The Economist and Brad Setser on the Dollar

The Economist put “The Panic About the Dollar” on its cover, which led to a speedy and lengthy analysis by Brad Setser who along with Menzie Chin are probably the most active and best informed bloggers on the currency beat.

Although the Economist isn’t what it used to be, the two pieces (the leader and the longer article) are both well done, factual without being overwhelming.

Setser gave a very detailed reaction to the basic issue addressed in both pieces: will the dollar fall further? His reply came off as being more nuanced than conclusive. That isn’t to say Setser dodging the issue, but his keen eye for detail sometimes means that he doesn’t always take a definitive position.

Setser charged that the Economist is generally a lagging indicator. Perhaps true, but not the degree that, say, Business Week is. For example, in June 2005, it had a great survey in housing bubbles around the world. They were pronounced, but had not reached their peaks. So I am willing to consider the possibility that the Economist is again commenting on a trend that has not yet run its course.

The leader articulates the essence of the Economist’s worries:

In recent years a fall in private inflows has usually been offset by central banks in emerging economies that link their currencies to the dollar. This system (often known as Bretton Woods II) has thus propped up the dollar. But this time these central banks have been less willing to take up the slack. Right on cue, the cracks in Bretton Woods are becoming clear. China is routinely attacked in America and Europe for linking its currency to the dollar. Squeezed between rising oil prices and the falling dollar, the Gulf states face rising inflation: speculation is rife that one or more of them will modify their currency pegs at a regional meeting on December 3rd.

There you have it: the ingredients of a nasty crash. But self-interest and sensible policy can cut the odds of trouble. The first step is for American policymakers to pay more heed to their currency. For all their talk about a strong dollar, American officials have behaved as if they cared little about its worth. A reserve currency is supposed to be a store of value; by running a huge current-account deficit America has left the dollar vulnerable. At such a tricky time, benign neglect will no longer do. For the moment, this need mean little more than some carefully chosen words. If the slide becomes chaotic, it could demand currency-market intervention and a willingness to hold back interest-rate cuts for the sake of the dollar.

The other part of the solution lies elsewhere, particularly with those countries with dollar-pegging currencies. These economies need to allow their currencies to rise, both to curb inflation and encourage the rebalancing of the global economy. Appreciation would mean that these countries accumulated new dollar reserves at a slower pace.

The longer article sets forth another element of the problem:

The dollar has weathered these storms. But now it faces a nasty squall that combines both cyclical and structural blasts. Its decline in the past five years has imposed a huge capital loss on foreign-exchange reserves. If this becomes too painful, central banks may be tempted to cut their losses and dump their dollars, causing a slump in the currency’s value. The lure of selling is made all the greater by the knowledge that other central banks are overloaded with dollars too. Those that get out first have more chance of saving their capital.

Setser give a two-part response: the dollar is probably done depreciating versus the euro, but not against Asian currencies:

I have long believed that a fall in the dollar’s real value was a necessary part of a broader adjustment needed to bring the United States’ trade deficit – and the United States need for external financing — down. And I have long argued that unprecedented intervention to support the dollar (in order to keep other currencies from rising) by the world’s central banks has impeded this correction, storing up problems for the future….

Bottom line: the dollar has fallen enough against the euro to encourage a needed adjustment. The “structural” argument for the dollar to fall v the euro is gone. With time, the US deficit with Europe should disappear. The argument for further falls in the dollar is now in large part cyclical — a slowing US economy and falling US rates. A loss of confidence in US financial engineering and the risk that some big holders of dollars may stop buying and start selling also plays a part.

That said, reserve managers should at least pause before buying into euros at current levels…

But too much of the talk about the dollar focuses entirely on the dollar-euro. The dollar-euro is important, but it isn’t the only currency pair that matters. The US has a lot more investment in Europe than Asia, but it imports far more from Asia than from Europe.

And while the dollar has fallen significantly v a range of European currencies over the past several year, it has yet to fall by much against most Asian currencies…

My conclusion: the dollar’s fall isn’t over even if the dollar’s fall v. the euro may be.

This is useful, but it doesn’t address the worrisome part of the Economist’s coverage, namely, a rout, or otherwise destabilizing fall. Personally (and this is merely instinct), I believe the dollar is too deeply traded a currency to suffer the kind of precipitous fall that emerging markets currencies experienced in 1997. But the flip side is that by virtue of being the reseve currency, it doesn’t take something as dramatic as a plunge to be destabilizing. The move that we’ve seen against the Euro over the last five months is disruptive enough to make planning for companies that function in the real economy difficult, to put it mildly. High volatility would have a similar impact.

And the Economist pointed to the scenario that has the dollar-worry-warts concerned:

If the slide becomes chaotic, it could demand currency-market intervention and a willingness to hold back interest-rate cuts for the sake of the dollar.

Let’s turn the causation around: further interest rate cuts will likely produce a dollar fall. We got a whiff of that last week, when the yen rising above 107 to the dollar also saw reports that the dollar being used to fund the carry trade. If the dollar becomes a popular vehicle for the carry trade, it will decline further.

Another factor that could impel further dollar deterioration is selling by Americans. Setser gave a detailed analysis of the truly horrific August Treasury International Capital report. It was bad enough that the magnitude of capital outflows (remember, we are supposed to have a capital surplus to offset our trade deficit) was unprecedented. Worse was that $34.5 billion of the total was purchases of foreign long term securities by US residents. In other words, capital flight.

And how will the currency market intervention that the Economist calls for come about? The US lacks the forex reserves to have serious firepower, and in any event, currency traders know well that they will win the game of fighting a central bank trying to shore up its currency. It’s one of the best games around, as witness when Soros broke the pound in the early 1990s.

The only ones who could successfully defend the dollar are the countries with big forex reserves, namely Japan, China, the Gulf States. But would they? They’d already rather be holding fewer rather than more dollars. Would they want to double their bets as the dollar fell? No rational trader would do that, unless they were confident they could not merely halt, but actually reverse a slide.

And what of the yen? While Japan is committed to keeping the yen cheap (notice how the officialdom continues to portray Japan as a basket case as they accumulate ever-larger forex reserves) and the dollar fell from 107 to 111 to the dollar as of this writing. But Japan has signaled that it is willing to let the yen appreciate, as long as it is gradual. Why would it now consider a more costly yen, something it has long resisted?

We are now seeing a rush for the bottom by three of the worlds’ biggest currencies: the dollar, and derivatively, the yuan and the yen by virtue of their desire to maintain their pegs (although it isn’t that formal in Japan, since they have retail traders who do the dirty work for them). That isn’t viable unless the dollar reverses course, which seems unlikely given the upcoming Fed rate cuts.

My Asia sources tell me that China is willing to let the yuan appreciate only if the yen rises first, and they are actively buying yen to make sure that comes to pass. Although it isn’t direct confirmation, the unexplained slowdown in China’s forex reserve accumulation would be consistent with such an effort.

Heretofore, rises in the yen have occurred when concerns about risk have also been on the upswing. The yen at 111 is allegedly below where China wants to see it. If we see yen appreciation next week in the absence of bad credit market news, it would seem to prove out the China thesis.