Wednesday, April 16, 2008

Nouriel Roubini and the US dollar

Nouriel Roubini, on point as always highlighting the inadequcies of the G7 attempts to talk up the US as the ECB faces growing concerns that intervention may be the only hope the Forex market has to return to some sense of normalcy.

What that is in today's markets is anybody's guess.


G7 Stance on the US Dollar: Talk is Cheap

Nouriel Roubini Apr 14, 2008

The French Finance Minister Lagarde compared the G7 statement on the US dollar to the 1985 Plaza Accord to weaken the US dollar; but the forex market pretty much ignored the statement pushing the dollar further down. The statement certainly signals that the G7 are getting closer to the point where the dollar weakness bothers both the US and Europe and where coordinated forex intervention may be considered; but as the saying goes “talk is cheap”. Verbal intervention – of the sort used even by Trichet in the last few weeks and used by the G7 in their weekend statement – almost never works (as the Japanese learned a few years ago). Also sterilized fx intervention usually does not work – unless such intervention goes with the wind rather than against the wind, is seriously coordinated and aggressive and signals future changes in actual monetary policies (i.e. unsterilized intervention).

What works in affecting exchange rates is unsterilized intervention – or equivalently – changes in relative monetary policies, i.e. changes in policy rates.

Currency movements are driven – apart from market noise and momentum – by economic fundamentals. Several fundamentals are driving the dollar south relative to euro and other floating currencies.

Lets discuss these fundamentals and their implications…

First, the still large and structural US current account deficits that – however shrinking – is still huge is bearish for the dollar.

Second, relative interest rate differentials; and with the Fed still expected to cut rates while ECB and BoJ are so far on hold this is dollar bearish.

Third, relative growth differentials; and with the US entering a recession while Europe and Japan slowing but at a more moderate rate this is also bearish for the US dollar.

Fourth, the relative riskiness of US assets relative to European and Japanese assets; and with the US financial crisis still in full swing, toxic assets still partly hidden (who is holding them and how much?) and the risks of further writedowns still large this is another bearish factor for the dollar.

Fifth, with China and other effective members of BW2 still effectively heavily managing their currencies relative to the US dollar (or still into outright pegs as in the Gulf states) downward fundamental pressures on the dollar are reflected in the dollar rate relative to the floaters rather than against the Asian and BW2 currencies.

So, all these five fundamental factors imply a weaker dollar ahead relative to the euro and most of the other floaters. So would verbal intervention work to stem the fall of the dollar? Of course not. So, would coordinated sterilized intervention work? Maybe for a few days but not much more.

Would unsterilized intervention or reduction in policy rates in Europe work to stop the ascent of the euro? Yes but an ECB worried about inflation has not yet reached the point of easing Eurozone rates to stem the rise of the euro. So Trichet may express his concerns about a strong Euro – and a euro close to 1.60 relative to the dollar implies pain not only for exports of the
PIGS (Portugal, Italy, Greece, Spain) but increasingly also for those of France and of the Germany (the export superpower); but unless he is willing to ease rates the fall of the dollar relative to the Euro may continue for a while.

So, what could stop a disorderly fall of the dollar and a disorderly rise of the euro and the yen? At some point the rise of euro and yen is going to weaken enough economic growth in the Eurozone and in Japan that two things will happen: the growth slowdown in Europe (with outright recession in some European economies) and Japan (with the risk of Japan tipping into another recession) will tip growth rate differentials that are now bearish for the dollar into being bearish for euro and yen. Second, such a growth slowdown in Europe and Japan will lead to expectation if policy rate easing by ECB and BoJ that will also tip interest rate differentials against euro and yen.

Certainly with the euro now closer to 1.60 than 1.50 the euro is overvalued in real terms: European traded goods are much more expensive than American goods (or as European observers put it to me: “for European tourists goods are now cheaper in New York than in Bangkok!”). I.e. on a PPP basis the euro has already overshot upward its fundamental value. But market dynamics, herding and momentum can drive the euro above 1.60 (and possibly the yen back towards 90). But the more this short-run overshooting occurs the weaker the Eurozone and Japanese economies will get and the more likely the probability of ECB and even BoJ cutting rates. Thus, if euro and yen were to overshoot in the short run market forces (relative expected growth and interest rate differentials) will put a floor to how weak the dollar can get and how strong the euro and yen can get.

So, with BW2 central banks still aggressively managing their currencies values relative to the US dollar and the currencies of the floaters being controlled by endogenous changes in relative economic fundamentals a total disorderly crash of the US dollar is unlikely. And given a severe US recession and a global recoupling of growth these limits to further sharp weakness of the US dollar may imply that global imbalances may remain large for the foreseeable future even if the dollar weakness does – at the margin – help the narrowing of the US current account deficit.

In conclusion, Mr. Trichet if you are really worried about the rise of the euro there is something very simple you can do to stem that rise: cut European policy rates! All the rest – including coordinated sterilized intervention – may end up being cheap talk.

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