dollars. It is in their interests to keep the RMB cheap (to keep exports competitive) and stable (to encourage futher foreign direct investment).

The policy is definitely mercantilist in nature - businesses have concluded that China is the only scalable manufacturing base in the world: close to a huge pool of inexpensive but skilled labor and also close to fast growing markets (in China and the rest of Asia). The PRC government does not want to do anything to alter these beliefs, which led to $60B in FDI last year. Perhaps more important than the dollar investment figure, there is a huge transfer of technological and business knowledge in progress.

Once it is too late for Western companies to turn back, and domestic demand has grown enough that the economy is not wholly dependent on exports, they will definitely let the currency float.

This is essentially what happened with Japan: export driven growth on the back of a cheap currency, followed by eventual appreciation of the currency. It is hard for us to remember that the Yen used to be cheap in the 60s and 70s.

Another related point, the size of the PRC economy is very different when measured by nominal FX rates vs. PPP. It is clear that this differential will eventually go away as the country becomes fully integrated with the world economy. (Perhaps one could define "integration" in terms of no large discrepancy between PPP and nominal FX rate, since the same bundle of goods should cost roughly the same in China as in the US, if trade is working properly.) This will only happen if the RMB goes up substantially in value (just as the Yen did).

Posted by: steve at November 8, 2004 01:54 PM

For additional discussion:

http://www.tacitus.org/?op=displaystory;sid=2004/11/8/115059/258

Posted by: Bernard Guerrero at November 8, 2004 01:55 PM

For additional discussion:

http://www.tacitus.org/?op=displaystory;sid=2004/11/8/115059/258

Posted by: Bernard Guerrero at November 8, 2004 01:56 PM

Jim,

The PRC runs a big trade surplus with us, so they have a lot of dollars. It is in their interests to keep the RMB cheap (to keep exports competitive) and stable (to encourage futher foreign direct investment).

The policy is definitely mercantilist in nature - businesses have concluded that China is the only scalable manufacturing base in the world: close to a huge pool of inexpensive but skilled labor and also close to fast growing markets (in China and the rest of Asia). The PRC government does not want to do anything to alter these beliefs, which led to $60B in FDI last year. Perhaps more important than the dollar investment figure, there is a huge transfer of technological and business knowledge in progress.

Once it is too late for Western companies to turn back, and domestic demand has grown enough that the economy is not wholly dependent on exports, they will definitely let the currency float.

This is essentially what happened with Japan: export driven growth on the back of a cheap currency, followed by eventual appreciation of the currency. It is hard for us to remember that the Yen used to be cheap in the 60s and 70s.

Another related point, the size of the PRC economy is very different when measured by nominal FX rates vs. PPP. It is clear that this differential will eventually go away as the country becomes fully integrated with the world economy. (Perhaps one could define "integration" in terms of no large discrepancy between PPP and nominal FX rate, since the same bundle of goods should cost roughly the same in China as in the US, if trade is working properly.) This will only happen if the RMB goes up substantially in value (just as the Yen did).

Posted by: steve at November 8, 2004 01:57 PM

Steve

"Perhaps more important than the dollar investment figure, there is a huge transfer of technological and business knowledge in progress."

A most essential point! China does look to be doing development right, and surely echoing Japan.

Posted by: anne at November 8, 2004 02:00 PM

If Herbert Hoover Redux suceeds in taking us all way to the end of the road he's currently got us on, who's best poised to play the role of FDR in 2008?

Posted by: Brian Boru at November 8, 2004 02:11 PM

steve wrote, "The PRC runs a big trade surplus with us..."

Don't forget that their total net surplus is far small than their surplus with us.

Posted by: liberal at November 8, 2004 02:13 PM

http://www.morganstanley.com/GEFdata/digests/latest-digest.html

Rethinking the China Slowdown
Stephen Roach (Beijing)

After extensive discussions in Beijing, I am changing my view on the China slowdown. Specifically, over the next year, I do not believe that the Chinese economy is going to soften as much as I had thought. This is a personal observation rather than a shift in our official view held by Andy Xie and his team, who are still looking for a marked slowing in Chinese GDP growth from 9.3% in 2004 to 7.0% in 2005. But it is clear to me that China’s policy makers are now aiming for only a modest further slowing in the economy. The key question is whether they will get their way in managing this gentle descent. My bet is they do.

I was eager to get back to China. I hadn’t been to Beijing since last June. Since that time, the China debate had moved to center stage in world financial markets. And with good reason: China’s marginal role in driving the global growth dynamic cannot be stated strongly enough. The IMF calculates that China accounted for fully 24% of the change in world GDP growth over the past three years (on a purchasing power parity basis) -- virtually double its 12.6% PPP weight in the world and fully six times its 4% share in nominal global GDP (at market exchange rates). Early this year, the Chinese leadership expressed serious concern about the overheated state of the economy. I heard this first hand from Premier Wen Jiabao at the annual China Development Forum in March. That, in fact, was the official stamp of approval on the slowdown debate that was then to follow. That pronouncement also ushered in a series of serious tightening measures taken by the Chinese authorities beginning in late April -- initially driven by so-called administrative actions aimed at restricting the quantity and allocation of credit but more recently accompanied by a more overt shift in monetary policy, underscored by the 28 October rate hike of the People’s Bank of China (PBOC).

Posted by: anne at November 8, 2004 02:47 PM

People, check your facts -- China was running a overall trade DEFICIT for the first half of the year, it tunned to surplus sometime recently, but the total cumulated surplus so far this year is less than $15 billion. Last year, it had a trade surplus with US for about $125 billion, but deficit with the rest of the world for about $100 billion. A lot of the increase in the Chinese foreign reserve have come from speculative inflows following all the yuan appreciation talks in the past two years. Don't blame China for our trade deficit -- our low savings rate is the problem!

Posted by: pat at November 8, 2004 03:44 PM

Stephen Roach thinks there will be no changing of the Yuan peg to the dollar in the near future. The Asian tigers then will likely continue to support the dollar, and the Bank of Japan in the near future is also likely to continue buying dollars.

Posted by: anne at November 8, 2004 04:12 PM

One rule of currency trading is never to bet against the big central banks. So, until the BOJ loses its resolve to defend 105 JPY/USD, it's not going down beyond that. Besides they can use the dollars to buy the anti missile system from the US and otherwise support the US military in North Asia.

By the way, whenever I post here, I get hundreds of spam mails.

Posted by: Amused Reader at November 8, 2004 05:17 PM

http://www.morganstanley.com/GEFdata/digests/latest-digest.html

Stephen Roach's essay on China is well worth reading in the entirety. China really does appear to be an astonishing growth engine for Asia that can continue indefinitely with proper fiscal and monetary policy applications and market privatization.

Posted by: anne at November 8, 2004 06:06 PM

The original point made by Brad was that it requires both the Asian banks and foreign private investors to support the dollar --such is the CAD and trade gap.
Most here seem to be betting that BOJ will resume where they left off last March, but the question is, can this intervention by Japan alone do the trick indefinitely?
Brad says nope.
The $200B of foreign investment that leaves this country every year, mostly to tha asian pasture is also telling us 'nopt'.

Posted by: calmo at November 8, 2004 07:09 PM

Ed wrote:
>>>>
I think that Prof. DeLong is forgetting (c) the willingness of oil exporting countries to denominate their sales of oil only in dollars. You need (c) to get (a), otherwise the Asian central banks would hold more than just dollars as their primary reserve.

A change in petrocurrency could create the type of non-linear spike that Steve is worried about. Does anyone here have any idea what portion of the value of the dollar is a result of its status as international petrocurrency?
<<<<

I've heard this "petrocurrency" meme for the past year or two, mostly but not exclusively from fringe-leftist sources*. (Not saying that you're a fringe-leftist, Ed; just saying where I've heard it before.) My instinct has always been that this was extremely unlikely; while oil is certainly an important commodity, it's got to be a small fraction of the annual transactions in dollars. So a switch by oil-exporters to denominating their product in euros shouldn't have much of an effect except maybe on the margin.

Obviously if the dollar just needs one spark to completely collapse, this could be it. But I'm not even convinced of that!

Can any macro guys chime in here with their opinion?

Guy

*Said fringe-leftists are always cackling with delight at the thought of the petrocurrency switch toppling the US economy.

Posted by: Guy at November 8, 2004 07:45 PM

Steve,

The indirect bid at yesterday's 3-year note auction was 53.6%, a new record. Indirect bids represent far more than just central banks, which is why the financial press obsession with indirect bids is misplaced. Even if we knew what the central bank bid was at any given auction, we would only know the gross figure, not the net after maturities. We would also not be able to tell the difference between technical adjustments to reserves and adjustments that result directly from fx manipulation.

As to the larger issue, the worry is, I think, that if China adjusts its reserves portfolio toward lower $ holdings, it will create an environment in which betting against the dollar is far more attractive. If, at the same time, oil exporters decide to hold a smaller part of their porfolios in dollars (as they apparently have), the motive to speculate against the dollar in the medium term is even greater. Overshoot is endemic in fx trade. A 20% move, well controlled, is not necessarily the most likely outcome. The notion that betting against the central banks is harmful to one's wealth has traditionally been true in the medium to long term, but the history of the past 20 years of so is that it can pay off hugely in the short term. Brad's notion of a 30%-60% dollar drop is not unreasonable. In 1998, there was a roughly 30% drop in Usd/Jpy over the course of a few weeks. In 1985, Usd/Jpy fell over 20%, then rose that much again. From early 198 to mid-1985, Usd/Jpy fell nearly 50%. Less spectacular moves against other currencies limited the range in the trade-weighted dollar, of course, but if China adopts a less rigid system, the trade-weighted dollar will have less stability. Even without China taking the big step, the bigger the current account deficit, and the larger fx flows relative to central bank reserves, the bigger the risk that we will have a dollar adjustment that is large by historic standards.

Posted by: kharris at November 9, 2004 06:28 AM

Kharris,

Looking at Everbank, I notice that the Aus and Nz dollars, as well as the pound, offer a decent interest rate. The Euro rate is quite low. Any advice on a good punt based on expectations of a short-term move against the dollar?

I seem to see a critical mass of opinion building in the financial community, with more and more people looking to bet against the dollar. A big move could be on the way...

Steve

Posted by: steve at November 9, 2004 09:50 AM

anne,

Didn't I link that one already in post #5?

Posted by: Michael Carroll at November 9, 2004 10:18 AM

Michael Carroll

Thanks. The essay was most useful.

Posted by: anne at November 9, 2004 10:41 AM

It strikes me the dollar is set up for a triple-whammy: 1) The only politically doable way out of our debt situation is to inflate it away by printing more dollars. Who in their right mind would hold dollars against that trend, all else equal? 2) There are already a huge surplus of dollars held by our "investors". They're misallocated already, and it would be only sensible for them to look to reallocate to less risky options. 3) Those dollars are only as good as the assets they can purchase. Which means what? Bonds? Headed down as interest rates rise on short-term fed moves and long term risk premium rises. Stocks? American companies are less competitive by the hour. As Bill Gross puts it, we're gone from being a manufacturing economy to a service economy to a finance economy. We "make" money increasingly by just shifting it around, not doing anything competitively against world manufacturing or services. How can US stocks at these historically high ratios be a good bet under these competetive conditions? Real estate? Look at the values. What sane person would buy real estate denominated in dollars at these levels? 4) With Bush in again, there's no sanity in sight as far as dealing with any of these issues.

Besides currency pegs (the longer they hold, the more power China gets over us) I can't see any affirmative reason to hold dollars right now. I get the sense China's quietly pulling the rug out without causing too much of a fuss (loosening gold holding regulations for its citizens, for example).

I suspect the way it may play out is at some point the American consumer will be just too underwater to keep up spending at high levels. China will observe this and reason that the peg has lost its effectiveness relatively speaking, as the American consumer will have spent herself under the table. At that moment it may make sense for China to start unloading dollar-denominated assets and release the peg. I'd imagine at that stage all hell breaks loose as bond prices collapse, interest rates go back up to double-digits, and the dollar finds amazing new lows.

Does this make sense to anyone else?

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Posted by: Pete at November 19, 2004 06:14 AM
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