Marc Chandler: "World View: Dollar correction may not help deficit" published by the Financial Times

World View: Dollar correction may not help deficit
By Marc Chandler
Published: November 28 2004 22:10

Could investors buying the rumours of a Chinese revaluation get caught out by selling after the fact?

Forecasting the foreign exchange market is a mug's game, according to Alan Greenspan, chairman of the Federal Reserve. But his warning has not stopped many people from trying and sentiment towards the dollar is currently as negative as it has been in nearly a decade.

The macro-economic argument seems straightforward and compelling. The US has been living beyond its means, importing much more than it has been exporting and in the process becoming the world's largest debtor. At nearly 6 per cent of gross domestic product, the current account deficit is unsustainable and the long-predicted dollar correction is upon us. A substantial decline in the dollar, so the argument goes, would boost US exports and deter imports. It may also force up US interest rates, to compensate investors for the currency risk, and reduce US appetite for imports.

Asia is the critical zone and China at the epicentre because it is there that the deficit is concentrated and officials are loath to allow the currency market to bear the burden of the adjustment process. If China allows the renminbi to appreciate in some fashion against the dollar from the Rmb8.278 peg, the political and economic elites of other Asian countries will also allow their currencies to appreciate against the US dollar. This in turn will help balance US books and allow China to achieve some domestic objectives, such as cooling the economy and slowing inflation.

But there is good reason to be suspicious that depreciation on any reasonable scale will bring the US trade account into balance. One critical fact is that the movement of goods within the same company accounts for a significant part of US trade - nearly a third of US exports and almost 40 per cent of US imports - and this trade tends to be less sensitive to currency market fluctuations.

A review of recent patterns may be even more persuasive. The euro reached its nadir in October 2000 near $0.825. That month, the 12-month US-western Europe trade deficit was $59.35bn. By September this year, the euro had appreciated by more than 50 per cent against the dollar, yet the 12-month trade deficit stood at $110.87bn - an 86 per cent increase.

Canada's story is similar. The US dollar peaked against the Canadian dollar in early 2002 near C$1.62. It is now trading at about C$1.18, a loss of just over a quarter of its value. But over that period, the 12-month US trade deficit with Canada has grown by 24 per cent from $50.35bn to $62.40bn in September 2004.

Let us not forget Japan. After putting in its historical low in the spring of 1995, worth less than Y80, the dollar recorded its cyclical high in August 1998 near Y147.50. Having lost nearly a third of its value since, the dollar is currently trading near Y103. The US 12-month trade deficit with Japan has widened by almost 20 per cent to $73.1bn.

If there is no guarantee that dollar depreciation will reduce the US current account deficit significantly, what about the benefits to Asia of floating currencies? The assertions often appear exaggerated. Most countries that have adopted floating currencies did so reluctantly. This includes the US as much as Brazil and Argentina. Europe has been reluctant since the get-go to embrace the volatility that floating exchange rates imply. The euro itself is the logical culmination of attempts since the break-up of Bretton Woods to minimise foreign exchange volatility among key trading partners.

The US, western Europe, and even Japan enjoyed rapid growth and modernisation under fixed exchange rates and limited capital mobility. Many countries in east Asia have experienced a prolonged period of strong growth under similar conditions. In response to the 1997-1998 financial crisis, Malaysia resisted the liberalisation pressure. It pegged the ringgit and limited capital mobility. In recent years, Malaysia's economic performance is just as good, if not better than its neighbours.

This is the context for arguments by some developing countries that the G7's repeated calls for more flexible currency regimes amount to kicking the ladder after one has climbed off.

The non-deliverable forward market, largely the creation of investment banks to circumvent a country's capital market restrictions, currently implies less than a 4 per cent appreciation of the renminbi against the dollar over the next 12 months. This is close to the historical extreme and in the big picture represents little more than a drop in the bucket, especially given that labour costs in China are on the magnitude of 1/25 of US levels. This also seems modest given the flood of speculative money that has reportedly flowed into the east Asian equity markets in anticipation of an appreciation of the renminbi.

Moreover, there are signs of moderating inflationary pressures and the latest data also suggest fixed asset investment and loan growth has slowed, easing the economic pressure for a stronger currency. Of course, China faces numerous challenges but the case for a near-term foreign exchange rate adjustment does not appear as compelling as the speculative community seems to think. In addition, it is possible that, in the not too distant future, China will begin running small trade deficits - not with the US but with the world as a whole.

In spite of the clamour and seemingly nearly universal opinion, the evidence suggests that an appreciation of the Asian currencies, and particularly China's renminbi, is no panacea for either the US trade deficit or China's own economic challenges. Structural reforms are the key not price adjustments. Investors pouring money into Asian currencies and equity markets, betting on a significant revaluation of the renminbi are vulnerable to disappointment. And even if a small revaluation takes place down the road, these investors are vulnerable to "buy the rumour sell the fact" type of activity. Forewarned is forearmed.

The writer is a partner in Terra Capital Partners, a financial advisory firm.E-mail: marc.chandler@ worldnet.att.net