The Hindu Business Line : Fed chief weighs down on the dollar

The dollar's attempted rebound last week was killed by the Federal Reserve Chairman, Mr Alan Greenspan, arguing that the world would not indefinitely finance the American current account deficit. He did not offer any explicit remarks on the dollar but his words seemed to imply that he favoured the greenback's weakness as one way of re-adjusting the global current account imbalance, says V. Anantha Nageswaran.

FOR THE second week running, there was no short-term bounce for the US dollar. The currency ended the week at $1.3022 against the euro and spot gold traded at $447 per ounce.

The dollar's attempted mid-week bounce was killed by a speech delivered by the Federal Reserve Chairman, Mr Alan Greenspan, in Frankfurt on Friday. Participating in a panel discussion on the euro, the chairman went on to argue that the world would not indefinitely finance the American current account deficit. He did not offer any explicit remarks on the dollar but his remarks seemed to imply that he favoured the greenback's weakness as one way of re-adjusting the global current account imbalance.

It would be hard to divine what Mr Greenspan had in mind. We will never know whether the remarks were meant to set the markets on an unwavering path of dollar weakness. We would not know either if the remarks were meant to set the stage for the debate on budget deficit reduction in the US.

Mr Greenspan's scepticism on the continued global funding of the US current account deficit is a reasonable one. However, recent Treasury data shows that, in the first nine months of the year, foreigners have bought a net $692 billion worth of US long-term securities. It is well on its way to beating the figure of $747 billion last year (see Chart 1).

East Asian governments led by Japan and China have continued to accumulate US assets — predominantly debt securities. They have been closely followed by South Korea and Taiwan. Interestingly, Indonesia and Malaysia do not figure in the list of big buyers of US Treasuries. India has reduced its holding of US Treasuries by more than 25 per cent in 2004; its holdings stood at $16.7 billion in end-2003, and as of end-September, were down to $12.6 billion. At least, India cannot be accused of feeding the gargantuan American appetite for consumption by lending to them.

Most other Asian nations have been at it for many years and they see no problems in continuing with it. They will play this game, as long external growth remains the prime growth driver.

Witness how Japan has been forced to downgrade its economic assessment last week. Sans exports, there is no East Asian growth story. Hence, this cosy `vendor financing' arrangement between the America and East Asia can go on for quite some time. This would mean relentless upward pressure on other currencies.

Only vehement European protests and protectionism can force a realignment of exchange rates in Asia. Since America is cool towards `Old Europe', it is unlikely to overtly support such European protests.

If Europeans succeed, America would not be displeased at the resulting gains in American exchange rate competitiveness over East Asia (read, China) as well. Already, America is preparing for a quota-free textile import regime with increasing restrictions on Chinese textile goods. So, either way, America sees a weaker dollar as part of the solution.

It is of less concern to them as to whether Asia or Europe is hurt by it. For Washington, it is a win-win situation. Perhaps, Mr Greenspan's remarks on Friday make sense after all. A weak dollar has to be part of the game.

If and when the Europeans succeed in making East Asians share the burden, America would be in trouble and so would Asia be. Asia would have less need to buy Treasuries, after a currency revaluation. If the American current deficit had not come down by then, it most likely will have to be addressed through a combination of lower growth and higher yields on American bonds or both.

The author is no wiser than the readers are in predicting the timing of such a development. However, equities markets and their cheerleaders have begun to act as though a new bull

run has commenced. That is likely to end in disappointment. Readers of this column would know that we had argued for a tactical rally in equities going into the holiday season but not a long-term bull market. Sooner rather than later, valuations would hit their ceilings and a bubble would be staring at investors. The November 8 column had catalogued all that was wrong about the `strong' employment number for October.

Leading indicators have fallen for the fifth month and the Chief Economist of Merrill Lynch for North America puts it in historical perspective:

"This is the sixth time in the post-War period that the LEI has declined five times in succession. Out of those, four were followed by a recession. Only twice in the past did the economy manage to avert a recession after five straight monthly declines in the LEI — 1966 and 1995. What did both episodes have in common? The Fed stopped tightening after the fifth month of slippage. In fact, the next move by the Fed was to cut rates not raise them." (Source: Morning Call Notes, 19th November 2004, Merrill Lynch Economics.)

Manufacturing indices tracked by the Federal Reserve Bank of New York and Philadelphia dropped more than expected. It means that the ISM manufacturing index for December would decline and that the November payroll report would again disappoint. Against this, consensus earnings forecasts for S&P 500 in 2005 are too high. Further, earnings quality has begun to deteriorate. The gap between operating earnings and reported earnings (earnings as reported to the Securities and Exchange Commission in line with accepted accounting standards) has begun to widen and this is indicative of deteriorating earnings quality.

All this does not mean that the equities rally is about to end soon. It might run into some trouble before seasonal patterns re-assert. Similarly, the dollar might still rebound, as it appears oversold.

However, for the latter, the window of opportunity is closing fast. Of all the major countries in the world, forward interest rate expectations for the US suggest a 100-basis point rise. In all other cases, interest rate expectations are either flat or even lower (see Chart 2). Yet, the dollar has not benefited from it in recent weeks.

If the market's expectation for American deposit rates decline due to weak economic data (that is what the five-month drop in Leading Indicators portend), then there would be no respite for the dollar.

Even tactical bulls on US dollar will have to retreat. The eventual dollar correction and its ramifications on the global monetary system could end up proving the consensus expectation of an orderly correction in the dollar wrong.

(The author is founder-director of Libran Asset Management Pte Ltd., Singapore. The views are personal. Address feedback to van@libranfund.com)

More Stories on : Economy | Forex | Global Finance & Overview

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Trading with Bangladesh

Shareholder of an unlisted company — tough luck!

Fed chief weighs down on the dollar

Reflections on India's balance of payments — Use the surplus for essential investments

A style statement for mutual funds

No to politicians

When religion ends, politics begins

Why China wins the FDI race

A comprehensive public policy

Conscience vs job security

Newly taxable services