Thursday, December 27, 2007

Dollar Woes Part I

This is Part I or II (or III) and aims to discuss the falling dollar.

As a consultant in the field, I've been asked quite a bit, not the least by the august Monk himself, what is happening to the dollar?

The dollar has been in a secular [long-term] decline since about the beginning of 2002 when it was trading about 120 versus the Index (a basket of other currencies). Today it is trading about 76. This 36+% decline has been steady and inexorable and shows no real sign of abating. Before we go further let's use the European currency, the euro, as a proxy since its easier to visualize. At the beginning of 2002 the 'euro' was trading about 0.86 to the dollar, that is, 86 cents would buy you one euro. Today, it requires $1.47 (147 cents) to purchase one euro. Depending on how you look at it the dollar has lost 40% of its value or the euro has gained 70%against the dollar. (The difference has to do with the basis - by what you are dividing - but that's not relevant to the discussion here.)

Why has the dollar fallen so significantly? I would point to the following reasons:

1. Variance in the economic cycle

Up through the end of the bubble and for 6-12 months thereafter US growth dwarfed the growth of our primary trading partners. Money flowed into the United States from all corners of the globe to buy US assets and in order to buy US assets you'd have to pay in dollars. A banal example: Try buying a hot dog from a vendor with Japanese yen. From 2002 onwards the view was that the USD had grown too strong and an adjustment was necessary. Also while our growth slowed, growth in Europe and the BRIC countries (Brazil, Russia, India and China), particularly China, accelerated. (More on this later). Fast forward to 2007 US growth was seen to be slowing sufficiently - punctuated in March by the first subprime sniffles - that rate cuts would be necessary. Contrast this with Europe where growth is still strong and the hawkish European Central Bank [influenced heavily by the legacy Bundesbank] complained about inflation and looked to raise interest rates. The anticipated change in the interest rate differential between the US and its major trading partners has been a cornerstone of dollar weakness particularly over the past year. Also the heady inflows of the years have significantly shifted as other opportunities beckoned.

2. Balance of Trade

Our trade deficit with China has exploded over the past four years. This is due to the fact that the cost of Chinese labor and materials is much, much lower than those in the US. The other piece is that China has artificially kept its currency, the yuan (or reminbi) significantly lower than where it would trade if it floated freely. The yuan is trading about 7.40 to the dollar. It's "real" value at the moment if allowed to float may be somewhere near 5. This makes Chinese exports very affordable and hence the lion's share of products at the Wal-Marts and the Targets are "Made in China" and flying off the shelves. This is not a bad thing; a lot more product is made available to the American consumer at very low prices. However, a large trade deficit where there are a lot of dollars floating around tends to depress its value. If international holders of dollars wish to repatriate they need to buy currency, sell dollars.

Interestingly one reason why the dollar drop hasn't improved the trade deficit as much as one might think is that the dollar fall has come against trading partners like Canada and Europe but the greenback has remained steady against the renminbi (very slow crawling peg) and the Japanese yen, the latter has nearly 0% interest rates.

3. The market is very long dollars.

The world is long of US assets. In fact it is very, very long of US assets. All those exports that Americans have bought on the back of money taken out of houses in the bubbling real estate market, for example, were put to work. Typically countries like China bought interest bearing US government securities (as well as some others which we will get to presently). This had the effect of keeping US interest rates low and at some stage will probably cause China much pain. China can probably be accurately described as following a mercantilist policy. Why will this hurt them in the end? The articially low yuan has propelled economic growth in China to the tune of 10-15% A YEAR. There has been and continues to be a lot of capacity being added that probably should not be added. This is ramping up the bubble of all bubbles. At some stage there may be tremendous overcapacity and then the deflationary spiral will be terrible to behold. To give the butchers of Beijing credit their technocrats have managed their economy exceedingly well.

So what happens when a market is long? It tends to fall for the simple reason that there isn't much appetite to buy more. If, like China, you are long 600 billion dollars and the value of the dollar sheds 10%, well you've lost 60 BILLION DOLLARS. Instead of keeping all your earnings in dollars you may choose to exchange them for other currencies. Given the numbers involved even if the world exchanged a fraction of their US dollar receipts into other currencies we are talking tens of billions of dollars. This behavior, and this is important, THE ANTICIPATION OF THIS BEHAVIOR, puts a lot of pressure on the dollar.

On the other hand there is little motivation certainly by the holders of these dollar assets to liquidate. Simply put their position is too large to liquidate. The act of selling 600 billion dollars would destroy the value of those holdings by a significant fraction. In order to seriously reduce their dollar long the Chinese have to wait for a secular dollar RALLY.

In Part II we will look at some of the more recent events that have conspired against the dollar this year.

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