Part 2 of 2: Rebalancing the dollar, euro, yen

Part 2 of 2: Rebalancing the dollar, euro, yen

David E. Sumual, Jakarta

The question now is how far will the greenback sink? Or is
there any possibility of a currency crisis in the U.S. in the
next few years? The answer depends on whether the U.S. twin
deficits will keep growing, and/or whether the U.S. economic
landscape means dollar strength. So far, Bush's tax cuts policy
has improved the incentive to work, thus helping to boost the
U.S. economic prospects. In fact, Americans may have to work even
harder as the depreciation basically will mean extra demand due
to the relatively cheap price of the dollar that, in turn, boosts
U.S. exports. This is particularly true even though Americans
actually now work more on average than Europeans. With the U.S.
economy growing faster in the third quarter at 3.7 percent vis-a-
vis only a 3.3 percent annual rate in the prior quarter, U.S. job
growth soared in October. As such, the unemployment rate fell to
5.1 percent in October after peaking at 6.4 percent in the
beginning of this year.

As already explained above, the U.S. debt ceiling may also
limit Bush's political choices, thus reducing the risk that
future U.S. policies could further debase the dollar (this is not
hitherto appropriately priced in by the market). Signs of
receding budget risk are already there. The short-term budget
outlook is better today than a couple of months ago, largely
because tax revenues have risen surprisingly fast. Because of
higher growth, the budget deficit outlook in the 2004 fiscal year
is only US$412.6 billion, less than the $450 billion previously
expected. Moreover, the dollar is also backed by the stewardship
of the Federal Reserve that tries to pursue sustainable policy
responses. It has indicated on several occasions that the Fed
rate will be gradually raised. This policy response is basically
favorable for the dollar as the dollar is driven primarily by
interest rate expectations.

A recent paper by Obstfeld and Rogoff (October 2004) has
indeed predicted that the dollar should fall another 20-40
percent in order to rebalance the current account deficit. This
means that the dollar needs to trade at about 1.45-1.6 per euro
or 85-90 percent for the deficit to narrow, a level that seems
unbearable for both regions. Moreover, recent data shows that at
the dollar's current level, signs of a receding U.S. current
account deficit have yet to appear. Learning from the dollar
crisis in the 1980s, there is indeed a lag time between the time
a currency depreciates before benefits begin to accrue in terms
of an improving current account deficit. As such, there is still
significant potential for the euro (Asian central banks have
resisted a rise in their currencies) to overshoot to at least
$1.45 per Euro before the U.S. current account deficit improves.

The chances of the dollar overshooting have been increased by
recent developments. Greenspan, for instance, has urged foreign
investors to reduce purchases of U.S. assets in his latest
comments. At the same time, Russia's central bank plans to boost
its euro reserves at the expense of the dollar and plans to
switch its trade in oil from dollars to euros. China, which is
the second-largest foreign holder of U.S. T-bills, has reportedly
trimmed its holdings of U.S. Treasuries. This news in addition to
a massive shift in market psychology following Bush's reelection
has reinvigorated the U.S. dollar bears.

Furthermore, it is logical to assume that private creditors
and major foreign creditors of the U.S. have started quietly
buying the euro gradually since two years ago to diversify their
foreign exchange holdings. Moreover, the same news from the China
and Russia officials stating a plan to dump U.S. dollars has
actually been reported since last year. That partly might explain
why the U.S. dollar has gradually depreciated in the past three
years.

Should the dollar tumble further, it is in the interests of
the key foreign U.S. creditors that it happens in a gradual
fashion. Over the last few years, around 80 percent of the
deficit has been financed by foreign governments and
institutions. The willingness of Asian central banks to lend to
the U.S. has allowed their deficits to keep growing by acquiring
dollars to keep their exports cheap. The world financial system
should therefore stand firm as long as those central banks keep
buying dollars.

In the situation that they manage to exit from U.S. Treasury
Notes to diversify into euro assets, the exit has been seemingly
done very carefully and gradually, thus reducing the risk of a
financial crisis. The key foreign creditors would face huge
foreign exchange losses that wipe out the value of their U.S.
dollar assets if a currency crisis occurred in the U.S.. Such
foreign exchange losses could be viewed as U.S. one-sided
default, something that these countries should avoid. It might
undermine the U.S. economy and is likely to hurt their economies
as well, due to their high dependency on U.S. imports. This
explains why Japan as the world's largest holder of U.S. Treasury
notes may remain as the U.S. guardian angel to take action to
stem any speculative attacks against the dollar.

In fact, the genuine threat for a U.S. dollar crisis may come
if OPEC suddenly switches oil trade (as the biggest traded
product in terms of value in the world) to the euro. Such a
sudden reversal to euro could encourage other non-OPEC producers
and oil-consuming nations to switch to the euro and this could
potentially trigger a U.S. dollar crisis. However, there are
important political factors that may prevent this from occurring.
The situation in Iraq might prevent OPEC -- especially Middle
East countries -- from turning to the euro for an oil transaction
currency standard. This holds true even though the OPEC countries
realize that the dollars they were receiving for their crude oil
would buy less than before. As such, the OPEC countries have
recently pledged to stick with the dollar.

Given the current global economic climate, Bank Indonesia
actually has a better opportunity to defend the current rupiah
level of Rp9,000/US$ that we also see as representing the fair
value of the rupiah. It would be very hard for the rupiah to
strengthen, as many domestic companies still have to service
their debts since the 1997 crisis. The rising oil price also
increases the need for U.S. dollars to buy fuel, taking into
account Indonesia's current position as net oil importer.

The appreciating euro should also increase the possibility of
the issuance of euro denominated bonds in the expectation that
the U.S. twin deficits will ultimately recede in the medium term
to give a chance for U.S. dollar appreciation. We hope that
recent Bank Indonesia statements that consider raising the
portion of the euro in its foreign reserves composition are also
merely a verbal strategy, similar to other Asian and Russian
central banks.

Because if the central bank considers switching to the euro
now, the opportunity lost is already huge, or, in other words,
the potential upside is already limited. Since its launching in
January 1995, the euro initially dropped 40.9 percent against the
dollar in July 2001, but since then has risen 36.8 percent
hitting an all time high at the beginning of this week. Just
imagine how big the opportunity lost is, because under the above
scenario the dollar may strengthen in the medium term. Given how
far the dollar has dropped, a reversal is only natural and the
authorities may learn from the recent plans of some large
domestic banks to issue euro denominated bonds.

The writer is an analyst of Danareksa Research Institute
This article is a personal view and it is intended only to
enhance public debate.