Strong Talk for a Weaker Dollar
By Peter Luxton
Perhaps finance officials from the Group of Seven (G7) industrialized nations were swept up in a wave of nostalgia for the 1980s. On Sept. 21, the G7 wrapped up a summit in Dubai with an announcement aimed at taking some of the starch out of the U.S. dollar, particularly against the Japanese yen and Chinese yuan, both managed currencies.
The G7's Dubai declaration echoed the group's Plaza Accord of Sept. 22, 1985. That agreement also sought to bring the greenback down from its then-lofty heights. And it succeeded beyond the group's wildest expectations, as the dollar lost more than a third of its value vs. major currencies. Dubai suggests that history may be about to repeat itself, albeit to a more muted extent.
The final communique from the meeting called for more "flexibility in exchange rates," which is "desirable for major countries or economic areas to promote smooth and widespread adjustments in the financial system based on market mechanics." This is an implicit criticism of China, Japan, and other nations in the region, urging them to adjust their own currencies more realistically to the dollar.
And in currency-speak, it was clearly a shot across the bow, with some analysts seeing a political component in the statement. Various G7 sources have been quoted as saying the wording was aimed at addressing U.S. domestic concerns, as a Presidential election year approaches, without altering fundamental G7 policy.
While most recent G7 communiques are intentionally bland, the group has occasionally taken a stronger line. It expressed concern over dollar weakness in 1995, yen depreciation in 1998, yen strength in September, 1999, and January, 2000, and euro weakness in September, 2000. All of these statements, however, were followed by central bank intervention -- buying and selling of target currencies -- in the foreign-exchange markets. These moves were meant to head off potential instability in the global economy and financial system with an "orderly reversal" of overextended moves in those currencies.
With its demand that central banks allow market forces to make the necessary adjustments, the Dubai statement turns this "orderly reversal" strategy on its head, echoing the 1985 assertion that "exchange rates should play a role in adjusting external imbalances." In either case, central banks are notable by their absence.
This could signal a significant change in foreign-exchange policy, aimed at the Asian region rather than a more general global thrust. Unlike in 1985, the dollar has already weakened significantly against the European currency and the so-called minor dollars -- the Australian and Canadian currencies. It is the managed "bloc" of the yen, the yuan, and other emerging Asian currencies that has gummed up the system, as strength in those currencies has been artificially constrained.
Market reaction following the meeting was swift, with the dollar coming under broad-based selling pressure. On Sept. 22, the greenback plunged against the Japanese currency, to 112 yen to the dollar. Meanwhile, stock markets around the world took a beating, as the prospect of a suddenly weaker dollar sent investors to the exits. Japan's benchmark stock index, the Nikkei 225, tumbled more than 4%, in part because of worries about the effects of a resurgent yen on the country's exporters. In the U.S., the major indexes each fell over 1%, with Treasuries also hit by losses.
Team Bush, which has faced considerable domestic pressure from business groups and lawmakers on the dollar's strength against Asian currencies, had little to say following the meeting. Treasury Secretary John Snow reiterated the Administration's "strong dollar" policy, but he said little on the dollar's slide in the wake of the G7 meeting.
Snow's invocation of the strong-dollar policy could be a reaction to the drop in U.S. asset markets, especially Wall Street's unease that bonds could suffer from a sharp fall in the dollar as Asian central banks cut back on their purchases of Treasury and agency debt.
While underlying U.S. fundamentals (especially the swelling current-account and budget deficits) may justify a weaker dollar, the U.S. economy still looks strong compared to Europe or Japan. But looking ahead, there may be little wind remaining in the dollar's sails, as further losses vs. the yen could indeed drag the greenback lower across-the-board.
Even with the rapid strengthening in their currencies vs. the greenback, officials from Asia's twin export giants will likely tread carefully. China's deputy central bank chief reaffirmed Beijing's policy of keeping the yuan's value stable, while gradually moving toward a more flexible foreign-exchange policy. And the Bank of Japan is likely to be more circumspect when it chooses to intervene in currency markets to keep a lid on the yen's rise. So, don't expect any aggressive actions, at least for the short term.
Luxton is a currency market analyst for MMS International MMS staff analysts contributed to this report