One of the world’s ironies is that even as John Snow putters on about how currency values should be set by market forces, the market — or at least the private market — is now playing a comparatively small role in defining the dollar’s value (and in providing the capital flows the US needs). True, the dollar’s value v. the Euro is set in the private market, to the current chagrin of Germany’s finance minister. But the dollar’s value v. the Chinese renminbi (yuan) surely is not set in private markets — and the US is likely to import as much from China as the Eurozone this year. The dollar’s value v. the ruble is not really set entirely in the market, given the Bank of Russia’s reserve accumulation. Its value v. the yen? Certainly not set by the private market this spring, when the Japanese government spent $140 billion defending the dollar, and expectations of MOF (Ministry of Finance) intervention still cast a shadow over the market.
The US has not intervened to support a strong dollar during the Bush Administration (intervention requires selling the US government’s stock of yens or euros to buy dollars), but other countries sure as hell have intervened to keep their currencies weak against the dollar (buying dollars with their yen, renminbi or rubles). John Berry is right: the US may not have a strong dollar policy, at least not in the sense of using policy tools to keep the dollar strong. But lots of other countries clearly do have a strong dollar policy: they are spending real money to keep their currencies weak. Intervention is intervention: the dollar’s value is being managed, just not by the United States.
The interesting question is whether some countries currently intervening to keep their currencies weak (and the dollar strong) are tiring of that game — as it implies both the risk of importing inflation and growing holdings of risky dollar assets. Russia, for example, seems to be interested in holding more euros and fewer dollars. Korea intervened last week, but it may be having second thoughts. The other interesting question is whether some countries (or economic regions) not currently intervening to keep their currencies weak are tiring of watching their currencies strengthen against the dollar, and their economies slow — afterall, a stronger euro means weaker European exports and a weaker Eurozone economy. Eurozone finance ministers –if not the ECB — seem to be at least contemplating getting into the currency management game …
Intervention clearly played a big role supporting the dollar in 2003 and 2004. I increasingly suspect it will play a big role going forward as well. It is hard to go from borrowing $400 billion plus from the world’s central banks annually to zero. The key question may be whether central bank intervention is done to support the current overvalued dollar (as China is doing now), or whether it is done to support an “orderly” depreciation of the dollar — effectively providing the US with the financing it needs (at the rates the US needs to avoid a sharp slowdown) as it starts to adjust.
More details follow, but a warning first: the following dicussion is rather long, even by Nouriel Roubini/ Brad Setser blog standards.Roubini and some of his non-Setser coauthors developed an interesting model to explain the impact of large player — which they took to be the IMF — on financial markets in emerging economies. Their model is based on two observations. First, the IMF does not provide all the financing an emerging market needs in a crisis. The IMF can be overwhelmed if all external creditors and investors — or if all domestic creditors and investors — decide to leave. Second, the presence of IMF financing can change the perceptions of other actors in the markets, and thus still have an impact. The US Treasury/ IMF bailout of Mexico worked. Roubini, Corsetti and Guimaraes drew on the global games literature to develop a more sophisticated — you might even say nuanced — view of the impact of a large player like the IMF on the market for emerging market debt.
Take the following example. Suppose a country needs to raise $50 billion annually to roll over its domestic and external debt. Suppose its domestic and external private creditors think the private markets will only make $40 billion — max — available. That could generate a panic which leads everyone to get out before the financing shortfall leads to big asset price falls/ sharp falls in the currency/ other nasty things. The country might not even by able to get anything close to $40 billion, at least not until after its financial markets have tanked. No one wants to buy high and then sell low. Now suppose the IMF makes $20 billion available. Creditors now think, hey, the country has all the financing it needs, the IMF is putting up $20 and we think the markets will be good for at least $30 billion, so let’s stay in. That oversimplifies a bit — I am leaving out the role of improved policies in the debtor country, for example. But the basic idea is simple: the presence of a large player willing to put money on the table can influence the behavior of other players in the market.