What To Make Of The US Dollar

Over the weekend, the Group of Seven industrial
nations (G7) issued a joint statement indirectly calling for China and Japan to
adopt a free-market policy towards the value of their currencies–as opposed to
the current interventionist approach. Specifically, the communique stated “we
emphasize that more flexibility in exchange rates is desirable for major
countries or economic areas (China and Japan) to promote smooth and widespread
adjustments in the international financial system, based on market mechanisms.”  

As a result, today, investors sold equities,
bonds and the US dollar, which hit a three year low against the Japanese. Some
market observers are already predicting Armageddon, mass-hysteria and that dogs
and cats will be living together–that is, a sustained sell-off in stocks, bonds
and the US dollar. In my view, this weekend’s G7 statement is merely a
well-orchestrated attempt by the Western (G7) nations to quiet the growing
chorus of complaints coming from domestic manufacturers and any adjustments in
China and Japan’s currency policies will be token ones–at least for the time

Before I get into my reasoning, let me give
readers a little background on the current situation.

Many Asian economies are highly dependant on
exports for their livelihood. And in an effort to keep their goods competitively
priced, the central banks in these countries intervene in the currency markets
(buying US dollars while selling their country’s currency) when their currency
strengthens, as is the case with the Bank of Japan; China’s central bank is more
systematic with its intervention, as it keeps its currency pegged to the
dollar–that is, at a fixed rate.

Weakness in the dollar is often the result of a
trade deficit (more imports than exports). When foreign goods and services are
sold in the US, revenues from these transactions need to be repatriated back to
the exporting country, which means that US dollars are exchanged (sold) for
foreign currency (bought). This then pushes the value of the US dollar lower
relative to the currency of countries that have trade surpluses with the US–as
is the case with China and Japan.

Most of the US dollars that are purchased by
these central banks go towards purchasing the low-risk US Treasuries. Foreign
central banks now own $750 billion worth of US government securities, or roughly
20% of the existing market. Moreover, the biggest holders are the Bank of Japan
and the Bank of China.  As can be seen in the graph below, foreign central
bank ownership of US Treasuries has jumped over the past two years, after
remaining relatively steady during the 90’s– and most of this increase can be
attributed to China and Japan’s growing trade surplus with the US.

image src=”https://tradingmarkets.com/media/2003/Ed/foreign.gif” width=”540″
height=”292″ />

Indeed, this growing imbalance will need to be
corrected over the long-run, but as I mentioned above, this weekend’s press
statement is merely a well-orchestrated attempt by the Western (G7) nations to
quiet the growing chorus of complaints from domestic manufacturers. And the
reasons are :

 1) A deliberate attempt by the current
administration to weaken the dollar would cause more harm than good since the
resulting sell-off in US Treasuries would  be a volatile one, causing rates
and borrowing costs to rise too quickly thereby choking off the nascent economic
recovery. I expect a more gradual climb in bond yields as the year–and the
economic recovery–progress.

2) Today, China’s Deputy Governor of the
People’s Central Bank of China issued a statement saying that his country
remains committed to a stable currency, although there is room for future
exchange rate flexibility.

3) Japan’s Central Bank Governor also stated
that his country stands ready to take appropriate measures if short-term
currency fluctuations (strong yen) threaten sustained growth.

4) The US is trying to garner global support for
its operation in Iraq and realizes that cutting off an integral component of
Japan and China’s economic growth engine–that is exports–would not help its
cause in Iraq.

Edward Allen