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.