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In New Currency War, the ‘Strong Dollar’ is a Big Lie

Policy makers across the world favour weaker currencies as they bank on exports to boost growth

Jack Lew’s first act once he becomes US Treasury secretary will be to tell alie. On Day One as Timothy Geithner’s successor, Lew is bound to say “I support a strong dollar” to reassure markets that there will be no change in long-standing US policy. 

Nothing could be further from the truth, though, as the yen trades at 2-1/2-year lows and the world considers a response to Japan’s blitz on money markets. Get ready for Currency Wars 2.0. In a world in which growth is harder to come by, policy making verges on becoming a zerosum game. Officials in the US and China were caught flatfooted by how quickly Japanese Prime Minister Shinzo Abe turned the tables in currency markets with a few vague pledges of change. Rest assured that some big responses are on the way. “Japan has restarted the currency war by its open-policy goal of a weaker yen, which has surprised everyone by its success,” says Simon Grose-Hodge, head of investment strategy for South Asia at LGT Group in Singapore. “No country wants to be priced out of an already challenging export environment.” Take China’s incoming President Xi Jinping, who is walking into a positively treacherous situation in Beijing. He must act fast to rein in corruption, grapple with an unruly local media and tackle the pollution that obscures the sun and threatens public health. The last thing Xi needs is a plunge in exports as exchange rates move against him. The same goes for South Korean Presidentelect Park Geun Hye. Expect policy makers throughout Asia to act, too. 
Benigno Aquino, the president of the Philippines, says his government may borrow dollars onshore to temper the peso’s strength. Thai Finance Minister Kittiratt Na-Ranong is getting an earful from exporters and says he’s reviewing policy changes. The sense of urgency is rising as Akira Amari, Japan’s economic minister, joins the Bank of Japan in a campaign to accelerate the yen’s decline. 
European officials are none too happy, as evidenced by Luxembourg Prime Minister Jean-Claude Juncker calling the euro “dangerously high”. It’s a reminder of how bizarre the region’s crisis has been. Although Europe has endured a triumvirate of debacles — debt, banking and politics — the euro hasn’t been a source of trouble. That is, unless you consider how fallout from the yen might hurt exports. Swiss and Russian officials also are sounding the alarm. 
The US is wary, as well. A key goal for Barack Obama’s second term is to resurrect the nation’s manufacturing sector. Nothing would help that process more than a weaker dollar, and the Federal Reserve’s ever-expanding balance sheet may limit the currency’s gains. 
Japan can’t expect to sustain the yen’s decline for long unless the Group of Seven nations backs it. The strength of the Japanese currency, after all, was always more about the dollar and the euro being less appealing in relative terms than the yen. And now, as optimists seek Japanese assets amid hopes that Abe will end deflation, you have to figure that a yen rebound is inevitable. 
That’s why traders are looking for a material change in Japanese policy. Will they get it? Buying more foreign debt might help, but the purchases would have to be huge to matter. Japan would need to add significantly to its $1.2-trillion stockpile of currency reserves, something officials in Tokyo may be reluctant to do. 
The year ahead will see everyone simultaneously looking to export their way out of trouble. At best, this global race to the bottom will fail; at worst, it will lead to market swings that sap confidence and stifle growth. If Lew really is sincere about wanting a strong dollar, he will surely get it while everyone else heads the other way. — Bloomberg


Why the US dollar is still resilient.

TRILLION-dollar bailouts, trillion-dollar deficits, and the largest spending bill in US history. No matter how dire the news out of the US, the dollar strengthens. It has carried on rising in spite of new bailouts for two leading financial institutions — Citigroup and AIG — a catastrophic fall in US gross domestic product and more dreadful news about the US housing market. The dollar has risen 10% against the euro so far this year, and by 7.4% against the yen. The dollar just a fortnight ago had its best performance against the yen for 13 years — rising 4%.

Plans by the US Fed to buy $300 billion of US government debt has triggered on March 18 a fall of 3.01% for the dollar — the greatest, on a tradeweighted basis, since the signing of the Plaza accord in September 1985. The dollar had rallied since summer of 2008 largely on the perverse effects of ‘deleveraging’, as investors paying down debts often sold assets outside the US and bought dollars.

With the dollar suddenly cheaper, and US goods, therefore, more competitive, other central banks are in a dilemma. In the eurozone, where the European Central Bank continues to face criticism that it is “behind the curve”, the fate of beleaguered exporters who are facing 10% rise for the euro against the dollar in March 2009 could force the central bank to intervene to pull down the single currency . Similarly, in Japan, where the Bank of Japan has already intervened in the bond market, it is likely that the BOJ may intervene directly to weaken the yen. The yen is some 35% stronger than it was in July 2007, at the dawn of the credit crisis.

The US Dollar Index, which tracks the US currency’s progress against a basket of six leading currencies, has risen to a three-year high of 88.969 on a trade-weighted basis. Longer term, however, the US Dollar Index remains well off its highs of this decade, or even the last six years. As recently as 2003, the index traded above 100, which is about 12.5% above current levels.

A number of analysts had predicted the continued demise of the US dollar, thanks to the financial-sector bailout and weakening economy but its sharp upside has surprised many. The dollar’s recent climb is part of a massive reversal of long-standing investing trends (due to the global economic slowdown) such as buying emerging-market stocks or wagering on rising commodity prices.

Besides, many European banking systems built up long US dollar positions vis-à-vis non-banks and funded them by inter-bank borrowing and via FX swaps, exposing them to funding risk. When heightened credit risk concerns crippled these sources of short-term funding, the chronic US dollar funding needs became acute.

Given the dollar’s credentials as safe haven, its unchallenged role as global reserve currency, plus the fact that the market continues to give US fiscal and monetary policy action the benefit of the doubt, buying the dollar on dips remains the strategy of choice.

The dollar’s strength partly reflects the weakness of other currencies. Faith in the yen as a haven has been eroded by a flurry of dismal Japanese economic data while concerns over European banks and their exposure to problems in central and eastern Europe have seen the euro and, to some extent, the Swiss franc fall from grace.

The ability of central banks in Brazil, Russian, India, China and Saudi Arabia, which over the past few years have accounted for at least 30% of net treasury buying, to finance the ballooning US budget deficit is limited by the fact that their currency reserves are either falling — as in Brazil and Russia —or no longer rising, as in China.

Aside from the actions of global reserve managers, activity from US mutual funds shows an unwillingness to increase their allocations to foreign markets. This matters because US fund managers hold $30,000 billion of domestic and foreign securities, compared with the estimated $7,000 billion of foreign currency reserves managed by the world’s central banks.

Having increased their share of overseas assets from about 12.5% at the start of the decade to a high of 26% last summer, risk averse US funds reduced that share to 23%, where it has remained so far in 2009. I see further reductions in the proportion of their portfolios held in overseas markets and the subsequent repatriation of capital will help the US to continue to fund its current account deficit and thus support the dollar this year.

Besides, long-term portfolio allocation data for all US investors shows global shocks historically have caused US investors to steer away from overseas markets for several years. This time risk-averse American fund managers are unlikely to behave any differently in their response to the global economic slump.

The process of European banking sector de-leveraging is likely to generate significant US dollar demand over the months ahead, which will lend support to the US dollar against many other currencies. Dollar demand has also been reflected in the rise in purchases (and hence the price) of US treasury bonds, seen as the safest haven of all. The most recent data shows that such holdings of treasury bonds increased by about $100 billion over the past four weeks. Other countries are also feeling the effects (even more than the US) and so are slashing interest rates to try and boost domestic economic activity; so, the expected yield differential with the US is falling. With this trend set to continue, investors will continue to flock to the dollar.

I believe the world could see some growth return by the last quarter of 2009 and continuing through the first half of 2010. The actions of the Federal Reserve could stoke US inflation and ultimately undermine the dollar. However, this is probably a story which will continue to play itself out till 2010. Currently, the Fed thinks a rise in inflation is a lesser evil than further falls in house prices. When you’re competing against the likes of Europe, the US dollar suddenly doesn’t look so bad. Or rather, the US dollar is the prettiest pig in the herd.

PSU refiners can now convert bonds to dollars

THE Reserve Bank of India (RBI) has moved to support the rupee by starting special market operation(SMOs) enabling PSU refiners to convert their oil bonds into dollars. In the course of a SMO RBI buys the bonds and provides equivalent forex exchange to oil companies through banks.

RBI has been purchasing oil bonds from public sector refiners such as IOC, BPCL and HPCL since last week. A market source said that oil bonds worth Rs 2,500 crore have been purchased by RBI, with BPCL having sold Rs 800 crore and IOC around 1,500 crore worth of bonds.

Since the SMO is what is known as an off-market transaction, it imparts both liquidity to the oilcos and overall financial stability by providing dollars to the oil majors, who otherwise would have had to tap the forex market. Under the current circumstances, huge dollar demand by oilcos could further worsen the fall in the already struggling rupee.

The rupee has depreciated by 6.35% against the greenback in the calendar year to date, having hit a low of 52.18 to the dollar on March 3. The rupee’s fall is attributable to the unprecedented strength in the dollar relative to other currencies and continuing outflows from India.

The outlook for bonds too has worsened in the past few weeks with the government announcing extra borrowings from the market, increasing their supply. The same traders who were falling over each other to purchase quasi government bonds (like oil bonds in the hope that yields would fall) are now waiting for a chance to exit the market. This has meant that there is no appetite for oil bonds in the market, other than from RBI, LIC and provident fund trusts.

The RBI permits the oil companies to sell bonds to the extent of their import requirement. “We have so far received Rs 15,000 crore worth of bonds in the firstthree quarters of the current fiscal, while Rs 2,000 crore are receivable,” said SK Joshi, director (finance), BPCL.

“However, we can’t just offload whatever we wish to under the SMO. RBI permits us to sell bonds to cover our import requirements,” he said. SV Narasimhan, director (finance), IOC, said that the refiner had outstanding oil bonds worth Rs 30,000 crore at the beginning of March.

In the first leg, RBI buys the bonds and provides equivalent forex exchange in off-market deals to oil companies through banks Since SMO is an off-market transaction, it gives liquidity to the oil companies and overall financial stability by providing dollars to the firms Oil cos would otherwise have had to tap the forex market, weakening the Rupee.