Watching the dollar (you know it makes cents)

HEADS: The buck which bucked a trend

If you are paid in UAE dirhams you are effectively paid in US dollars, because of the currency peg which has been in place for a generation. Therefore, if you are an investor concerned to diversify your savings, perhaps an expat with a different currency base, you may (or should) be interested in the dollar.

It may have come to your attention that the dollar is supposedly weak compared to many other currencies. You may also have noted that oil and other commodities (notably gold) have become expensive in dollars, which is another way of saying that the dollar is weak in those terms too.

Of course, most other currencies are weak by those criteria. The dirham or dollar may still be taking adequate care of your daily shopping needs. Other, big-ticket items (such as property) have become more expensive in the UAE, but, both as to groceries and local real estate, there we are talking about purchasing power in domestic terms (hence inflation).

So it all depends on how you look at things. Here, we'll concentrate on the dollar internationally, the global greenback.

The charts alongside show its recent course. Clearly, the dollar is not as weak as it was in late 2004, when it dropped towards Yen 100, Euro 0.70 and £0.50 (i.e. $2 per pound). In 2005 it recovered, contrary to most expectations, to be nearer Yen 120, Euro 0.85 and £0.60, up by about 15 per cent against the yen and euro, and 10% against the pound. There are some conventional ideas as to why.

Low interest rates prevailed through 2001-4 (post-?9/11?), fuelling domestic demand and imports. The dollar suffered both from low yields and a worsening trade deficit. Moreover, in 2003 the Bush administration publicly veered away from the 'strong dollar' policy preference.

With those odds stacked against it, the dollar was not only expected to decline further. In fact, many felt (and still feel) that it had to, in order to help global trade imbalances adjust. Instead, it turned around, and in 2006 has held an upward trajectory.

The US trade deficit hit a new record in 2005, up 17.5 per cent to $726 billion, and from 5.3 per cent to 5.8 per cent of GDP, owing especially to surging oil costs and Chinese imports. The current account (which incorporates services and income balances as well as goods) may have reached a deficit of over $800bn, between 6 and 7 per cent of GDP.

The US Fed itself warns that, although deficits per se have persisted since 1990, they have "recently assumed extraordinary proportions", and the dollar's apparent U-turn may be incompatible with that tendency.

The Economist goes so far as to say unequivocally: "reducing [the deficit] will, at some point, require a much cheaper dollar", with "real risk" of a "sharp drop". Needless to say, the consensus view is for such a drop in 2006.

Economically, the threat is of a dollar slide, accompanied by higher interest rates in its defence, which causes recession. Many think that may be the only way now to close the gap, by making imports expensive, and diminishing the ability to afford them.

At the same time, a pending dollar slide might induce overseas investors in US securities, who have been financing America's 'living beyond its means', to flee, inducing collapse, aggravating the effects. So there is serious concern in some quarters.

Politically, the Americans have focused on the deficit with China, which was up 24.5 per cent to $202 billion. It has prompted further complaint of deliberate currency manipulation (i.e. undervaluation) for competitiveness purposes. Despite China's revaluation of the parity rate in July last year, simultaneously switching to a managed floating regime, the yuan has risen only modestly. China acknowledges the point, but is determined to stick to its gradualist guns in moving towards a freer market, which means the burden resting on the dollar is heavy.

Surplus

It remains a double-sided issue, however, precisely because China (and other surplus countries) are keeping the dollar afloat. Partly because they have to, and partly because they want to. It is in their own interests. Which makes the whole affair circular, and keeps the imbalances growing.

A key reason for the dollar's upturn in 2005 was the accumulation of dollar securities by foreign central banks, especially in Asia. Of a measured total of $269 billion, China bought $167 billion, so that its total reserves now exceed $800 billion.

Another reason was other portfolio shifts relating to the widening interest-rate gap between US and other blocs, particularly with American rates on a steady upward path. Such activity is exaggerated by market leveraging of positions ('carry trades').

A third source of support has been the recycling of Middle East petrodollar surpluses, also, it seems, predominantly into US assets, notwithstanding the huge scale of investment within the region.

A fourth boon was the repatriation of US firms' foreign profits owing to a one-year tax break, which therefore has only temporary impact.

Let's focus on the foreign capital, because it's critical. It's not only providing the funds to spend, it's actually boosting the dollar!

In other words, whereas the US current account is in hefty deficit, its capital (or, formally, financial) account has been in bigger surplus. Latest data (for 2005 Q3) showed a huge net inflow of around $275 billion, overwhelmingly of private (not 'official' government/central bank) funds.

US data actually underestimate the extent to which foreigners buy US bonds, ignoring secondary markets abroad (particularly London and offshore financial centres). For instance, when it was said that central banks bought $280 billion in 2003, the Bank for International Settlements gave the figure as $440 billion.

Overseas investors now own over 45 per cent of outstanding Treasury securities. The fact that the foreign holders of dollars are concerned to uphold the value of their own existing dollar portfolios (by buying more of the same) is something which cannot be ignored.

That sort of security for the dollar is the type which says: when we owe so much, it's not our problem, it's yours (which is actually what a US Treasury Secretary did say in another era).

Reserves

Asia certainly knows about it. The People's Bank of China is very wary of making changes except "in an orderly fashion", and is watching what Japan and South Korea do at the same time.

Incidentally, in this regard Asia really is in a cleft stick, concerned not just to protect its foreign investment, but also about domestic liquidity and inflation issues as reserves climb.

Besides having that card in its hand, the US holds another ace, in the enviable position of being able to pay its way simply by printing more of its own currency, thanks to the dollar's status as the world's unofficial reserve currency.

That's one reason why the rest of the world (Europe especially) has been seeking alternatives, including creating one (the euro), and even potentially a common currency in the GCC, though possibly itself linked to the dollar, as its component units currently are. However, the euro, though apparently 'strong' (as a counterpart of dollar weakness), has not entirely convinced as regards this potential role, owing to fractures in political institutions and economic structures. Thus, 60-65 per cent of global reserves are still held in dollars.

Moreover, virtually all the US's foreign liabilities are in its own currency, whereas 70 per cent of its overseas assets are in foreign currencies. The US actually benefits in this respect as its own currency falls, as the value of its other-denominated assets rises!

Furthermore, as the world's most liquid capital market, the US has a natural tendency to pay less on its securities than others pay on theirs, which earns the US a worthwhile margin (though in reality US interest rates rising from very low levels have now diminished or removed that advantage).

The US's (latest) financial account shows net investment income of around $30 billion, although there are arguments about the data. It is certainly difficult to fathom, with the US now such an enormous debtor (with accumulated current account deficits of $4500 billion in the twenty-five years 1980-2004, and accumulated net foreign debt of $2.5trn).

Incidentally, overseas purchases of US Treasuries keep the merry-go-round moving not only by keeping the dollar up but by keeping (long) US interest rates down. (High) bond prices by definition are inversely correlated with (low) interest rates, which are important for certain types of borrowing (including mortgages), even while the Fed hikes (short) rates, which relate rather to consumer credit.

So, will foreigners continue to favour the dollar, and will central banks continue to prioritise preventing their own currencies rising (by buying dollars) over returns on their foreign assets (if they agree the dollar has to fall)? The sustainability of the situation depends on them doing so. In fact, if they don't (or can't indefinitely), the global economy is in danger. Is there a way out?

TAILS: A riddle wrapped in a mystery ?

A balance of payments crisis occurs when credit is reclaimed. Some feel that such a moment is inescapable. The US current account may reach $900bn this year.

The problem is that exports and imports are only a small percentage of the total economy (10 per cent and 16 per cent respectively), so that any aggregate adjustment to impact them indirectly has to be large. Exports have to grow much faster than imports, or imports contract much faster than exports, just to keep the trade deficit still in absolute terms. Hence the temptation of protectionism (particularly ahead of mid-term Congressional elections later this year).

As the external debt rises, the interest rates required to finance it should rise, creating an exponential spiral in five or ten years' time. Equally, the US cannot hike rates very far anyway, owing to existing indebtedness at national and household levels, besides the knowledge of its own pivotal role for world economic growth. Fortunately, inflation does not seem to require it, having apparently decoupled from the oil-price influence.

And yet. While pessimists claim unsustainability and warn of calamity, optimists claim (not that deficits will retreat) that easy financing will continue. Indeed, if dollar collapse is inevitable, triggering a stampede from US debt, a rate shock and global recession, why have financial markets not forced that crisis? There may be a better story to tell.

First, to keep things in proportion. At less than 25 per cent of GDP, external debt is far from onerous at present. And we have already noted that because the US borrows in dollars (ultimately under its own control), it is not so exposed to creditors. Also, the share of the world's foreign assets held in dollars has fallen and, at 27 per cent, is below the US?s share of the world economy.

Second, where would the money (foreign capital) go for a better return? The US remains attractive as a place to invest in terms of outstanding growth performance, averaging 3.3 per cent per annum in the past ten years. If currency markets follow the growth differential argument as well as the interest-rate spread, the dollar can remain in favour (though the current account deficit itself drags on growth).

It is worth remembering that, precisely because domestic demand in the US is growing faster than elsewhere, and (crucially) is the main reason for the growing trade gap, a falling dollar should not be the primary solution even if it's agreed there is a problem.

History certainly suggests devaluation does not work, notably in the US case, and there has been no obvious relationship between the dollar (or, by the way, the budget deficit) and the trade deficit over time. Meanwhile, if a depreciating dollar creates concern for investors, weakening capital flow, it might compound the difficulty, not helping trade much, but jeopardising financing.

Third, the deficit may actually exist only because of the capital account surplus. Though it seems like a truism, an accounting identity, Fed chairman Bernanke has talked in the past of the 'tail wagging the dog' in this sense. In this construct, growth (based on the right institutional ideas) promotes investment, not the other way round. Foreigners are fuelling the world's locomotive, and the deficit is just one aspect of a better economy (with better growth, productivity and employment), which needs to be kept that way.

Monetarists suggest that angst over the dollar is basically misguided, that a spending-driven budget deficit is a bigger problem, and that markets will find equilibrium without government intervention with some artificial cure, being unstable and dynamic by nature. They don't, however, say the dollar won't go down.

Fourth, factors beyond US control, and responsibility elsewhere. Picking up on the last point, others need to act too! If only Europe and Japan would grow faster! That's a big if, although there are some signs. Also, global demographics are relevant, since ageing populations, more so in other regions than in the US, can deliver the capital required, and are already doing so (what Bernanke has called a 'savings glut'). That spinning wheel again.

Fifth, some believe there is 'dark matter' unrecorded in the US accounts, namely assets which generate income but cannot be seen/measured. Items such as 'technological advantage' - which allow US FDI abroad to achieve superior returns -- when properly recognized mean there is little or no global imbalance and no crisis to deal with. Great idea, but unprovable, and challenged by other academics - apart from seeming to flirt with science fiction.

Lesson

Whom to believe? You pays your money and you takes your choice, as they say. For most of us, these all seem like obscure, long-term issues. What, on balance, is it likely to mean for the dollar?

On a week to week (i.e. short-term) basis, not much. The reality is that so much depends on how traders view the debate (if they bother). It often depends on which indicator is flavour of the month (whether growth numbers, interest rates, trade data, money supply, sports results, haircuts - you'd be surprised). If my own experience as a London economist for many years is any guide, not only can sentiment switch like a knife, but forecasting really is a mug's game.

A lesson never to be forgotten, learned as a novice weekly commentator on US markets, was that the same piece of information can be interpreted in precisely opposite ways for market direction.

A 'strong' piece of data (let's say for durable goods, or construction orders) might be interpreted as good for the dollar (by reflecting growth, and potentially higher deposit yields) or bad (by reflecting potential inflation, hitting the bond market). That's apart from the fact that market news is often discounted in advance (though you never know how much, another headache). It was all about mood, and momentum -- wholly intangible and unreliable influences. Part of that equation would also be whether the Fed (responsible for interest rate changes) was 'credible'. Have you ever tried to measure credibility?

A frankly brilliant exposition of this conundrum came from European professor Paul de Grauwe in a piece for the Financial Times only last month. Calling it the 'chocolate dollar' theory, he described in a nutshell the prevalence of perverse market behaviour whereby people don't buy when something's cheap, but buy if it's expensive (know anyone like that?). Merely relating price to quality, they therefore reinforce an existing trend (helping to explain why exchange rates systematically 'overshoot' estimations of equilibrium value).

Because "we simply do not know" why the dollar moves as it does, he observed, we talk to an analyst. That analyst "invents stories", finding variables which correspond to the dollar's movement, "carefully eliminating" all variables which have moved the other way. Thus, interest-rate spreads take over from deficits in today's fairy tale.

So what can we say about the future? The professor says the dollar probably will fall, on the basis of fundamentals (what Deutsche Bank calls a "structural downtrend") - but who knows when? Consensus Forecasts of London, which assembles data from an array of panellists as its name would suggest, confirms predictions generally of resumed dollar decline during the next twelve months (see box, also www.consensuseconomics.com), and the forecasts it carries generally outperform any individual contributor (i.e. they are less wrong).

As for me, my excuse is that I'm an analyst. Also, I know that currency forecasting is not a science, but a branch of the art world, and just as full of baloney.

In the meantime, with the US watching what China does, and China watching what Japan does, and everyone (petrodollar powerhouses Russia and the Gulf countries too) waiting for someone to blink, there's a lot of watching going on. Better watch out.

The dollar in the Gulf : Another day, another dirham (or dinar?)

Unofficially shadowing the dollar for many years, the GCC currencies have been formally pegged since 2003. Oil is not only priced and traded in dollars, but its proceeds have mostly been retained in dollars.

Although oil's impact on US growth and inflation appears relatively slight now, it has been argued that a dollar peg was inappropriate for the GCC because the US grew faster when oil was low, when the GCC itself would be slower (and vice versa), so that parallel interest rates were rarely right for both. Indeed, with oil prices high now, GCC inflation may be too fast, requiring higher rates than the US Fed has been setting.

It is also doubted whether it makes sense for a large creditor (the GCC states) to be pegged with a counterpart large debtor (the US), encouraging imbalances to persist.However, a stable peg, rather than a currency swinging with the oil price, may assist economic diversification.

Though not shifting so much from US Treasuries, GCC investors are spreading their additional assets, most obviously into their own economic infrastructure and stock markets. The UAE has been considering converting 5 per cent of its reserves to euros, but no decision has appeared.

The planned GCC single currency, due in 2010, might itself become a reserve currency. By perhaps shifting to a basket peg, it might hasten the process of dollar decline, and therefore gives pause for thought. It might be better to create an FX reserve buffer rather than remove the peg, which could squeeze the non-oil industry which the region is trying to nurture. By pegging to the dollar, the Gulf is linking to size as much as strength, besides any strategic alliance.

Oil producers as a group have been reported to be considering 'dollar defection' (which Iraq started in 2000). Iran, which is contemplating its own oil bourse to compete with London's IPE and New York's NYMEX, has suggested it will bill in euros (which some consider enough of a threat to have provoked the US's diplomatic aggression, regardless of the nuclear issue).

As well as capital surpluses, oil-producing countries have high savings ratios, like Asia. But Middle East funds may be different from the Asian central banks, more inclined to vary their investments.