Uncommon pressures on the global economy might be expected to lead to severe exchange rate risks, among the key currencies and those of emerging markets alike. At the same time, traditional and new-found benchmarks are subject to medium-term shifts. These immediate, and structural, forces can be examined in turn.
Much of the US dollar's direction these days appears to be the result of switching between short-term ‘risk-off' and ‘risk-on' positioning by investors. To what extent do you believe its underlying direction is being masked by this market symptom of the global financial crisis? Do you feel the dollar would otherwise be continuing a chronic, long-term decline, and is that what might follow?
This [situation] is more of a result of a consequence of the global financial crisis, i.e. the dollar suffering from the Fed's extraordinary policies. The dollar was seen as a haven/liquidity currency, but then it also became a major funding currency after the Fed began quantitative easing [QE]. There is effectively zero yield on US assets right now, and we saw a flood of money leaving US markets between 2009 first-quarter and 2011 second-quarter as the Fed launched its programmes.
As a result, the dollar became a funder, but by association, when positions need to be taken off in any unwinding, regardless of the underlying cause, [it] needs to be bought back.
We don't see it as a long-term decline, however. The US's savings rate is going up, industry is improving in competitiveness, and growth has surprisingly managed to hold this year despite adverse international conditions. We think the dollar needs to decline structurally as part of the global imbalance adjustments story, but against Asian currencies and other surplus countries. Against the likes of the euro (EUR), pound (GBP) and Swiss franc (CHF), and to a lesser extent the yen (JPY), the dollar [instead] needs to rally.
Considering the eurozone as an entity is in a perilous state, is it a surprise the euro itself remains comparatively strong? Or is that simply the function of relative lack of supply compared to the QE programmes of the US and UK? What is your central scenario for the path of the eurozone bailout efforts, and its consequence for the currency?
Euro breakup is not our core view right now. It is comparatively strong mostly because investors are still giving Eurozone policymakers the benefit of the doubt. It is clear that in the immediate future of two years or so there is no appetite whatsoever for a Eurozone breakup of any form, since the banking sector and wider growth consequences would be disastrous and could undermine the Eurozone political project. The European Central Bank (ECB) probably needs to play a greater role to prevent contagion, but in all likelihood the euro will survive in its current shape, albeit with stronger economic governance dictated from Berlin and Brussels.
What's really needed is fiscal union in the long term, and the Eurozone is aware that it needs to get there or risk disintegration.
It is apparent that the Chinese yuan renminbi is being carefully introduced onto the global stage as a potential rival to the US dollar's benchmark status. What is your opinion of the timeline of its emergence, and what that might mean not only for the US dollar as de facto reserve currency but also its associated, pegged currencies, not least in Asia itself? Does it have any particular implication for the yen?
The yuan (CNY) has the potential to become a major reserve currency, but the Chinese need to ask themselves whether they are ready for it. With the ‘exorbitant privilege' of a global/reserve currency comes responsibilities, such as better economic and financial governance and institutions, central bank independence, amongst other key reforms that China needs.
China is probably not quite ready for that, especially if there are sacrifices needed such as an open capital account and greater supervision of foreign exchange flexibility, upon which the IMF will play a greater role. China will point to the fact that the US has abused the dollar's position, but that is no excuse for exercising the same degree of largesse.
Internationalisation of the CNY will allow other Asian currencies to fully float their own currencies, though whether the dollar will be displaced remains to be seen. It is also the global financial transaction currency and trade invoicing currency. Even post-liberalisation, commercial agents have very little incentive to change their invoicing methods, for practical reasons. The JPY has arguably been an internationalised currency for three decades, yet Japanese corporates still invoice in dollars.
UBS strategists have been quoted in calling forward shadow, alternative currencies (Swiss, Canadian and Australian) as likely forerunners of a rebalancing in the FX market. Is there a serious process of fragmentation going on? How far is it a healthy development in creating some kind of diversification, and how far in fact just a reflection of a desperation to find pockets of strength in terms of exchange rate exposure?
So far there isn't a process of fragmentation, because every time the market looks for some form of decoupling, investors discover that liquidity remains ‘king', and when worst comes to worst all the ‘high-beta' shadow currencies are liquidated in favour of the majors.
However, structurally the CHF, Canadian dollar (CAD) and Australian dollar (AUD) will benefit from diversification because their underlying fundamentals are sound.
There is some degree of desperation amongst sovereigns amid the current fiscal problems in the US and Eurozone, but often not as problematic as the media makes it out to be.
Take the Chinese for example: they are overweight dollars, but being overweight Treasuries is probably a bigger problem. The Chinese sovereign investment entities are now looking to keep their USD exposure but increase investments on the corporate front as their overall fundamentals (cash-heavy, efficient) are stronger than the US's government's by far.
Finally, no matter how attractive the CHF, CAD and AUD may prove, their total liquidity is still limited, and sovereign investors know they will be crowded out very easily in terms of pricing.
What do you make of the contention by some emerging-market countries of a ‘currency war'? Is there any validity in the concern of a globalized ‘beggar-thy-neighbour', protectionist tendency, in conjunction with the world's economic policy morass and accumulated imbalances?
"Currency War" is a low-probability event in our view at this stage. Most governments know there is far more to lose than gain in any such step. Beggar-thy-neighbour policies have fallen out of fashion, despite the rhetoric. Most emerging market central banks intervene simply for the sake of financial stability rather than as a policy response to what happens in the US, because they do not have the firepower to engage in any such steps, and if global growth is hurt as a result their currencies would probably suffer anyway as yields fall.
The world is adjusting its imbalances out of necessity rather than active policy action, and even the Chinese have acknowledged that their current growth model is unsustainable in the long run. The only problem is that the steps being taken to rectify the problems are too timid and the pace is too slow.
Protectionist signals from the US are strong right now mostly because an election is coming up, and China knows that. Behind the sabre-rattling, economic co-operation is still proceeding apace because it's in everybody's interests.
The dollar link
How would you advise Gulf governments to consider their established and prospective policies towards the lodestars of the US dollar link, the eurozone as a template for regional monetary union, and any associated issues such as setting interest rates, regulating economies and minding capital flows?
I don't have a strong view [here], especially in the current political environment in the Gulf. Ultimately, the Gulf states are importing US monetary policy through their respective currency pegs, and in the long run this is unsustainable, regardless of the financial resources these countries have.
Painfully evident throughout the last few months or so, high inflation erodes living standards in real terms, and without an appropriate policy response it is hard for the populace to countenance the status quo. Perhaps the Gulf is not ready institutionally for a monetary union, but greater common governance is a good first step.
Nobody wants to be a first-mover in breaking free from the dollar peg, for competitiveness and practical reasons, so it is worthwhile for Gulf states to explore the opportunities to move together.