Bloomberg Asian Analyst Andy Mukherjee: Can Asia Dump Bretton Woods II as Dollar Falls

Can Asia Dump Bretton Woods II as Dollar Falls? by Andy Mukherjee
Bloomberg

Nov. 9 (Bloomberg) -- President George W. Bush's second term may be a challenging time for Asian central bankers.

With the dollar hitting an all-time low against the euro yesterday, traders are betting that Bush may add to the $412.6 billion U.S. budget deficit, increasing the pressure on the dollar to decline. And unlike during the last three years, the brunt of the dollar's fall may not be borne by Europe alone.

Bank of America Corp. says China may allow its currency to fluctuate in a wider range as early as the first quarter of 2005. Together, the two factors -- record current account and budget deficits in the U.S. and a possible appreciation in the yuan --may lead to stronger Asian currencies next year.

The adjustment could mean an end to the current system of semi-fixed Asian exchange rates that has been termed the ``Revived Bretton Woods,'' by Michael Dooley of University of California at Santa Cruz, David Folkerts-Landau, Deutsche Bank AG's head of research, and Peter Garber, the bank's strategist.

Revived Bretton Woods, or ``Bretton Woods II,'' is supposed to be a re-embodiment of the Bretton Woods arrangement, a post World War II system in which the U.S. was obliged to pay gold at $35 an ounce to its official foreign creditors. Other countries pegged their currencies to the dollar.

Whereas the original Bretton Woods system collapsed in 1973, its replacement is seen as an ongoing and mutually beneficial agreement between the U.S., which is the world's financial ``core'' and Asia, which is its ``periphery.'' The periphery is allowed to expand its exports by keeping its currencies cheap, as long as it supplies capital to the core to pay for its spending excesses.

Bretton Woods II

As Dooley and the Deutsche economists pointed out in their paper last year, ``Exporting to the U.S. is Asia's main concern. Exports means growth. When their imports do not keep up, the official sectors are happy to buy U.S. securities. Their appetite for such investments is, for all practical purposes, unlimited because their growth capacity is far from its limit.''

At the heart of Bretton Woods II is China's 200 million underemployed rural population. ``And even if this reserve of labor was gone,'' the authors say, ``India is ready to graduate to the periphery with its vast supply of underemployed workers.''

If it's in the interest of Asian central bankers to keep a lid on their home currencies until every surplus worker in rural China and India has found a job in an export factory, then why should there be a change in Asia's currency policy in the next four years of Bush's presidency?

Weak Dollar

There are strong reasons. On the U.S. side, the issue is political. Jobs are at stake. A weak dollar is ``ultimately what the economy needs,'' says Bill Gross, the chief investment officer at Pacific Investment Management Co. in Newport Beach, California. On the Asian side, the reason why the region must now choose to live with higher currencies is inflation. By increasing interest rates for the first time in nine years, China has sent a signal that it's taking inflation seriously.

Yet, if the People's Bank of China increases domestic interest rates significantly -- and keeps the currency pegged at 8.3 to the dollar -- it will invite more speculative capital into the country, aggravating inflation.

There's another important reason why Bretton Woods II may have to be dumped. Nouriel Roubini, a professor of economics at New York University's Stern School of Business, says that the current global financial system can be sustained only if Asian central banks act as a cartel and keep their existing and future reserves in U.S. dollars.

There is, however, no formal cartel. As a result, every Asian central bank will want to protect itself against an erosion in the value of its assets from a decline in the dollar.

Tragedy of Commons

In other words, what's in the interest of one Asian central bank isn't for all. Social scientists have a name for this phenomenon: ``Tragedy of the Commons.''

``All central banks may be better off if no bank tries to diversify its reserve holdings,'' Roubini says, ``but as the risks of dollar depreciation grows, each central bank has an incentive to defect and to try to protect itself from losses.''

Losses could indeed be large. Asian central banks own more than $2.2 trillion in foreign-exchange reserves out of a global total of $3.4 trillion. At the end of last year, almost 64 percent of central bank reserves globally were denominated in U.S. dollars, according to the International Monetary Fund.

As Asia tries to diversify out of the dollar, the U.S. currency may decline further. An individual central bank ``can only protect itself if it either shifts out of dollars and into euros ahead of the others, or buys a euro/dollar hedge before everyone else,'' Roubini says.

Adjustments will be painful. Still, it would be better for everyone concerned to end the Bretton Woods II agreement now before it's too late for both the U.S. consumer and the Asian exporter.

To contact the writer of this column:
Andy Mukherjee in Singapore at amukherjee@bloomberg.net.

Bloomberg: Philippine Debt Ratings May Be Lowered by Moody's as Tax Increases Held Up

Philippine Debt Ratings May Be Lowered by Moody's as Tax Increases Held Up

Nov. 9 (Bloomberg) -- The Philippines' credit rating may be cut by Moody's Investors Service on concern President Gloria Arroyo will fail to get lawmakers to pass tax increases needed to narrow the nation's budget deficit.

The ratings are on review for possible downgrade ``due to concerns over the sustainability of the government's fiscal and debt positions,'' the company said in a statement released in Hong Kong. Moody's foreign- and local-currency ratings for the Philippines are Ba2, two levels below investment grade and on a par with Fiji and Bulgaria.

Arroyo is seeking to end a run of deficits since 1998 that bloated national debt to 3.54 trillion pesos ($63 billion) in June, 19 percent higher than a year earlier. Credit rating cuts have made it more expensive for the government to borrow and caused the peso to slump, making it harder to meet debt payments.

``This is the price we have to pay for the slow passage of needed tax reform,'' said Jun Mendoza, who helps manage about $1.3 billion at Banco de Oro, a Manila-based lender.

Arroyo, who won a May election, submitted an eight-part tax package to Congress in July, saying it would boost annual revenue by 80 billion pesos. A bill raising cigarette and liquor taxes by an estimated 7.6 billion pesos, less than the 19 billion pesos sought in the package, has been passed by the House of Representatives for approval in the Senate.

Stocks Drop

``Attempts by the government to pass into legislation urgently needed revenue measures are proving to be politically difficult,'' Moody's said in today's statement. The ratings company has had a negative outlook on all of the Philippines' long-term ratings since they were cut in January.

The Philippine key stock index posted its biggest drop in two weeks after today's announcement, sliding 1.3 percent to 1789.03 at the noon close in Manila.

The yield gap between the Philippines' 8.25 percent bond due in 2014 and similar-maturity U.S. Treasuries widened to 4.68 percentage points at 11:00 a.m. in Manila after the Moody's announcement, according to HSBC Treasury & Capital Markets. The spread was 4.61 points yesterday and narrowed to as little as 3.82 points in April.

Banco de Oro's Mendoza said he isn't buying the nation's 10- year dollar bonds, forecast the yield spread would widen 20 basis points more this week. A basis point is 0.01 percentage point.

``After months of wrangling, we still do not have clarity on if and when the tax measures will be passed or, if passed, whether they would be watered down.'' Said John Teng, a fixed- income analyst at Nomura International (Hong Kong) Ltd.

Lower Ratings

Standard & Poor's said on Oct. 7 it may lower the outlook on its debt rating for the Philippines unless tax increases are approved this year. Fitch Ratings may announce a change to the nation's BB debt rating this month, according to Brian Coulton, the company's Hong Kong-based head of sovereign ratings for Asia. Like Moody's both companies have Philippine ratings that are two rungs below investment grade.

``We are looking at the fiscal adjustments, whether we will see significant tax measures implemented in 2005,'' Coulton said. The government should approve increases in taxes on oil, cigarettes and beer, and raise value-added taxes, he said.

Finance Secretary Juanita Amatong, speaking from her car en route to a meeting with the Senate Ways and Means Committee, said the government expects to have some of its proposed tax changes approved this year.

Opposition

The legislators ``are double-timing but it is a democratic country, of course there will be opposition,'' she said. ``We are talking to the different stakeholders.''

Moody's review will take place in Manila and begin on Dec. 1, according to Corazon Guidote, the government's investor relations' officer. A rating cut may force the Philippines to borrow less than planned from abroad and increase domestic bond sales, Finance Undersecretary Eric Recto said.

The nation, which uses a third of government spending to pay interest, plans to borrow $3 billion to $3.1 billion abroad next year to fund the 2005 budget deficit and to lend to National Power Corp., the country's unprofitable state-owned power monopoly, Finance Undersecretary Eric Recto said.

``We will have to deal with it if a downgrade happens,'' he said.

The Philippine budget deficit was 141.9 billion pesos in the first nine months of the year, 72 percent of the government's full-year forecast. The shortfall reached a record 211 billion pesos in 2002 and the government, which said it doesn't expect a balanced budget before 2009, forecast a 198 billion pesos gap for this year.

The Philippines is the only Asian nation to have had its debt rating cut over the past two years. Ratings have been raised in eight other countries, including Malaysia, India and Indonesia.

To contact the reporter for this story:
Jun Ebias in Manila jebias@bloomberg.net

The Economist: America’s privilege, the world’s worry

America’s privilege, the world’s worry

Nov 8th 2004

From The Economist Global Agenda

The dollar plumbed new depths against the euro this week. The greenback’s fall has unnerved European policymakers. But it is their Asian counterparts who have most reason to worry

CHARLES DE GAULLE, founder of France’s fifth republic, famously resented America’s paramount position in the global economy of the 1960s. The United States, he complained, enjoyed an “exorbitant privilege”. Because its currency, the dollar, served as the world’s reserve asset, America could live beyond its means, unconstrained by the periodic shortages of foreign exchange that haunted other, less privileged nations. Nicolas Sarkozy, France’s spirited finance minister, wants to inherit de Gaulle’s mantle as president of the fifth republic. Though somewhat smaller in stature than the great general, both physically and politically, Mr Sarkozy seems to share his outsized resentment of America’s economic privileges.

Mr Sarkozy has more to envy than de Gaulle ever had. Today’s America lives beyond its means more flagrantly than ever before. Its government will spend about $427 billion more than it raises in taxes this year. The nation as a whole is running a deficit of $571.9 billion on its current account with the rest of the world. These twin deficits, Mr Sarkozy points out, weigh heavily on the dollar. The currency’s fall, interrupted in February, has resumed (see chart). On Monday November 8th, it plumbed a new low against the euro of a whisker under $1.30. Only if America restrains its deficits will the markets regain confidence in the dollar, Mr Sarkozy warned. “This is a unanimous message from the Europeans and the International Monetary Fund that we send to the United States.”

Mr Sarkozy no doubt fears that his American counterparts are quite happy to watch the dollar fall. Their professed commitment to a “strong dollar policy” might disguise a policy of benign neglect. America’s net overseas liabilities amounted to 23% of GDP at the end of last year, close to the record debts it amassed in 1894, according to Ken Rogoff and Maurice Obstfeld of the National Bureau of Economic Research. Crucially, the bulk of these debts are denominated in dollars. Thus America may be sorely tempted to dishonour its dollar debts, not by defaulting on them, but by devaluing them.

The immediate casualties of such a policy would be America’s East Asian creditors. By the end of last year, Asian central banks held $1.89 trillion of foreign reserves, the vast bulk of them in dollars. If these reserves lost value, Asian economies would suffer an almighty capital loss in domestic-currency terms. A recent study by the New York Federal Reserve counted the costs. If the Chinese yuan were to appreciate by 10% against the dollar (and other reserve currencies), China would suffer a capital loss worth almost 3% of GDP, the study found. If the won rose by 10%, South Korea would suffer similarly. The toll would be even greater in Singapore (10% of GDP) and Taiwan (8%).

To avert such an appreciation, Asian central banks would have to amass ever greater holdings of dollars. But this would only expose them to greater capital losses down the road. Alternatively, they might seek to avoid the consequences of a dollar fall, by diversifying into other reserve currencies, such as the euro. But that would only bring the dollar crashing down all the more quickly. In other words, Asian central banks are caught in an awkward dilemma: either they try to break the dollar’s fall, or they try to escape from underneath its collapse.

Despite this dilemma, Asia’s central bankers created less of a fuss on Monday than Europe’s did. Jean-Claude Trichet, president of the European Central Bank (ECB), described the dollar’s fall against the euro as unwelcome and “brutal”, repeating the melodramatic language he adopted in January. Why the worry? In some ways, the stronger euro will do Mr Trichet’s job for him. It will contain euro-area inflation, which has remained stubbornly above the ECB’s ceiling of 2%. It will offset the higher dollar price of oil—last month’s worry du jour. And if the euros in their pockets gain in value, European households might be more willing to spend them, overcoming the caution that has held the European recovery back for much of this year.

It is true that the dollar has never been weaker against Europe’s single currency since its birth in 1999. But as recently as 1997 it was weaker against a basket of the 12 currencies out of which the euro was fashioned. Back then, no one described the dollar’s movements as brutal. Indeed, at times it seems that European resentment of America’s privileges is a little exorbitant.

Daily Telegraph: When a taste for the exotic is plain good sense

When a taste for the exotic is plain good sense
Daily Telegraph

The risks are real but bonds issued by developing countries may be more rewarding than you think, says Robert Miller

Rising interest rates are usually bad news for bondholders, because it makes the fixed interest or "coupon" they pay relatively less attractive.

But, despite last week's interest rate rise in China - the first in nine years - investors in emerging market bond funds have generally been rewarded for accepting high risks in recent years. The average return from this sector has been nearly double the average from all types of pooled fund over the past five years.

Although their outperformance has been more marginal over the past year, these funds have tended to benefit from investors' worst fears not being realised by subsequent events. Even so, this is not an investment sector for widows and orphans. Emerging market finance ministers at last month's annual meetings of the World Bank and International Monetary Fund (IMF) in Washington made outspoken verbal assaults on the greed of the world's richest nations, demonstrating that investors in their bonds need strong nerves.

In this instance, bonds are IOUs issued by the governments of developing countries. Taken at face value, many of the ministers' attacks appear to convey the threat of government debt defaults - refusal to pay interest or capital - as happened most recently in Argentina.

"There's always a bad news story somewhere," says Paul Murray-John, the manager of the £86m Threadneedle Emerging Market Bond fund, who attended the meetings. "But investors must look beyond what is in large part political posturing and point scoring for a domestic audience. If you study the investment fundamentals which underpin emerging market sovereign [government] bonds it is quite another story."

Mr Murray-John, whose investments include bonds issued by the governments of Brazil, Turkey, Bulgaria, Venezuela and Russia, adds: "These emerging market countries need the foreign money raised on the international bond markets to help their domestic economies grow. They talk tough but actually work very hard to make sure they meet the requirements on financial reporting, timely debt repayments and other governance issues laid down by authorities such as the IMF."

The Threadneedle manager, who has run the fund since its launch in 1997 with Russian-born Igor Ojereliev as his deputy, concedes that for many investors, and particularly risk-averse ones, putting money in emerging market bonds, even if they are issued by governments rather than companies, is a big step.

"But what is the alternative?" he asks. "In the past, UK gilts - bonds issued by the British Government - have yielded enough to meet the requirements of the most risk-averse investors. That is no longer the case. I would argue strongly that if you want to take risks with your portfolio, then you are fully invested in equities. If you want income, then emerging market bonds should be seriously considered as a fully fledged asset class."

However, no bond is any better than its guarantor. The risk with high yielding bonds is that the price of a good income today could be capital erosion tomorrow.

Threadneedle's fund, which offers an average yield of 8.15 per cent to maturity, is one of two emerging market bond funds domiciled in the UK and authorised by the Financial Services Authority, and therefore covered by the official compensation scheme, which pays a maximum of £48,000 in the event of a default. The other is run by M&G.

There are more than a dozen other funds listed under the Standard & Poor's "fixed income global emerging markets" category that are based in Luxembourg and Ireland.

A spokesman for the FSA explains that some, but not all, of these funds are covered by the UK compensation rules because their parent management company is supervised directly by the UK watchdog.

He adds that all EU states must now by law have a compensation net for investors which covers 90 per cent of an investment up to a maximum of 20,000 - about £13,900, less than half the UK safety net. Some do pay more. He advises investors to check the standing of a particular fund before buying.

As a rule of thumb, most of the S&P listed emerging market fixed income and bond funds steer clear of corporate bonds - IOUs issued by local companies. "We don't do corporate," says Mr Murray-John. "You need a huge team on the ground and it can be very hard to do a proper investigation of the reports and accounts. You've also got the currency risk, which you don't have in the sovereign bond market because it is all traded in dollars."

Jerome Booth of Ashmore Investment Management, which specialises in emerging market debt, says: "There is massive prejudice among investors against emerging market bonds.

"You have got this big equity culture here in the UK and in the US and yet they ignore an asset class such as emerging market sovereign bonds which produce very attractive yields."

Investors with long memories may, however, recall the various Mexican financial crises of the 1970s and 1980s and the huge debt defaults in Latin America of the past decade - not to mention the crash that leapt from Brazil to Russia in 1998.

Mr Booth points out that today's politicians in charge of emerging market countries recognise that they must follow the rules on "openness and accountability" set down by the IMF and other bodies. "And," he adds, "you always need liquidity. Trading in global emerging market sovereign bonds is currently valued at around $3trillion. That's more than twice the value or liquidity of the FTSE 100 Index."

A lot of the new money that underpins emerging market bonds at present comes from big pension funds in the UK, US and Europe, according to Mr Booth. "It is very definitely an established trend now that pension funds have been forced to look for higher returns to cover widening deficits. Equities alone are simply not going to do that.

"Of course, there are risks," he adds. "But investing in property is a risk. So, too, is putting all your money into one asset class and one country, even if it is the UK. Look at it this way. You've got around 85 per cent of the world's population in emerging market countries. That's where the real economic growth and new markets will come from in the foreseeable future."

Keith Swabey, managing director of JP Morgan Fleming's fixed income division, says: "Everybody is risk-averse and I'm not suggesting that you come straight out of UK gilts and go for emerging market bonds. Take it a step at a time where, on the risk scale, gilts are one and emerging market sovereign bonds are five. But they have produced spectacular gains over the past few years compared with other asset classes and therefore deserve serious consideration."

What about future prospects? Mr Swabey says: "I think the biggest single risk comes from the dollar and the currency hit if US interest rates rise more quickly than anticipated. That would reduce the returns for UK investors. To put that in perspective, however, I'm talking about a total return of maybe 5 per cent or 6 per cent rather than the 6 per cent to 8 per cent you might expect if US rates rise more slowly, as predicted."

Martyn Ingram is a specialist fund analyst at Investors Partnership, which advises intermediaries such as independent financial advisers. For investors considering emerging market bond funds, he suggests: "Narrow the list down to those funds fully covered by the UK compensation scheme. As for your manager, you want someone who understands the politics and economics of emerging market countries. You want them to interpret the trends and to be there ahead of the crowd."

Mr Ingram's firm recommends Threadneedle's Emerging Markets Bond fund as well as the High Income rival run by Paul Thursby at Thames River. The fund analyst acknowledges that annual charges of around 1.5 per cent are steep but adds: "The right manager will make sure the performance of the underlying portfolio generates a total return that should more than outweigh the extra expense."

The Sunburn - Iran's Awesome Nuclear Anti-Ship Missile

The Sunburn

Iran's Awesome Nuclear Anti-Ship Missile

The Weapon That Could Defeat The US In The Gulf

By Mark Gaffney11-2-4

A word to the reader: The following paper is so shocking that, after preparing the initial draft, I didn't want to believe it myself, and resolved to disprove it with more research. However, I only succeeded in turning up more evidence in support of my thesis. And I repeated this cycle of discovery and denial several more times before finally deciding to go with the article. I believe that a serious writer must follow the trail of evidence, no matter where it leads, and report back. So here is my story. Don't be surprised if it causes you to squirm. Its purpose is not to make predictions history makes fools of those who claim to know the future but simply to describe the peril that awaits us in the Persian Gulf. By awakening to the extent of that danger, perhaps we can still find a way to save our nation and the world from disaster. If we are very lucky, we might even create an alternative future that holds some promise of resolving the monumental conflicts of our time. --MG

Last July, they dubbed it operation Summer Pulse: a simultaneous mustering of US Naval forces, world wide, that was unprecedented. According to the Navy, it was the first exercise of its new Fleet Response Plan (FRP), the purpose of which was to enable the Navy to respond quickly to an international crisis. The Navy wanted to show its increased force readiness, that is, its capacity to rapidly move combat power to any global hot spot. Never in the history of the US Navy had so many carrier battle groups been involved in a single operation. Even the US fleet massed in the Gulf and eastern Mediterranean during operation Desert Storm in 1991, and in the recent invasion of Iraq, never exceeded six battle groups. But last July and August there were seven of them on the move, each battle group consisting of a Nimitz-class aircraft carrier with its full complement of 7-8 supporting ships, and 70 or more assorted aircraft. Most of the activity, according to various reports, was in the Pacific, where the fleet participated in joint exercises with the Taiwanese navy.

But why so much naval power underway at the same time? What potential world crisis could possibly require more battle groups than were deployed during the recent invasion of Iraq? In past years, when the US has seen fit to "show the flag" or flex its naval muscle, one or two carrier groups have sufficed. Why this global show of power? The news headlines about the joint-maneuvers in the South China Sea read: "Saber Rattling Unnerves China", and: "Huge Show of Force Worries Chinese." But the reality was quite different, and, as we shall see, has grave ramifications for the continuing US military presence in the Persian Gulf; because operation Summer Pulse reflected a high-level Pentagon decision that an unprecedented show of strength was needed to counter what is viewed as a growing threat in the particular case of China, because of Peking's newest Sovremenny-class destroyers recently acquired from Russia.

"Nonsense!" you are probably thinking. That's impossible. How could a few picayune destroyers threaten the US Pacific fleet?" Here is where the story thickens: Summer Pulse amounted to a tacit acknowledgement, obvious to anyone paying attention, that the United States has been eclipsed in an important area of military technology, and that this qualitative edge is now being wielded by others, including the Chinese; because those otherwise very ordinary destroyers were, in fact, launching platforms for Russian-made 3M-82 Moskit anti-ship cruise missiles (NATO designation: SS-N-22 Sunburn), a weapon for which the US Navy currently has no defense. Here I am not suggesting that the US status of lone world Superpower has been surpassed. I am simply saying that a new global balance of power is emerging, in which other individual states may, on occasion, achieve "an asymmetric advantage" over the US. And this, in my view, explains the immense scale of Summer Pulse. The US show last summer of overwhelming strength was calculated to send a message.

The Sunburn Missile

I was shocked when I learned the facts about these Russian-made cruise missiles. The problem is that so many of us suffer from two common misperceptions. The first follows from our assumption that Russia is militarily weak, as a result of the breakup of the old Soviet system. Actually, this is accurate, but it does not reflect the complexities. Although the Russian navy continues to rust in port, and the Russian army is in disarray, in certain key areas Russian technology is actually superior to our own. And nowhere is this truer than in the vital area of anti-ship cruise missile technology, where the Russians hold at least a ten-year lead over the US. The second misperception has to do with our complacency in general about missiles-as-weapons probably attributable to the pathetic performance of Saddam Hussein's Scuds during the first Gulf war: a dangerous illusion that I will now attempt to rectify.

Many years ago, Soviet planners gave up trying to match the US Navy ship for ship, gun for gun, and dollar for dollar. The Soviets simply could not compete with the high levels of US spending required to build up and maintain a huge naval armada. They shrewdly adopted an alternative approach based on strategic defense. They searched for weaknesses, and sought relatively inexpensive ways to exploit those weaknesses. The Soviets succeeded: by developing several supersonic anti-ship missiles, one of which, the SS-N-22 Sunburn, has been called "the most lethal missile in the world today."

After the collapse of the Soviet Union the old military establishment fell upon hard times. But in the late1990s Moscow awakened to the under-utilized potential of its missile technology to generate desperately needed foreign exchange. A decision was made to resuscitate selected programs, and, very soon, Russian missile technology became a hot export commodity. Today, Russian missiles are a growth industry generating much-needed cash for Russia, with many billions in combined sales to India, China, Viet Nam, Cuba, and also Iran. In the near future this dissemination of advanced technology is likely to present serious challenges to the US. Some have even warned that the US Navy's largest ships, the massive carriers, have now become floating death traps, and should for this reason be mothballed.

The Sunburn missile has never seen use in combat, to my knowledge, which probably explains why its fearsome capabilities are not more widely recognized. Other cruise missiles have been used, of course, on several occasions, and with devastating results. During the Falklands War, French-made Exocet missiles, fired from Argentine fighters, sunk the HMS Sheffield and another ship. And, in 1987, during the Iran-Iraq war, the USS Stark was nearly cut in half by a pair of Exocets while on patrol in the Persian Gulf. On that occasion US Aegis radar picked up the incoming Iraqi fighter (a French-made Mirage), and tracked its approach to within 50 miles. The radar also "saw" the Iraqi plane turn about and return to its base. But radar never detected the pilot launch his weapons. The sea-skimming Exocets came smoking in under radar and were only sighted by human eyes moments before they ripped into the Stark, crippling the ship and killing 37 US sailors.

The 1987 surprise attack on the Stark exemplifies the dangers posed by anti-ship cruise missiles. And the dangers are much more serious in the case of the Sunburn, whose specs leave the sub-sonic Exocet in the dust. Not only is the Sunburn much larger and faster, it has far greater range and a superior guidance system. Those who have witnessed its performance trials invariably come away stunned. According to one report, when the Iranian Defense Minister Ali Shamkhani visited Moscow in October 2001 he requested a test firing of the Sunburn, which the Russians were only too happy to arrange. So impressed was Ali Shamkhani that he placed an order for an undisclosed number of the missiles.

The Sunburn can deliver a 200-kiloton nuclear payload, or: a 750-pound conventional warhead, within a range of 100 miles, more than twice the range of the Exocet. The Sunburn combines a Mach 2.1 speed (two times the speed of sound) with a flight pattern that hugs the deck and includes "violent end maneuvers" to elude enemy defenses. The missile was specifically designed to defeat the US Aegis radar defense system. Should a US Navy Phalanx point defense somehow manage to detect an incoming Sunburn missile, the system has only seconds to calculate a fire solution not enough time to take out the intruding missile. The US Phalanx defense employs a six-barreled gun that fires 3,000 depleted-uranium rounds a minute, but the gun must have precise coordinates to destroy an intruder "just in time."

The Sunburn's combined supersonic speed and payload size produce tremendous kinetic energy on impact, with devastating consequences for ship and crew. A single one of these missiles can sink a large warship, yet costs considerably less than a fighter jet. Although the Navy has been phasing out the older Phalanx defense system, its replacement, known as the Rolling Action Missile (RAM) has never been tested against the weapon it seems destined to one day face in combat. Implications For US Forces in the Gulf

The US Navy's only plausible defense against a robust weapon like the Sunburn missile is to detect the enemy's approach well ahead of time, whether destroyers, subs, or fighter-bombers, and defeat them before they can get in range and launch their deadly cargo. For this purpose US AWACs radar planes assigned to each naval battle group are kept aloft on a rotating schedule. The planes "see" everything within two hundred miles of the fleet, and are complemented with intelligence from orbiting satellites.

But US naval commanders operating in the Persian Gulf face serious challenges that are unique to the littoral, i.e., coastal, environment. A glance at a map shows why: The Gulf is nothing but a large lake, with one narrow outlet, and most of its northern shore, i.e., Iran, consists of mountainous terrain that affords a commanding tactical advantage over ships operating in Gulf waters. The rugged northern shore makes for easy concealment of coastal defenses, such as mobile missile launchers, and also makes their detection problematic. Although it was not widely reported, the US actually lost the battle of the Scuds in the first Gulf War termed "the great Scud hunt" and for similar reasons.

Saddam Hussein's mobile Scud launchers proved so difficult to detect and destroy over and over again the Iraqis fooled allied reconnaissance with decoys that during the course of Desert Storm the US was unable to confirm even a single kill. This proved such an embarrassment to the Pentagon, afterwards, that the unpleasant stats were buried in official reports. But the blunt fact is that the US failed to stop the Scud attacks. The launches continued until the last few days of the conflict. Luckily, the Scud's inaccuracy made it an almost useless weapon. At one point General Norman Schwarzkopf quipped dismissively to the press that his soldiers had a greater chance of being struck by lightning in Georgia than by a Scud in Kuwait.

But that was then, and it would be a grave error to allow the Scud's ineffectiveness to blur the facts concerning this other missile. The Sunburn's amazing accuracy was demonstrated not long ago in a live test staged at sea by the Chinese and observed by US spy planes. Not only did the Sunburn missile destroy the dummy target ship, it scored a perfect bull's eye, hitting the crosshairs of a large "X" mounted on the ship's bridge. The only word that does it justice, awesome, has become a cliché, hackneyed from hyperbolic excess.

The US Navy has never faced anything in combat as formidable as the Sunburn missile. But this will surely change if the US and Israel decide to wage a so-called preventive war against Iran to destroy its nuclear infrastructure. Storm clouds have been darkening over the Gulf for many months. In recent years Israel upgraded its air force with a new fleet of long-range F-15 fighter-bombers, and even more recently took delivery of 5,000 bunker-buster bombs from the US weapons that many observers think are intended for use against Iran.

The arming for war has been matched by threats. Israeli officials have declared repeatedly that they will not allow the Mullahs to develop nuclear power, not even reactors to generate electricity for peaceful use. Their threats are particularly worrisome, because Israel has a long history of pre-emptive war. (See my 1989 book Dimona: the Third Temple? and also my 2003 article Will Iran Be Next? posted at http://www.InformationClearingHouse.info/article3288.htm )

Never mind that such a determination is not Israel's to make, and belongs instead to the international community, as codified in the Nonproliferation Treaty (NPT). With regard to Iran, the International Atomic Energy Agency's (IAEA's) recent report (September 2004) is well worth a look, as it repudiates facile claims by the US and Israel that Iran is building bombs. While the report is highly critical of Tehran for its ambiguities and its grudging release of documents, it affirms that IAEA inspectors have been admitted to every nuclear site in the country to which they have sought access, without exception. Last year Iran signed the strengthened IAEA inspection protocol, which until then had been voluntary. And the IAEA has found no hard evidence, to date, either that bombs exist or that Iran has made a decision to build them.

(The latest IAEA report can be downloaded at: http://www.GlobalSecurity.org)

In a talk on October 3, 2004, IAEA Director General Mohamed El Baradei made the clearest statement yet: "Iran has no nuclear weapons program", he said, and then repeated himself for emphasis: "Iran has no nuclear weapons program, but I personally don't rush to conclusions before all the realities are clarified. So far I see nothing that could be called an imminent danger. I have seen no nuclear weapons program in Iran. What I have seen is that Iran is trying to gain access to nuclear enrichment technology, and so far there is no danger from Iran. Therefore, we should make use of political and diplomatic means before thinking of resorting to other alternatives."

No one disputes that Tehran is pursuing a dangerous path, but with 200 or more Israeli nukes targeted upon them the Iranians' insistence on keeping their options open is understandable. Clearly, the nuclear nonproliferation regime today hangs by the slenderest of threads. The world has arrived at a fateful crossroads.

A Fearful Symmetry?

If a showdown over Iran develops in the coming months, the man who could hold the outcome in his hands will be thrust upon the world stage. That man, like him or hate him, is Russian President Vladimir Putin. He has been castigated severely in recent months for gathering too much political power to himself. But according to former Soviet President Mikhail Gorbachev, who was interviewed on US television recently by David Brokaw, Putin has not imposed a tyranny upon Russia yet. Gorbachev thinks the jury is still out on Putin.

Perhaps, with this in mind, we should be asking whether Vladimir Putin is a serious student of history. If he is, then he surely recognizes that the deepening crisis in the Persian Gulf presents not only manifold dangers, but also opportunities. Be assured that the Russian leader has not forgotten the humiliating defeat Ronald Reagan inflicted upon the old Soviet state. (Have we Americans forgotten?) By the mid-1980s the Soviets were in Kabul, and had all but defeated the Mujahedeen. The Soviet Union appeared secure in its military occupation of Afghanistan. But then, in 1986, the first US Stinger missiles reached the hands of the Afghani resistance; and, quite suddenly, Soviet helicopter gunships and MiGs began dropping out of the skies like flaming stones. The tide swiftly turned, and by 1989 it was all over but the hand wringing and gnashing of teeth in the Kremlin. Defeated, the Soviets slunk back across the frontier. The whole world cheered the American Stingers, which had carried the day.

This very night, as he sips his cognac, what is Vladimir Putin thinking? Is he perhaps thinking about the perverse symmetries of history? If so, he may also be wondering (and discussing with his closest aides) how a truly great nation like the United States could be so blind and so stupid as to allow another state, i.e., Israel, to control its foreign policy, especially in a region as vital (and volatile) as the Mid-East.

One can almost hear the Russians' animated conversation:

"The Americans! What is the matter with them?" "They simply cannot help themselves."

"What idiots!"

"A nation as foolish as this deserves to be taught a lesson"

"Yes! For their own good."

"It must be a painful lesson, one they will never forget. "Are we agreed, then, comrades?"

"Let us teach our American friends a lesson about the limits of military power..."

Does anyone really believe that Vladimir Putin will hesitate to seize a most rare opportunity to change the course of history and, in the bargain, take his sweet revenge? Surely Putin understands the terrible dimensions of the trap into which the US has blundered, thanks to the Israelis and their neo-con supporters in Washington who lobbied so vociferously for the 2003 invasion of Iraq, against all friendly and expert advice, and who even now beat the drums of war against Iran. Would Putin be wrong to conclude that the US will never leave the region unless it is first defeated militarily? Should we blame him for deciding that Iran is "one bridge too far"?

If the US and Israel overreach, and the Iranians close the net with Russian anti-ship missiles, it will be a fearful symmetry, indeed.

Springing the Trap

At the battle of Cannae in 216 BC, the great Carthaginian general, Hannibal, tempted a much larger Roman army into a fateful advance, and then enveloped and annihilated it with a smaller force. Out of a Roman army of 70,000 men, no more than a few thousand escaped. It was said that after many hours of dispatching the Romans, Hannibal's soldiers grew so tired that the fight went out of them. In their weariness they granted the last broken and bedraggled Romans their lives.

Let us pray that the US sailors who are unlucky enough to be on duty in the Persian Gulf when the shooting starts can escape the fate of the Roman army at Cannae. The odds will be heavily against them, however, because they will face the same type of danger, tantamount to envelopment. The US ships in the Gulf will already have come within range of the Sunburn missiles and the even more-advanced SS-NX-26 Yakhonts missiles, also Russian-made (speed: Mach 2.9; range: 180 miles) deployed by the Iranians along the Gulf's northern shore. Every US ship will be exposed and vulnerable. When the Iranians spring the trap, the entire lake will become a killing field.

Anti-ship cruise missiles are not new, as I've mentioned. Nor have they yet determined the outcome in a conflict. But this is probably only because these horrible weapons have never been deployed in sufficient numbers. At the time of the Falklands war the Argentine air force possessed only five Exocets, yet managed to sink two ships. With enough of them, the Argentineans might have sunk the entire British fleet, and won the war. Although we've never seen a massed attack of cruise missiles, this is exactly what the US Navy could face in the next war in the Gulf.

Try and imagine it if you can: barrage after barrage of Exocet-class missiles, which the Iranians are known to possess in the hundreds, as well as the unstoppable Sunburn and Yakhonts missiles. The questions that our purblind government leaders should be asking themselves, today, if they value what historians will one day write about them, are two: how many of the Russian anti-ship missiles has Putin already supplied to Iran? And: How many more are currently in the pipeline?

In 2001, Jane's Defense Weekly reported that Iran was attempting to acquire anti-ship missiles from Russia. Ominously, the same report also mentioned that the more advanced Yakhonts missile was "optimized for attacks against carrier task forces." Apparently its guidance system is "able to distinguish an aircraft carrier from its escorts." The numbers were not disclosed.

The US Navy will come under fire even if the US does not participate in the first so-called surgical raids on Iran's nuclear sites, that is, even if Israel goes it alone. Israel's brand-new fleet of 25 F-15s (paid for by American taxpayers) has sufficient range to target Iran, but the Israelis cannot mount an attack without crossing US-occupied Iraqi air space. It will hardly matter if Washington gives the green light, or is dragged into the conflict by a recalcitrant Israel. Either way, the result will be the same. The Iranians will interpret US acquiescence as complicity, and, in any event, they will understand that the real fight is with the Americans. The Iranians will be entirely within their rights to counter-attack in self-defense. Most of the world will see it this way, and will support them, not America. The US and Israel will be viewed as the aggressors, even as the unfortunate US sailors in harm's way become cannon fodder. In the Gulf's shallow and confined waters evasive maneuvers will be difficult, at best, and escape impossible. Even if US planes control of the skies over the battlefield, the sailors caught in the net below will be hard-pressed to survive. The Gulf will run red with American blood.

From here, it only gets worse. Armed with their Russian-supplied cruise missiles, the Iranians will close the lake's only outlet, the strategic Strait of Hormuz, cutting off the trapped and dying Americans from help and rescue. The US fleet massing in the Indian Ocean will stand by helplessly, unable to enter the Gulf to assist the survivors or bring logistical support to the other US forces on duty in Iraq. Couple this with a major new ground offensive by the Iraqi insurgents, and, quite suddenly, the tables could turn against the Americans in Baghdad. As supplies and ammunition begin to run out, the status of US forces in the region will become precarious. The occupiers will become the besieged.

With enough anti-ship missiles, the Iranians can halt tanker traffic through Hormuz for weeks, even months. With the flow of oil from the Gulf curtailed, the price of a barrel of crude will skyrocket on the world market. Within days the global economy will begin to grind to a halt. Tempers at an emergency round-the-clock session of the UN Security Council will flare and likely explode into shouting and recriminations as French, German, Chinese and even British ambassadors angrily accuse the US of allowing Israel to threaten world order. But, as always, because of the US veto the world body will be powerless to act... America will stand alone, completely isolated.

Yet, despite the increasingly hostile international mood, elements of the US media will spin the crisis very differently here at home, in a way that is sympathetic to Israel. Members of Congress will rise to speak in the House and Senate, and rally to Israel's defense, while blaming the victim of the attack, Iran. Fundamentalist Christian talk show hosts will proclaim the historic fulfillment of biblical prophecy in our time, and will call upon the Jews of Israel to accept Jesus into their hearts; meanwhile, urging the president to nuke the evil empire of Islam. From across America will be heard histrionic cries for fresh reinforcements, even a military draft. Patriots will demand victory at any cost. Pundits will scream for an escalation of the conflict.

A war that ostensibly began as an attempt to prevent the spread of nuclear weapons will teeter on the brink of their use.

Conclusion

Friends, we must work together to prevent such a catastrophe. We must stop the next Middle East war before it starts. The US government must turn over to the United Nations the primary responsibility for resolving the deepening crisis in Iraq, and, immediately thereafter, withdraw US forces from the country. We must also prevail upon the Israelis to sign the Nonproliferation Treaty (NPT) and open all of their nuclear sites to IAEA inspectors. Only then can serious talks begin with Iran and other states to establish a nuclear weapon free zone (NWFZ) in the Mid East so essential to the region's long-term peace and security. 10/26/04 "ICH"

*Mark Gaffney's first book, Dimona the Third Temple? (1989), was a pioneering study of Israel's nuclear weapons program. He has since published numerous important articles about the Mid-East with emphasis on nuclear proliferation issues.

New York Times: The Dollar's Long-Term Direction: Down

The Dollar's Long-Term Direction: Down
By EDUARDO PORTER and ELIZABETH BECKER

New York Times

November 4, 2004

The election drove the dollar all over - down when it looked like President Bush would lose, up briefly when Senator Kerry conceded defeat.

But ultimately, the dollar's fate never hinged on the outcome of the presidential election. Now that the dust has settled, the currency is back on its long-term path: downward. According to most economists, it is likely to stay there over the next four years.

"There is a certain inevitability to the decline,'' said Alan Blinder, an economist at Princeton University who served as vice chairman of the Federal Reserve and was an adviser to President Bill Clinton. "I think the Treasury understands this. It would be nice if they would say so."

Managing this potentially painful move will be a pressing challenge for Mr. Bush's economic team. The nation's current account - the broad gap between the nation's exports and imports of goods and services - has reached a deficit of nearly $600 billion, almost 6 percent of the nation's overall economic activity. And it shows no signs of diminishing on its own.

Closing this gaping hole will overshadow the administration's trade policy, coloring its push for better access to foreign markets for American products, and adding urgency to its attempts to make China and other Asian nations revalue their currencies against the dollar so that American industry can be more competitive.

Today, the dollar is at the center of a delicate interlocking web of international financial imbalances. The United States imports much more than it exports. Asian countries - some of the biggest exporters - send the proceeds back into the United States by investing here, mostly in government bonds. That keeps interest rates low, fueling spending and leading Americans to import even more goods and services from the rest of the world.

Both sides benefit from this arrangement. The Asian money allows Americans to spend beyond their means. At the same time, dollar purchases by Asian central banks depress the value of Asian currencies, stimulating their exports to the American market.

An influential group of economists has argued that there is no reason that this imbalance cannot go on relatively undisturbed - if not forever, at least for a very long time. But most mainstream economists argue that, at a minimum, the unraveling of this web would send the dollar lower and squeeze American consumption.

Kenneth Rogoff, a professor of economics at Harvard, said that to smoothly and significantly narrow the current account deficit requires a depreciation of at least 20 percent in the dollar, making it much more costly for Americans to buy imported goods and travel abroad.

The imbalance is fueling a stupendous buildup of foreign debt in the United States. At the end of last year, the nation's net financial deficit - broadly, what Americans owe the rest of the world minus what the rest of the world owes to the United States - amounted to nearly 30 percent of total output. And both sides are digging themselves deeper into holes, with American debts mounting and foreigners acquiring ever greater piles of depreciating paper assets.

Economists who speak of the current account deficit often quote the economist Herb Stein: "If something cannot go on forever, it will stop.''

So what will it take for the brakes to be applied? Barry Eichengreen, a professor of economics at the University of California, Berkeley, argues that Asian policy makers are going to force a change. He contents that as they move away from their present export-led growth strategies, which require cheap currencies, to focus monetary policy on managing internal demand, Asian governments will support the dollar less, buy fewer Treasury bonds and shift some of their foreign reserves to other currencies, like euros.

Indeed, China's decision to raise interest rates last week put upward pressure on the yuan and indicated a willingness to take market-based measures to cool its galloping economy.

"Asian policy is changing," Mr. Eichengreen said. "The end is growing increasingly near."

This suggests that President Bush's efforts to maintain open markets will increasingly be up to others. The United States' leading trade partners - Europeans, Asians and even Canadians - are promising more challenges to Washington on trade issues, bringing disputes to the World Trade Organization and going after new markets as well.

A cheaper dollar would stimulate American exports but would create some conflicts with other countries. And a dollar depreciation, on its own, would do little to curb the nation's dependence on foreign money. For a devaluation to work effectively, economists explain that other measures to reduce the nation's excess spending are needed as well.

The situation, some suggested, is analogous to the problems faced by Ronald Reagan early in his second term, when the United States, despite robust growth, suffered from an expensive dollar, weak exports and big deficits.

In 1986, the administration negotiated the Plaza Agreement with six other major industrial powers, helping pave the way to a manageable, if sometimes rocky, 40 percent decline in the value of the dollar.

"We have to do something similar to get the value of the dollar down and not wait for a market adjustment which could be more damaging to the economy," said Robert E. Scott, of the liberal Economic Policy Institute in Washington.

The strategy worked for Mr. Reagan because he also pushed through a couple of tax increases that helped narrow the budget gap. Economists are not very confident, however, that a second Bush administration would be prepared to do something similar.

That could leave the economy vulnerable to a more painful adjustment, with the dollar falling rapidly and interest rates rising fast. The result would almost certainly lead to a recession and perhaps a collapse in the real estate market.

"There is a real possibility,'' Catherine Mann, an economist at the Institute for International Economics, wrote in a study earlier this year, "that the entanglements created by this co-dependency cannot be undone by anything short of a global economic crisis."

Businessweek: A Windfall from Foreign Bonds

A Windfall from Foreign Bonds

Arthur Steinmetz of Oppenheimer International Bond Fund explains why he likes fixed-income securities from emerging markets

Despite the risks, foreign bonds have paid off in recent years for investors willing to weather volatility in exchange for higher returns. Oppenheimer International Bond/A (OIBAX ), managed by Arthur P. Steinmetz, head of Oppenheimer's international fixed-income team, looks for value and yield in both developed and emerging markets around the globe.

For the 12-month period ended Sept. 30, the $1.6 billion portfolio rose 11.6%, vs. 6% for the average global fixed-income fund. For the three-year period, the fund gained 18.2% annualized, vs. 9.1% for the peer group. For the last five years, it has risen 12.8% annualized, vs. 6.5% for its peers.

Given that Oppenheimer International Bond can invest in emerging markets, the portfolio is more volatile than its peer group, which is illustrated by its higher standard deviation. It also has a substantially higher annual turnover rate. The fund's expense ratio of 1.22%, however, is below the 1.29% peer group average. Based on risk and return characteristics over the last three years, Standard & Poor's gives the fund its highest rank of 5 Stars.

Steinmetz took over as sole manager in April, 2004, following the departure of Ruggiero de Rossi. However, Steinmetz has been on the management team in one capacity or another since the fund's inception in June, 1995. He also manages the Oppenheimer Strategic Income Fund (OPSIX ).

Palash R. Ghosh of Standard & Poor's Fund Advisor recently spoke with Steinmetz about the fund's investing strategy and top holdings. Here are edited excerpts of their conversation:

Q: How does the performance of foreign bonds correlate with the performance of U.S. securities?

A: There's actually a very high correlation between domestic bonds and the fixed-income markets of most of the developed world. For example, in 1994, U.S Treasuries sold off dramatically when the Federal Reserve enacted an aggressive tightening campaign. Interestingly, the German bond market also sold off by about 90% as much as the U.S., even though the German Bundesbank didn't move interest rates at all.

One major exception to this rule is Japan. Japanese bonds do not correlate with our markets, given that their business cycle has been out of whack with global economies for the past 15 years.

Q: What about emerging markets?

A: Emerging-markets bonds also have a low correlation with U.S Treasury bonds because they essentially provide a credit spread. By investing in emerging-markets securities, we add diversification to our portfolio and some protection against changes in U.S. markets.

However, most of the diversification that foreign bonds provide [to] investors comes from taking on currency exposure, and this is central to our investment philosophy.

Q: How do you assemble your portfolio?

A: We seek to create a broadly diversified portfolio by country, region, and currency to minimize volatility. We invest in both developed countries and the emerging markets. Our exposure to emerging markets provides us with a bit more yield than funds that invest exclusively in developed nations.

Essentially, through our investments, we're seeking an income advantage over U.S. markets. Currency is the most important variable in the construction of our portfolio. On a top-down, macroeconomic basis, the three most important global currencies are the U.S. dollar, the euro, and the yen. We evaluate the relationships between these three. The relative strengths and weaknesses of other currencies are of less significance.
Q: How is the fund currently positioned?

A: This fund operates on three different types of risk: interest rate risk, credit risk, and currency risk. At the moment, we're underweight in credit risk, underweight in interest rate risk -- by moving to shorter durations -- and overweight in currency risk.

Q: Do you invest in sovereign bonds or corporate bonds?

A: We're free to invest in both sovereign and corporate bonds. However, in practice, we usually have no exposure to corporates. The primary drivers of return are from currency risk and sovereign credit spreads. Any additional money we might make from buying high-grade corporate bonds would not enhance our overall returns.

We also avoid emerging-markets corporate bonds because they're especially problematic. The credit spread that these issues trade at doesn't compensate for the probability of a sovereign or corporate blow-up in these volatile markets. We find vastly better value and liquidity in sovereign bonds.

Q: What's your currency allocation at present?

A: We have about a 53% exposure to developed-market currencies, emerging markets denominated in U.S. dollars account for 19%, local emerging-markets currencies, 7%, and 10% is in U.S. currency.

We actually have an underweight in dollar-denominated emerging-markets bonds because we thought that rising U.S. interest rates would be a problem for the emerging markets and present a credit risk, but that has turned out not to be the case thus far.

Q: How has the portfolio changed over the last year?

A: We've reduced our interest rate duration as rates declined in the U.S. We've increased our exposure to emerging-markets bonds denominated in local currency, notably in Turkey and Brazil. We like countries with high real returns and declining inflation. Q: What is the fund's average credit rating?

A: It is currently at A+, but typically it's not that high since we're willing to invest in both emerging-markets bonds and below-investment-grade bonds. However, keep in mind that many emerging-markets bonds have witnessed upgrades to their sovereign debt in recent years.

Q: This fund generated big returns in 2002 (20.8%), and 2003 (25.9%). What drove this outperformance?

A: In 2002, we got big performance from emerging-markets bonds. In 2003, it was a combination of the continuing strength of emerging-markets bonds and the sustained weakness of the U.S. dollar.

Q: Why does the fund have such high annual turnover rates, as much as 300%?
A: The high turnover is a result of our investment methodology, and we think it's a spurious number. Currency hedging and active currency overlays are usually done on a 1- to 3-month rolling basis. Therefore, simply maintaining the positions requires several rolls per year, which inflates the turnover figure.

Q: Do you expect foreign bonds to outperform U.S. bonds as we head into next year?

A: Yes, and for two reasons: rising interest rates in the U.S. and the necessary correction in the U.S. dollar, which is ongoing. Interest rates are falling around the world, outside of the U.S. European bonds perform particularly well when the U.S. dollar weakens.

Bloomberg: Dollar Drops to Record Low on Speculation Europe to Tolerate Gain in Euro

Dollar Drops to Record Low on Speculation Europe to Tolerate Gain in Euro

Nov. 5 (Bloomberg) -- The dollar tumbled to a record low against the euro after German Chancellor Gerhard Schroeder suggested he will tolerate a stronger European currency, overshadowing a surge in U.S. job growth in October.

The euro's rise is ``not yet dramatic,'' Schroeder, leader of Europe's largest economy, told a press conference in Brussels. His remark followed European Central Bank President Jean Claude Trichet's failure yesterday to protest a four-week euro advance that helps offset the impact of higher oil prices.

``We were lined up with everyone else to buy euros; we did buy some,'' said David Durrant, chief currency strategist in New York at Bank Julius Baer & Co., which manages $95 billion. European officials may ``allow the euro to appreciate somewhat because of their inflationary concerns,'' he said.

Against the euro, the dollar weakened to $1.2964 at 5 p.m. in New York from $1.2872 late yesterday, according to EBS, an electronic currency-trading system. The dollar fell as low as $1.2972, breaching the Feb. 18 record low of $1.2930. The U.S. currency fell to 105.58 yen, a six-month low, from 106.03 yesterday.

The dollar, down 5 percent in the past month against the euro, initially jumped after the Labor Department said employers added 337,000 workers in October, after a gain of 139,000 a month earlier, fueling bets the Federal Reserve will raise its benchmark interest rate twice more this year.

``If a payrolls like this can't cause the dollar to rally it's the clearest signal that there is something seriously wrong with the dollar,'' said David Bloom, a currency strategist at HSBC Holdings Plc in London.

`Loving This Market'

The dollar has lost 8.3 percent since its high for the year of $1.1761 on April 26, surrendering gains made on expectations the Federal Reserve would raise its benchmark interest rate from a four-decade low. The U.S. currency is also down this year against the yen, British pound, Swiss franc, Brazilian real and the currencies of Australia and New Zealand.

Hedge funds, pension funds and mutual funds are selling dollars, said Michael Klawitter, a currency strategist at WestLB AG in Duesseldorf, Germany.

``A lot of currency hedge funds had a miserable year, and so they're loving this market now,'' he said. ``The euro will be testing $1.30, which the market desperately wants to see.''

The ECB may sell the euro for the first time to stem a rally should it reach $1.35 per dollar, Stephen Jen, head of currency research at Morgan Stanley in London, in a report.

Decline Under Bush

The dollar is weakening as the U.S. current account deficit widens, economists pare forecasts for U.S. economic growth and foreign demand for U.S. assets wanes. The currency has shed 21 percent since President George W. Bush, who won a second term on Nov. 2, took office in 2001.

Slowing purchases by foreigners of U.S. securities fueled speculation the economy won't be able to attract enough capital to compensate for a record current-account deficit and maintain the dollar's value, said Aziz McMahon, a currency strategist at ABN Amro Holding NV in London.

``The dollar's decline is really not a function of relative growth,'' said Michael Rosenberg, senior strategist and managing director in New York at Harbert Management Corp., an investment firm with about $5 billion in assets. ``It's really a function of the current account deficit,'' and strong U.S. growth may actually hurt the dollar by inflating that deficit, he said.

The shortfall in the current account widened to a record $166.2 billion in the second quarter. The gap is equivalent to 5.7 percent of gross domestic product, up from 5.1 percent in the first quarter, meaning the U.S. economy needs to attract about $1.8 billion a day to match it, according to Bloomberg calculations. The current account is a measure of trade, services, tourism and investments.

Schroeder, Trichet

A widening deficit in the current account may cut demand for the dollar, Robert McTeer, president of the Dallas Fed, said in a speech in New York on Oct. 7. San Francisco Fed President Janet Yellen and Kansas City Fed President Thomas Hoenig have also said they're concerned. Currency policy is set by the U.S. Treasury.

The dollar has lost 1.3 percent this week against the euro, and 0.2 percent versus the yen. The U.S. Dollar Index fell below 84 for the first time since December 1995. The index tracks the dollar against a basket of the euro, yen, British pound, Canadian dollar, Swedish krona and Swiss franc.

Schroeder said the rise in the euro isn't yet ``dramatic,'' so ``we don't need to take any political measures.'' He spoke at a press conference after a summit of European Union leaders in Brussels.

Trichet

When asked about the euro's gains at a press conference in Frankfurt yesterday, Trichet referred to a statement by the Group of Seven earlier this year that ``excess volatility and disorderly movements in exchange rates'' are undesirable, stopping short of his January denunciation of ``brutal'' exchange- rate moves.

``In the previous dollar down phase at the start of the year, we swiftly got complaints from European officials,'' said McMahon. ``This time around, there have been no complaints and some arguments that the euro appreciation, in the context of high oil prices, would provide some sort of shield for the economy.''

Speculators including hedge funds boosted futures bets on euro gains to a record, according to data released today from the Washington-based Commodity Futures Trading Commission.

In the week through Nov. 2, speculators boosted so-called euro long positions, which profit from euro gains against the dollar, to 53,465 greater than euro short positions. It was the largest net long stance since the euro's debut in January 1999. Net long yen futures holdings rose to 36,814, the highest since February, according to the CFTC.

To contact the reporter on this story:
Mark Tannenbaum in New York at at mtannen@bloomberg.net.

Morgan Stanley's Andy Xie: Back to Carry Trades

Back to Carry Trades
Andy Xie (Hong Kong)

Carry trades are dominating investment themes among the financial investors I visited in the UK last week. Long commodities and emerging markets and short on the US dollar seem to remain the core investment ideas. The expected revaluation of the renminbi, continued strong demand from China for commodities, and the large US current account deficit are the three building blocks for the carry trades.

The reviving enthusiasm for carry trades after a lull in the spring and summer is due to several factors. 1) China did not raise interest rates in September, 2) the level of liquidity, especially the flow into hedge funds, has remained strong despite three Federal Reserve rate hikes, and 3) there is still nothing else to be really bullish about.

While the recent rate hike by China is denting the enthusiasm for carry trades, its impact is unlikely to last. We believe the carry trades will truly unwind when the Fed funds rate is significantly above inflation and/or there is physical evidence that China’s demand for commodities has declined.

Putting on Carry Trades Again

The hedge fund community in London has grown rapidly. I spent three days in London last week and did not feel unproductive. The city appears to have successfully made the transition from a center for traditional money managers to one for hedge funds in the two years since the former was decimated by the tech burst. I believe this speaks volumes on how flexible and dynamic London’s financial community is in taking advantage of the shift to absolute from relative performance in the money management business.

The mood of investors I met was somber in general. The seesawing market conditions have made it difficult to make money this year. Even hedge funds can only make money when there are trends to catch. The recent weakness in the US dollar, which has made carry trades profitable again, has not been big enough to change the investor mood.

Most investors I met in London have convictions on going long emerging markets (equity, credits or currencies) and commodities (commodity futures, currencies or commodity producers) and are short on the US dollar or long on the yen, euro and emerging market currencies. The US current account deficit, expected renminbi revaluation and continuing strong demand for commodities from China are the fundamental arguments in favor of the carry trades.

Low Fed Funds Rate Still Drives Carry Trades

The low Fed funds rate is the source of enthusiasm for carry trades. Even though the Fed has raised the rate by 75bps, it is still substantially below the inflation rate in the dollar block (East Asia plus US). The US liquidity indicators are all turning down but the level of liquidity is still high. The amount of liquidity with money managers, especially in hedge funds, is still significant. Another 100bps of rate hikes by the Fed could reverse this liquidity tide.

Most money managers I have met are expecting stock markets to rally after the US election. If oil prices come down, which is already taking place after China’s rate hike, this should be the case and would be another example of a self-fulfilling expectation in a world with too much liquidity.

The carry trades will only work for everyone if China revalues its currency, which would cause another round of US dollar weakness and an even bigger commodity bubble. If China raises interest rates but keeps the peg, as I believe, carry trades will be a negative sum game for all participants.

Dollar Devaluation Is the Wrong Solution to Global Imbalance

The case for a weaker US dollar is the large US current account deficit, as it reduces the deficit through more exports and/or more import substitution. However, last year’s dollar devaluation had the opposite result. The main reasons for this were: 1) that consumption in other major economies would not rise much, given their stronger currencies and 2) that global companies have spread their capacity to lower-cost locations and could meet more US demand with foreign production. Therefore, the level of globalization has changed how currencies affect economies.

I believe the right solution to the US current account deficit or the global imbalance is for a US consumption correction. The US consumer has overspent in the past four years. Two to three years of below-trend growth, say 2-3%, could well correct the global imbalance. In my view, this would not be such a high price to pay for the consumption binge that has been going on in the US.

The US dollar is the anchor currency for globalization (i.e., global trade). Devaluing this anchor currency to gain trade advantages just does not work. If policymakers insist on pushing the dollar down, there may be global financial crisis. Two to three years of US consumption weakness would be more preferable for everyone, in my opinion.

China's Outlook Does Not Support Carry Trades

I believe an overwhelming majority of money managers are on the same side of carry trades, pushing up commodity prices and pushing the dollar down. The only way for everyone to make money is for the global equilibrium to change to justify a lower dollar value and higher commodity prices. A revaluation of the renminbi would have done the trick, which is why the expectation of a Chinese currency revaluation was so central to the carry trades around the world.

The rate hike by China shook the confidence in this plan a little, as the market had thought China would deal with inflation by raising the currency’s value rather than increasing interest rates to slow demand. This undermined the fundamental assumption for carry trades. Oil prices appear to have declined in response to China's rate hike as some speculative positions were unwound.

However, most money managers appear to have found a way to interpret the rate hike in favor of carry trades: if China could increase interest rates suddenly, it could also just as suddenly increase the value of the renminbi. In my view, this expectation is what continues to support the carry trades that are prevalent in currency and commodity markets.

I believe that China will continue to raise interest rates along with the Fed but keep the currency stable. With the economy in overshooting territory and surrounded by a lot of speculation, appreciating the currency – even if it is small amount – could cause speculation to mushroom and thus create a bigger bubble, with a big crash bound to follow. In my view, China is unlikely to take such a risk.

I believe the best course of action for China is to gradually raise interest rates to maximize the economy’s chances of landing softly. Only after this has occurred should China contemplate exchange rate reform.

Bloomberg's Chet Currier: Grantham, Gross Gloomy Over Troubles and Bubbles

Grantham, Gross Gloomy Over Troubles and Bubbles:

Bloomberg

by Chet Currier

Nov. 5 (Bloomberg) -- Here's a handy way for optimistic investors to test the strength of their convictions:

Spend an hour or two perusing the latest comments of two widely respected money managers, Jeremy Grantham and Bill Gross.

Gross's views are so glum he himself speaks of them as ``the economics of despair.'' Grantham says the history of investment ``bubbles'' argues for a drop of about 35 percent in the Standard & Poor's 500 Index, on top of the 40 percent slide already endured in 2000-02.

``Asia has hollowed out our manufacturing base and is now making inroads into services,'' says Gross, chief investment officer at Pacific Investment Management Co. in Newport Beach, California, where he oversees $415 billion including the biggest bond mutual fund. ``We can't really educate or innovate our way out of this.''

In the circumstances, Gross says (at http://www.pimco.com/LeftNav/Late +Breaking+Commentary/IO/2004/IO_ N ov_04.htm), the Federal Reserve will have to hold interest rates very low. ``While that keeps the patient/economy breathing, it leads to asset bubbles, potential inflation, and a declining currency over time,'' he says.

Grantham, chairman of Grantham, Mayo, Van Otterloo & Co., a Boston-based manager of $66 billion in mostly institutional money, says ``the current U.S. equity bubble'' is the 28th he found combing through the history of currency, commodity and stock markets ( http://www.gmo.com , registration required).

Painful Pattern

All the other 27 bubbles, he says, ``broke and went back to the pre-existing trend.'' For the S&P 500 to do the same now, he calculates, it would have to hit 720, compared with a recent level above 1100.

``Everything important about markets is mean-reverting or, if you prefer, wanders about a trend,'' he says. ``Prices are pushed away from fair price by a series of `inefficiencies,' and eventually dragged back by the logic of value.''

One of those inefficiencies, says Grantham, is a phenomenon called herding, which occurs among both individual and institutional investors.

In a highly specialized institutional world where managers are measured almost microscopically against benchmarks, Grantham says, ``refusing on value principles to buy in a bubble will look dangerously eccentric. This has guaranteed increasingly larger and longer market distortions.''

Both Sides Now

Gross gives us an external reason -- Fed policy -- to figure on bubbles as a continuing part of the investment scene. Grantham gives us an internal reason, forces in modern financial life that reinforce the human tendency to ``buy because others are buying.''

For myself, I need little convincing that we already live in a bubble-prone age. Stocks, notorious for their attempt to defy gravity in the late 1990s, have since been mimicked by real estate markets in many places, and perhaps some commodity markets too. Look no further than the almost-doubling in the price of crude oil over the last year.

If bubbles are so readily apparent, and so dangerous, why aren't more investors fleeing them? In the week or two since Gross's and Grantham's commentaries came out, stock prices have actually risen.

``The problem with bubbles breaking and going back to trend is that some do it quickly and some slowly,'' Grantham writes. He says the time spans of past bubbles he examined ranged from three minutes to 18 years.

Matter of Time

Thus, a simple strategy of staying away when bubbles threaten poses problems for many people who need to invest within a limited period of years -- before the children are ready for college or it's time to retire.

Suppose you or I detected an incipient bubble in the stock market when price-earnings ratios climbed above 15 to one in the early 1990s, and jumped out of stocks. A dozen years later, we would still be waiting for a proper chance to buy back in, and we would have lost a big chunk of precious time.

So what to do? Investors can heed Grantham's advice to ``lower risk and survive to fight another day.'' Those who don't agree with his assessment of the situation can still take his view into account by submitting their investments to a Grantham- style crash-test.

How would the investment plan look, and how would the investor feel, if the stock holdings were marked down by 35 percent or 40 percent? Given one's age and circumstances, how much time would the plan have to try to recoup the losses?

No bullish investor ought to shy away from such questions. At the very least, they help differentiate between reasoned optimism and reckless see-no-evil, hear-no-evil hope.

Energy Central.com: US economy more vunerable to energy prices than generally reported

US economy more vunerable to energy prices than generally reported
TORONTO, Nov 04, 2004 Canada NewsWire

Despite progress towards improved energy efficiency over the past 30 years the overall net increase in household and transportation demand ensures that the US economy is still vulnerable to energy prices, according to CIBC World Markets' Monthly Indicators Report for November.

"The widely held view that the US economy is half as sensitive to higher oil prices as it was during previous oil shocks simply does not pass muster," says CIBC Chief Economist Jeff Rubin. "The median household spends no less of its income on energy than it did 25 years ago. Energy efficiency is fast improving, but energy usage is rising even faster. And while energy-intensive goods are no longer as likely to be made at home, the energy costs imbedded in their manufacture will still be borne by American consumers."

Citing the impact of high oil prices on the two worst post-war recessions in 1973 and 1979-80/1981, Rubin and fellow CIBC World Markets economists Benjamin Tal and Leslie Preston suggest that the American economy is more sensitive to the current rise in oil prices than many economic commentators are suggesting. By using more realistic and meaningful indicators to measure overall energy use, such as energy consumption per household rather than the energy-to-GDP ratio, the CIBC World Markets economics team suggests that the North American economy is still highly vulnerable to the current high price of oil.

"We may well consume energy more efficiently than in the past, but that doesn't necessarily mean we consume any less of it," the Monthly Indicators report explains. "In fact, on average, North American households consume about 10% more energy than they did twenty-five years ago."

Energy and the Canadian Dollar

The November Monthly Indicators Report also features an article by senior economists Avery Shenfeld and Peter Buchanan on the impact of the increased demand for energy on the Canadian dollar as a result of Canada's role as a net exporter of oil and gas, particularly to the US market.

"The world's newest petro-currency, the Canadian dollar, looks poised to hold onto most of the stunning appreciation seen in the past two years," explain Shenfeld and Buchanan. The recent rally in the Canadian dollar "is supported not by unrealistic interest-rate differentials, but by a massive current account and goods trade surplus. That, in turn, attests to the octane from a hot US economy and surging Chinese growth for resources, which comprise about half of Canada's export sector."

"What's particularly new has been the role played by oil and gas prices. Oil shocks in 1973 and 1979-80 did little for the Canadian dollar. Back then, however, Canada was a net oil importer and its natural gas was trapped by pipeline limitations. It's only in recent years that the oil/gas trade balance has mushroomed into a huge source of net-demand for Canadian dollars in the current account. Moreover, capital investment inflows are being drawn to Alberta's tar sands and other opportunities, a contrast with the outflows seen under the National Energy Program following the second OPEC shock."

Lagging profitability in non-resource manufacturing suggests, however, that the Canadian dollar resource-levered rise is hurting other sectors and suggests Canada may face problems similar to those created in the Netherlands by North Sea oil in the early 1990s.

Tax News.com: Hedge Fund Barometer Sees Shift In Sentiment Towards Commodities

Hedge Fund Barometer Sees Shift In Sentiment Towards Commodities

by Carla Johnson, Investors Offshore.com

02 November 2004

Geneva-based hedge fund advisory firm Tara Capital last week released its quarterly hedge fund strategy barometer, which has shown investors tending to shy away from convertible arbitrage funds in favour of managed futures and commodity trading funds.

According to the barometer, sentiment has consistently shifted against convertible arbitrage strategies in recent times, due largely to a dip in implied volatility on longer term convertibles, which has resulted in “relatively significant losses” for many funds in this sector.

Noting a drop in the CBOE Volatility Index (which measures volatility in the equity markets) to the lowest level since 1997, John Lowry, CEO of Tara Capital, commented: “This reflects a complacency amongst investors, which is somewhat curious given the backdrop of concerns over growth rates and higher energy prices.”

Meanwhile, the barometer has recorded a noted shift in sentiment back towards Managed Futures funds and CTA (Commodity Trading Advisor) funds, with 44% of respondents stating that they plan to increase asset allocations in these sectors, contrasting sharply with the 6% who said the same in the last survey.

The barometer also found that Multi Strategy funds continue to be very popular, with many investors looking to increase exposure in these strategies.

Fixed Income strategies are also gaining strength, partly reflecting an increase in the number of available funds in this sector.

However, Tara Capital anticipates the popularity of Equity Market Neutral Funds will soon wane following three quarters of increased investor interest

Minesite.com: Toledo Mining Steps Up The Pace In Its Philippines Nickel Business

Toledo Mining Steps Up The Pace In Its Philippines Nickel Business

October 26 2004

Minesite.com

By Robert Wallace

We last wrote about Toledo Mining in August. It’s not like us to feature a reported company just two months later as there are so many juniors clamouring for a bit of exposure to investors in Europe. Rapidly evolving events at its nickel projects in the Philippines have, however, demanded an update.

To recap, when it listed in April this year, the company was named Toledo Copper as its sole project was the Carmen copper mine near the town of Toledo on Cebu island. This is a medium-term project where the rehabilitation required to return the project to operational status has now been costed at US$ 178 million. Endeavour Financial has just been appointed to plan capital provision. Toledo acquired a 40 per cent interest in what was effectively a dormant resource from Atlas Consolidated Mining Corporation, a Philippine-registered company owned by the Ramos family, which also own substantial publishing interests in the country.

This summer, the company did a second set of deals primarily with the same family, acquiring stakes in two established but non-producing nickel laterite mines located on Palawan island in the south-west Philippines, acquiring 44 per cent in Berong and 52 per cent in Celestial. These deposits are so important that on 6th October, the company changed its name to emphasise its wider-than-copper activities; its AIM epic also altered from TCU to TMC.

At Berong, mining is expected to be contracted to Australian company Leighton Contractors and the total cash cost of operations will be around US$1.30 per pound of nickel shipped. Profitability is helped by a strong nickel price and a weak Philippine peso. An FOB shipping contract has now been signed with a Japanese customer, Nippon Metals and Alloy, to supply 300,000 tonnes of dried ore pa at a nickel grade of 2.2%. At the current price of US$6 per pound, this should give total annual revenues of US$15.7 million , of which Toledo’s share will be US$6.9 million. A second agreement with Japanese buyers for a further 350,000 tonnes of ore pa is nearing signature. This would bring the total to 650,000 tonnes, generating total income of US$35.5 million and US$15.6 million respectively.

Negotiations are also proceeding with a prospective Australian customer which would take 600,000 tonnes of high grade nickel/cobalt limonite material at a grade greater than1.8% nickel equivalent. At the same nickel price, Toledo’s revenue from this additional contract should be US$5.9 million.

Total annual Toledo cash flow from Berong of US$21.5 million is therefore thought by management to be within reach. All that is needed is a road, a shipping pier and a final government mining permit to add to the regional one already obtained. Permitting and confidence is helped by the existence some 150 kms south of Berong on Palawan island of the Rio Tuba nickel mine which has been direct shipping nickel for over 25 years and has just installed and is commissioning a 10,000tonnes/year HPAL processing plant which has recently received its government environmental permit.

The Berong nickel deposit is said to be the fourth largest in the world with 275 tonnes of reserves at 1.3% nickel, ie 3.6million tonnes of contained nickel. As it has an approximately 50/50 mix of limonite and saprolite orebodies it offers options for either leaching or smelting. The company intends to commission a bankable feasibility study at a cost of some US$20 million which it could fund out of cash flow to asses the economics of developing the mine into a not less than 50,000 tonnes of nickel pa producer. Not surprisingly, there is considerable interest already from majors to farm in to its future large scale operations.

Toledo’s success is largely due to its Australian CEO Chris Kyriakou. Originally a lawyer, he was a mine developer in Australia, Canada and South Africa for 20 years. In the late 90’s he left the industry but returned with a keen interest in the Philippines where he first met Atlas in July last year. Most mining companies have to discover an economic orebody, attract capital and then develop a mine. What Kyriakou especially likes about Berong is that Toledo just has to dig ore, dry it and deliver it to a port.

The Philippines hosts some of the world’s most important mineral resources, especially of copper, nickel, cobalt and gold and silver. Yet currently mining development in the country is minimal; the effects of past typhoons, economic strife and environmental antipathy to mining have conspired to close most previously viable mines. The government is now actively courting mining companies and hopefully the Minister of Mines will be in London for a Special Philippines Mining Forum run by Minesite in February 2005.

At the moment there are less than a dozen operating miners either listed on the Philippines Stock Exchange or foreign explorers active in the country. Most of the prospects being explored or developed are previously-active mines which closed in the 90’s; Toledo’s Carmen copper mine is an instance. No wonder the Philippines Environment Secretary Michael Defensor appealed at a business leaders’ forum in Manila last week for investors to “participate in developing mineral resources”.

Toledo heard the call ahead of the crowd. So have some other shrewd investors in this rapidly-evolving story; with a purchase of 30million shares, 3.4%, AIM listed Cambrian Mining has just joined RAB Capital and Resources Investment Trust as significant holders on Toledo’s share register.

The Economist: "The wolf at the door"

The wolf at the door
Oct 28th 2004 From The Economist print edition
A further steep decline in the dollar seems inevitable

MOST economists, and this newspaper, have been fretting about America's huge current-account deficit and predicting the dollar's sharp decline for years. The trouble with crying wolf too often is that people stop believing you. After slipping 14% in broad trade-weighted terms since 2002, the dollar had stabilised this year, even as the current-account deficit continued to grow. This has encouraged some economists to offer theories explaining why America's current-account deficit does not matter and why the dollar need not fall further. But the dollar has now started to slide again: this week it hit $1.28 against the euro, within a whisker of its all-time low of $1.29. Trust us, the wolf is real.

The dollar's latest slide seems to have been triggered by uncertainty about the presidential election and a flurry of comments from Fed officials. Robert McTeer, the president of the Dallas Federal Reserve, mused (only “theoretically” of course) that when capital inflows into America dry up, “there will be a crisis that will result in rapidly rising interest rates and a rapidly depreciating dollar that will be very disruptive”.

Policymakers' usual reply when asked about exchange rates is to say that they are set by the market. But if the dollar was truly being set by the market it would now be much weaker. The dollar has fallen by over 30% against the euro since 2001, but its trade-weighted index has fallen by much less because of heavy intervention by Asian central banks, aimed at holding down their currencies against the dollar. This policy seems likely to continue, despite China's decision this week to raise interest rates for the first time in nine years. That decision was aimed at curbing its overheating domestic economy, rather than bolstering its currency.

Because Asian currencies have been held down against the dollar, America's current-account deficit has continued to swell, reaching almost 6% of GDP in the second quarter. The dollar is already below most estimates of its fair value against the euro, but it will need to undershoot if the deficit is to be reduced. Economists at UBS estimate that the dollar's trade-weighted value might need to fall by another 20-30% to trim the deficit by enough to stabilise the ratio of America's external liabilities to GDP. Though it might seem unthinkable, that could imply a rate of around $1.70 against the euro.

Other economists, however, argue that America can sustain its large current-account deficit for at least another decade, without a sharp fall in the dollar, because it will be happily financed by China and other Asian countries. In a series of papers Michael Dooley, David Folkerts-Landau and Peter Garber at Deutsche Bank have argued that the present arrangements resemble a revived Bretton Woods, the system of fixed exchange rates after the second world war.

Asian economies, they argue, have chosen to link their currencies to the dollar at undervalued rates, supported by heavy purchases of dollar reserves. Asian countries want to keep their exports cheap to support rapid growth and are in consequence happy to keep acquiring dollars indefinitely. In turn, by buying Treasury bonds, they reduce interest rates, which supports spending and ensures that American consumers keep buying Asian goods.

Since 2001, Asia's official reserves have increased by $1.2 trillion, equivalent to two-thirds of America's cumulative deficit over that period. Currency intervention by Asian central banks helps to explain why America has so far been able to finance its deficit without higher American bond yields or a bigger fall in the dollar. However, the claim that the deficit is sustainable for another decade is highly dubious.

An excellent paper by George Magnus, an economist at UBS, argues that the parallels with Bretton Woods are superficial. One big difference is that in the 1960s the United States ran a current-account surplus and was a net creditor to the rest of the world. Today, America is the world's biggest debtor, which could undermine the dollar's role as an anchor currency.

Second, it is wrong to describe the Asian countries as habitual “peggers”. In the 25 years to 1998, non-Japanese Asian currencies typically fell against the dollar, and over the same period their countries mainly ran current-account deficits, not surpluses. Their more-firmly-tied exchange rates and current-account surpluses generally date only from 1998 when these countries needed to rebuild reserves after the Asian crisis. Their desire to tie their currencies to the dollar may be a temporary response to a cyclical problem.

A third important difference is that, unlike under the Bretton Woods regime, most Asian countries have scrapped capital controls or where they still exist, as in China, they are leaky. This requires much greater “sterilisation” by central banks to prevent an increase in reserves spilling into faster credit growth. As sterilisation has become less effective, excessive credit growth is pushing up inflation and causing overinvestment in property, especially in China. As the inflationary costs of maintaining their link to the dollar grow, Asian countries may shift to more flexible regimes.

Lastly, under Bretton Woods there was no real alternative to the dollar as a reserve currency. Today there is the euro, into which Asians could diversify.


Mr Magnus reckons that the revived Bretton Woods is an illusion which will crack within a year or two. Even if it lasts longer, it is a dangerous way to run the world, for it encourages both China and America to pursue reckless policies. Excessive liquidity is causing the Chinese economy to overheat. Meanwhile, by buying Treasury bonds, Asian central banks are subsidising American borrowing costs, encouraging more consumer profligacy, and so allowing the current-account deficit to get even bigger. The inevitable correction will then be all the more painful.

Until recently, some argued that America's current-account deficit was sustainable because foreign investors were eager to buy American assets to take advantage of the economy's faster productivity growth and hence its higher returns. But private inward investment has slumped, leaving America dependent on foreign central banks. And foreign savings are no longer financing investment and hence future productivity gains as they were in the late 1990s. Foreigners are now financing consumption and government borrowing.

America's current-account deficit largely reflects puny domestic saving, so dollar bulls often argue that a fall in the dollar is neither necessary nor sufficient to trim the deficit. But Stephen Roach, chief economist at Morgan Stanley, reckons that a weaker dollar would spark a rise in real bond yields, as foreign creditors demanded extra compensation for currency risk. That would slow consumer spending, boost saving and reduce the deficit.

In the three years from 1985, the dollar fell by 50% against the other main currencies. Inflation and bond yields rose and, in October 1987, the stockmarket crashed. America's current-account deficit is now almost twice as big as it was then, so the total fall in the dollar—and the fall-out in other financial markets—could well be larger. The wolf is licking his lips.