Rebalancing the dollar, euro and yen

Rebalancing the dollar, euro and yen

David E. Sumual, Jakarta

Two major events that occurred in the first week of February
may play an important role in expediting the rebalancing of the
dollar, euro and yen.

The first event that raised the possibility of a protracted
dollar recovery was the relatively smooth elections in Iraq,
signified by less violence and a better-than-expected turnout of
voters. The second event was the widely expected rise in the
federal funds rate by 25 basis points (bps) to 2.5 percent, which
at least could contribute to the halt in the greenback's downward
trend.

This move appears to confirm the earlier conviction that the
Federal Reserve will continue raising interest rates for most if
not all this year until it hits a "neutral" rate of about 3.5
percent to 4 percent. This level is estimated to be neutral in
combating inflation without curtailing economic growth.

The relatively smooth elections in Iraq suggest that the
situation in Iraq will steadily improve in the months ahead.
Accordingly, the cost of Iraq's reconstruction and the budget for
maintaining U.S. forces in that country will be less than
estimated earlier, thus easing the pressure on the U.S. budget
deficit.

The other immediate impact of the smooth elections in Iraq
was lower oil prices thanks to the declining "risk premium" on
current oil prices (estimated at about US$10-15/barrel) due to
the unstable situation in Iraq. As seen since last week, crude
oil futures fell from an eight-week high of $49.80 per barrel on
January 25 to $45.20 at the beginning of this week following the
elections in Iraq.

With the prospect of military conflict between U.S.-led
forces and Iraqi insurgents receding, international oil price may
gradually head lower toward the $35 to $40 a barrel level.

In fact, the impact of a reduced risk premium on oil prices
and the dollar could also be seen when the Gulf War ended in
February 1991. Oil prices fell and the dollar strengthened in the
first half of 1991 following the swift conclusion of the first
Gulf War.

Particularly for the dollar, there is however an essential
difference between now and 1991. In 1991, the dollar instantly
rallied after the end of the Gulf War as the Gulf countries had
to transfer their contributions toward the cost of the military
operation to the U.S. But now the U.S. has to carry most of the
financial burden of the military operations in Iraq. In addition,
the diminished sensitivity of the U.S. current account deficit to
U.S. dollar fluctuation also contributes to the slow recovery of
the dollar.

We have often heard about the contribution of the U.S. current
account deficit to the slow recovery of the dollar, even though
U.S. growth is actually accelerating and the latest employment
numbers are upbeat. It seems that the time lag between the dollar
depreciation and the improvement in the U.S. current account
deficit has increased compared to the late 1980s and the 1990s.

I believe that the main driving force for the longer period
of U.S. dollar adjustment is the changing pattern of world trade
and the trends of regionalism in the past 10 years.

For example, the emerging euro currency has encouraged
European countries to trade and to invest intra-regionally. And
following the Asian economic crisis in 1997, trade and financial
cooperation among East Asian countries has also intensified. In
1993, the intra-regional trade in ASEAN+3 (including Hong Kong
and Taiwan) stood at only 45.8 percent. It has increased
consistently since then, and by 2002 intra-regional trade reached
52.8 percent of the total region's trade.

This trend shows that many countries now see the increasing
role of the regional market. No wonder then, at the same time,
Asian imports from other regions -- including the U.S. -- are
going down. As a consequence, the time lag in U.S. current
account improvements due to the dollar's depreciation is longer
than in the previous decade.

Against this backdrop, the move by G7 countries to pressure
China to revalue the yuan in an effort to reduce the huge U.S.
current account deficit is actually irrelevant. This is
particularly true as China already trades more with Asian
countries -- especially Japan, Korea and ASEAN countries -- than
with the U.S. (China accounts for only 10 percent of America's
total trade).

Moreover, costs in China (especially China's unit labor cost)
are so low that such a revaluation would be unlikely to narrow
the U.S. deficit significantly. So in that sense, the yuan
appreciation would prove to be ineffective to reduce the huge
U.S. current account deficit.

In contrast, rather than external pressures, China's own long-
term interests may play a greater role in inciting China to move
to a more flexible exchange rate. By pegging its currency to the
dollar, the Chinese monetary authority is being forced to adopt
overly loose monetary policy. But in fact, the Chinese economy
needs a tighter monetary policy now than the U.S. economy.

At the same time, an undervalued exchange rate spurs
speculative capital inflows on the expectation of a yuan
revaluation. Data shows that China's forex reserves jumped $67.5
billion in the last two months of 2004. Most of those funds may
be portfolio capital inflows seeking to profit on a rise in the
yuan. That increase in forex reserves in turn broadens the
monetary aggregates, thus making it harder for the Chinese
monetary authority to keep inflation under control.

With 9.5 percent economic growth in the fourth quarter of
2004, China's inflation rate of 3.9 percent in 2004 is not much
of a concern. Thus far the central bank of China has been able to
sterilize the potential increase in liquidity by undertaking open
market operations and increasing its reserve requirement.

However, if the speculative capital inflows continue to build
up, pressure on China to realign its currency will increase.
Given the significant role of inflation as an element of
political-social stability, China has good reasons for pursuing
low and stable inflation. As such, the Chinese inflation rate
would be the best indicator to predict a yuan revaluation.

As elaborated at the beginning of this article, the smooth
elections in Iraq and the Fed's commitment to a tighter monetary
policy stance may expedite a turnaround in the dollar's fortunes.
A nascent sign of a recovery in the dollar is the dollar's
appreciation to a three-month high of $1.2762 per euro at the
beginning of last week, after the Fed signaled that interest
rates would continue to rise over the rest of 2005.

In line with the U.S.'s strong economic performance, I
believe that higher interest rates in the U.S. will play a role
in reducing the global imbalances. Higher interest rates will
somewhat decrease the U.S.'s dependence on international
investors for funding its twin deficit, and in turn boost
domestic saving.

Nonetheless, a bottoming-out of the dollar could be risky in
regard to the current overvaluations or prices bubble of stocks
and bonds in emerging markets. A turn in the fate of the dollar
could prompt major reversals in asset markets in emerging
countries. However, a sudden dollar rally in our view may not
precipitate another financial crisis in Asia since the region's
financial systems are now in far better shape than a decade ago.
The region is now more ready for a sudden reversal of global
capital flows. This is a consequence of the lower foreign-
denominated debt, more flexible exchange rates and the abundant
forex reserves, some virtues that the region lacked a decade ago.

The writer is an analyst at the Danareksa Research Institute.
This opinions expressed in this article are personal.