The Hindu Business Line : Hard ball at Boca Raton

The statement from Florida seems like a compromise, with it talking about reduction in excessive volatility, more flexibility in exchange rates by major countries.

THIS has been one of those weekends that could have turned the direction of the foreign exchange markets.

It is the G-7 Finance Ministers' meeting over the weekend in Boca Raton, a resort in Florida, which aimed to discuss the economy and currency related issues.

All in all, this event was supposed to turn into a tug of war between the US and the rest of world over the direction and stability of dollar. The US has been using the policy of weaker dollar to find trading partner countries to share the burden of its gaping current account deficit.

Not surprisingly political compulsions have also been driving the US administration to go after countries like China, which have not been heeding the pressure to let their currency appreciate against the dollar.

The European contingent, which included French and German Finance Ministers, Mr Francis Mer and Mr Hans Eichel, had been pushing for statement to reflect concern over volatility and push for burden sharing, thereby giving some reprieve for the surging euro.

Weaker payroll numbers have become the bane of the Bush administration. Even the January non-farm payroll number was far below market expectations.

This comes on the heels of a shockingly poor payroll number in December.

The administration has been putting the blame for the job losses on the unfair trade balances and currency levels with some countries like China.

In the Democratic Congressional primary, Mr John Kerry, is not only emerging as the front runner but is currently ahead of even the US President, Mr Bush.

The Democratic campaign is also focusing on targeting the President for the huge job losses and the slow rate of growth in jobs.

This does not leave many options for the Treasury Secretary, Mr John Snow, but to toe the old line at the G-7 meeting. However, it is now evident that this did not cut much ice at the meeting.

One risk from any shift from currency flexibility to `burden sharing' would be that some Asian currencies would have to appreciate.

The yen has risen around 30 per cent against the dollar but has not strengthened to the same degree as the euro over the past two years. Japan may argue that it has allowed the yen to rise significantly since the last meeting in Dubai.

This would bring China, Korea and Taiwan into the picture for them to participate in the adjustment. It may be difficult to get China to agree to any major adjustments.

China has promised to look at widening the band of currency movement over the long term and any short-term shift may be unlikely.

One hot debate topic has been the trade surplus of China against the US. There is a difference in the number that China and US claim to be their bilateral trade balance. The US claims that China runs a current account surplus of around $120 billion (in 2003). Chinese numbers put this figure close to $60 billion.

Even if one takes the US figures, the Chinese bilateral trade surplus with US is only just approaching the size that Japan run in 1985/86 as a percentage of US gross domestic product.

This figure represents only one-fifth of total trade deficit.

One factor that drives the Chinese current account deficit is the capital inflows.

There is large foreign direct investment into China which comes not only from Hong Kong but also from the US and Japan.

The data indicates that the foreign direct investments into China have consistently been higher than the current account surplus over the last decade.

Even though the capital inflows have been large, there has been lower level of currency intervention by China than by Japan.

Japan has spent a staggering $175 billion on currency intervention in 2003. Even though China does not report the corresponding figure but the increase in foreign exchange reserves for Japan and China in 2003 have been approximately around $210 billion and $120 billion respectively.

Japan remains the largest buyer of US treasuries and this number is much higher than China's purchase. Japan bought around $128 billion whereas China just bought $24 billion of US treasuries.

If one includes China's purchase of US agency bonds of around $27 billion, still this would account for only half of the foreign exchange reserve accretion.

This clearly points to a diversification in its holdings and possible shift into non-US assets. This indicates that any impact of change in China's exchange rate regime would not have any direct impact on US treasury market.

However, such purchases have taken the US 10-year yields lower by around 40 basis points that what it otherwise be.

In case China heeds the calls for exchange flexibility then it would make it difficult for Japan to stand in the way of yen intervention.

The pronouncements by Bank of Japan's Governor, Mr Toshihiko, over the past few days have been to defend Japan's stance on standing in way of excessive yen appreciation.

The statement from Florida seems like a compromise, with it talking about reduction in excessive volatility, more flexibility in exchange rates by major countries.

On the sidelines of the meeting, the US Treasury Secretary, Mr John Snow, also paid lip service to strong dollar policy.

The G-7 meeting may not result in any significant change in trend of the dollar!

(The author is Senior Manager, Corporate Treasury Sales -Western India for HSBC. The views expressed herein are his own and not necessarily those of his employer.)