Watch out for the great dollar crash! For most of this decade, gloomy economists and policymakers have warned that the mighty dollar is destined for a nasty correction that could shake the global economy to its core. And if it were to happen, things would look especially grim for the Asian countries that rely on U.S. consumers to snap up all their DVD players, flat-screen TVs, and Toyotas (TM), and which have recycled their surplus savings to finance America's gargantuan budget and current account deficits.
Yet the long-awaited currency adjustment that would get the process under way never seemed to materialize -- until now, that is. A confluence of factors has sent the dollar down against key Asian currencies in recent weeks. First, the Group of Seven finance ministers issued a fairly blunt statement on Apr. 21 saying it's time to get serious about dealing with the global imbalances in trade and capital flows. To some, such as Merrill Lynch Chief Economist Jesper Koll, that could be the first signal of a "powerful shift in the global economy" if the dollar continues to decline in value (see BW Online, 4/27/06, "Protection from a Falling Dollar").
On top of that, Federal Reserve Chairman Ben Bernanke has signaled the U.S. rate-tightening cycle may be drawing to a close. Though the U.S. central bank is expected to raise it key Fed Funds rate to 5% on May 10, Bernanke has suggested the Fed could pause for a few months to get a better read on the inflation outlook.
Figuring out just how far Bernanke will go is sure to be a big priority for currency traders this spring and summer. "Whether the final level of the Federal Funds rate is 5% or 5.25% or 5.5% probably does matter to the dollar's performance over the next few months," says Robert Sinche, head of foreign currency strategy at the Bank of America.
Longer term, it looks like the dollar will be under considerable trading pressure. While the credit tightening cycle that started in mid-2004 is drawing to a close in the U.S., it is really just getting started in Japan, China, and much of developing Asia, where growth is strong and inflation is a real concern. Currencies are traded for a variety of reasons, but one big one is the future direction of interest rates. So if the Asians raise rates, it will add to the negative outlook for the dollar.
Global investors and Asian finance ministers have started to focus on the dollar's swoon against key regional currencies in recent weeks. It is sure to be a hot topic among finance ministers attending the Asia Development Bank's annual meeting in India this week. So far, the adjustment has been fairly modest and orderly. The Japanese yen is up about 4% this year against the dollar, and Barclays Capital currency analyst Toru Umemoto sees the yen appreciating to 110 to the greenback over the next month, from about 113 as of May 3.
Meanwhile, other regional currencies such as the Korean won, Thai baht, and Indonesian rupiah have appreciated by nearly 10%. China, of course, which carefully manages the trading range between the yuan and dollar, is feeling an enormous international push to let its currency appreciate dramatically against the dollar.
This currency shift need not to be a catastrophe. In fact, if the adjustment is gradual, it could be positive. The big question is whether key Asian economies will start to fight the trend via currency interventions and other measures if they see their export sectors -- vital drivers of growth across the region -- starting to suffer.
Two figures likely to play a big role in that drama will be Bank of Japan Governor Toshihiko Fukui and People's Bank of China Governor Zhou Xiaochuan. They chart the monetary policies of the region's two biggest economies, and the central banks they lead control nearly $2 trillion in foreign currency reserves -- the lion's share of which is invested in U.S. Treasury bonds and other dollar assets.
Without a doubt, China is home to the biggest undervalued currency in the region, thanks to Beijing's insistence that dollar and yuan trade in a very narrow range. Back in mid-2005, the PBOC did abolish its fixed currency peg to the dollar and tolerate a yuan appreciation of about 3%, but the rate hasn't budged much since then despite intense pressure from the U.S. to do more.
The Chinese government is reluctant to take dramatic action on its currency because it needs a robust export sector and lots of growth to avoid social unrest and absorb 10 million-plus new workers every year. Most economists think Beijing will tolerate a modest appreciation in the yuan in 2006 of 3% to 5% -- though that's still well below the 20% to 40% shift some believe is needed.
But Zhou is probably more worried at the moment about the explosive growth of lending and investment in a Chinese economy that grew a scorching 10%-plus in the first quarter. Economic overheating could result in a boom and bust scenario that could create the very kind of economic stall Chinese President Hu Jintao's government fears.
The PBOC raised a key interest rate on one-year loans on Apr. 26 (see BW Online, 4/28/06, "China Taps on the Brakes"). But it's too small to have much impact and doesn't address the central problem. Nicholas R. Lardy, a senior fellow with the Institute for International Economics, thinks China's grossly undervalued currency and huge trade surplus are creating a "large increase in the domestic money supply," heavy lending, and over-investment.
"LINE IN THE SAND."
In Japan, Fukui faces similar political pressure to go slow in any shift away from the BOJ's ultra-loose monetary policy. He has signaled the time is approaching when rates will start to move from near levels in gradual steps starting later this year. The BOJ is worried about inflation taking hold of the economy, while Prime Minister Junichiro Koizumi's government is far more anxious about a stronger yen's impact on the country's powerful export sector.
A few years back, Japan's Finance Ministry intervened massively in the currency market to depress the value of the yen against the dollar. To be sure, Japan's economy is far stronger now. But Barclays analyst Umemoto thinks Japan will act if a stronger yen starts to hit earnings at Japanese corporations. An exchange rate of about 100 yen to the dollar "could be a line in the sand" for the Finance Ministry, he thinks.
Few would deny that at some point the U.S. has to shore up its pitiful savings rate, consume less, and address its twin deficits. And most Asian leaders realize that they must stoke domestic demand and rely far less on exports for growth and prosperity. If the status quo continues, at some point the doomsayers will be proven right and things could turn very ugly for the global economy. Here's hoping the dollar adjustment in Asia isn't a rocky one.