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.