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2006, The year of the euro (and pound)

by Brad Setser
November 30, 2006

Like many others, I expected that Asian currencies – notably emerging Asian currencies – would appreciate against both the euro and the dollar this year.    That hasn’t happened. 

Sure, the RMB has moved up a bit against the dollar, but not as much as euro.   Or the pound.  Both the euro and its high-carry cousin on the other side of the Channel are on course to end the year stronger against China and India (and flat v. Korea and Thailand, both of which have allowed their currencies to appreciate) as well as Japan and the US.  

The euro’s strong performance against the dollar in 2006 can be chalked up to shifts in the relative pace of European and US growth (and shifts in expectations about the path of European rates).   Per capita Eurozone growth is likely to exceed US growth this year.  

But it is hard too see how growth differentials explain the Euro’s appreciation against the RMB …  

Since China now exports about as much to Europe as to the US, I rather suspect the RMB will end up depreciating this year on a trade weighted basis.   That is hardly what China needs to wean its economy off exports.

Four other observations: 

One. The dollar’s slide against the euro looks to be a consequence of slower US growth, not the cause of it.   A weaker dollar combined with falling US long-term rates is not recipe for a hard landing driven by the unwillingness of foreigners to finance the US.   For that to happen, a falling dollar needs to be combined with rising US long-term rates.

Two.  The dollar’s slide v. the euro and pound, combined with the relatively strong performance of foreign equity markets, means that the US net international investment position (to simplify a bit, the difference between the dollar value of US investment abroad and foreign lending to the US) won’t deteriorate by much again this year.   The dollar value of US assets in Europe continues to rise.   

The counterpoint is that the US hasn’t been a great place for foreigners to invest.  Rather than letting the US borrow against the rising (dollar) value of US equity investment in Europe, the rest of the world would have been better off if they had forced the US to sell its European assets to finance its current account deficit.  (For more on valuation effects, see this new paper from Philip Lane and Gian Maria Milesi-Ferretti) 

Three.  In the past, stronger euro has generally been associated with a big pick up in (valuation-adjusted) reserve growth in emerging Asian economies not named China.   That is one reason potential why a falling dollar hasn’t led to higher US rates: Asian central banks have been willing to finance the US at relatively low rates when private markets don’t want to.  I will be watching the data on Asia's end November reserves with interest.

Four.  There are a lot British expatriates who don’t like a strong pound.   At least there are a lot of British expats in Dubai who don’t like a strong pound.    They may not pay taxes in Dubai, they do get paid in a currency linked to the US dollar.     Moving to Hong  Kong doesn’t solve that particular problem. 

The British tourists who flock to Dubai presumably have a rather different view. 

Update: The Economist seems to have put the dollar, not the euro on its cover — perhaps allowing the euro to avoid the dreaded cover jinx on a technicality.

Hat tip: to wcw for his comment on the euro/ baht/ won.  My initial post was a bit sinocentric.

19 Comments

  • Posted by wcw

    Well, the RMB hasn’t moved like the Euro, but the KRW and THB sure have. Cf http://finance.yahoo.com/q/bc?t=1y&s=EURUSD=X&c=KRWUSD=X,THBUSD=X,CNYUSD=X

  • Posted by KingBee

    “A weaker dollar combined with falling US long-term rates is not recipe for a hard landing driven by the unwillingness of foreigners to finance the US. For that to happen, a falling dollar needs to be combined with rising US long-term rates.”

    Precisely!!!! At last! You see? It is not happening as you expected… All your exagerations forecasting dramatic global financial crises were plain wrong; you just overestimated the dimension of the US disequilibrium.

    “Two. The dollar’s slide v. the euro and pound, combined with the relatively strong performance of foreign equity markets, means that the US net international investment position (to simplify a bit, the difference between the dollar value of US investment abroad and foreign lending to the US) won’t deteriorate by much again this year. The dollar value of US assets in Europe continues to rise.”

    Yes, you got it! Implication: the US disequilibrium is not as bad as you boosted for years, thus global imalkances were not as tragic as you depicted them for years! The dollar index is quite fairly valued.

    “In the past, stronger euro has generally been associated with a big pick up in (valuation-adjusted) reserve growth in emerging Asian economies not named China. That is one reason potential why a falling dollar hasn’t led to higher US rates”

    …….. obscure!!

    The dollar is adjusting to a new equilibrium: markets are factoring in the US slowdown and the EU recovery (which happens in 2006 while the Euro rises from 1.17 to above 1.30: so much for appreciating currencies slowing down growth). But the $ was broadly in equilibrium at the beginning of 2006 against the Euro. Now the $ is depreciating gently to factor in the US SLOWLY GROWING and not yet very high foreing debt. Even if the dollar move will be rapid it will not cause turmoil in the USdebt market.

  • Posted by bsetser

    wcw — cool chart, good point. the indian rupee, by contrast, hasn’t moved with the $. http://research.stlouisfed.org/fred2/series/DEXINUS/5yrs?&cid=15&cs=Medium&crb=on&cf=lin&seid2=&same_scale=

    King Bee — I did not over-estimate the size of the US disequilbrium. The US current account deficit has expanded. I did under-estimate the rest of the world’s willingness to finance that disequilbrium –

    but I think that i have been upfront about that for some time. Global reserve growth hasn’t slowed. I have recognized for some time now that if the US is slowing, it is not because of the “Foreign flight” scenario that I sketched out with Roubini in early 05. It is more of a consumer burnout story.

    Re: your point on the dollar index, it is actually at odds with your point about the rising dollar value of US extenral assets keeping the US net international position from rising. for the dollar value of us assets to continue to rise to offset ongoing current account deficits, the US dollar needs to continuously fall against the currencies of the countries that have the most US investment. that happens to overlap with the currencies in the dollar index.

    But my strongest view is that correcting the trade deficit will require a depreciation of the $ against many currencies that aren’t in the dx. And i don’t see how recent events contradict that view. the dollar hasn’t corrected against most emerging market currencies, and partially as a result, the US trade deficit is still growing (or at best stable) even with a $/ euro at 1.30.

  • Posted by bsetser

    wcw — from your chart it even looks like the moves in KRW and THB preceded the move in the $/ euro both in the spring and more recent. It also looks to me like Korea has been active in the fx market recently. Any one have a good sense of the scale of recent Asian intervention? The FT has reported that there has been some , but hasn’t given numbers.

  • Posted by FTX

    Is the strength of the pound just carry?

    On the face of it, sterling doesn’t look a good bet. An economy with extremely high levels of household debt, property prices in a bubble, worsening public sector debt, high trade deficit, and the country became an oil importer in 2005 (a situation that’s just going to get worse in the coming years as North Sea production declines).

    But opposed to the US, access to UK assets is fairly open. Not a week seems to go by without some large UK company being taken over by a foreign suitor, and Russian/GCC oil profits are flooding into London real estate.

    Who’s making the smart move here? Will the Fortress America attitude rebound on it one day? Or in twenty years time will the US be laughing because all it gave in exchange for its imports was pieces of paper, whereas the Brits sold the silverware?

  • Posted by bsetser

    Russian/ GCC/ asian reserves are also flooding UK banks …

  • Posted by Guest

    I’m a translator and researcher in China. I have launched a blog at http://china-dynamics.blogspot.com/ that posts my own selection of update about developments in China’s economy. I’m trying to update it every 12-24 hours. Please feel free to discuss those topics in my selections. If you like to know more about those subjects, please do not hesitate to let me know.

  • Posted by dissent

    “I rather suspect the RMB will end up depreciating this year on a trade weighted basis. That is hardly what China needs to wean its economy off exports…”

    This seems to have gloomy implications for American voters/workers: with an undervalued RMB continuing, our well-paying job hemorrage will continue, our tradeables sector will fall further and further behind what is necessary for global re-balancing, and the end result is all the worse for the American prosperity.

  • Posted by Guest

    What are the implications vis-a-vis Saudi Arabia? Will they maintain the 3.75 SAR/USD peg? Does this mean that they will need to starting filling SAMA’s (Saudi central bank) vaults with tons of US treasuries? Or have they other options?

  • Posted by Cassandra

    Brad Setser said:
    Russian/ GCC/ asian reserves are also flooding UK banks …

    Note that Russians/GCC/asians are also flooding into upscale central London residential property, and posh UK boarding schools. Are these events perhaps related??!?

    FTX-
    Considering that the Brits are themselves queued up at Dover, Waterloo and Stanstead to escape to France at every opportunity if not permanently (note: there are no queues of French people tripping over themselves in the other direction), I think the Brits will not regret having sold (at astronomical prices) what’s in effect damp moldy real estate, in a not terribly pleasant climate, with little redeeming qualities outside the tax benefits, and tax avoidance it offers to wealthy non-Brits. Moreover, as they did to the Japanese speculators with “Bush House” (the BBC World Service Headquarters) on the Aldwych, they are likely to buy much of the property back at lower values when said holder get bored (or squeezed) and move to Paris or Cannes, before flipping it back out to the next sucker in line.

  • Posted by bsetser

    guest — I am thinking a lot about sama right now. and about the peg. i suspect that they have relatively few options if they want to maintain the peg other than dollars (tho not necessarily US treasuries). indeed one of the questions I have is whether or not the Saudis have in effect been forced to defer conversion of their oil proceeds (in $) into euros to try to stem the dollar’s decline. keeping a constant share of non-dollar assets if you are paid in dollars requires continuous dollar sales …

    so one theory is that sama has been effectively forced to hold on to all the oil inflows ($7b a month or so) in november to avoid putting further pressure on the $. Another theory would be that sama decided to lighten up on dollars, so it is a source of the pressure … i honestly don’t know.

    ADIA and the others with investment funds seem to have found another option — buy into China. That gives China more $, which they are forced to eat (i.e. the banks are forced to hold them)

  • Posted by Emmanuel

    The assumption in point 3 is that Asian CBs tend to accumulate reserves in whichever currency is weaker at the moment; euro in most of 2005, USD at YE 2006.

    To date, there has been good evidence for this CBs-as-currency-stabilizers hypothesis. But, it might not work for much longer if CBs see the USD as being in terminal decline. Then again, if they feel like making guaranteed money-losing “investments,” Treasuries are the way to go. They will have no one to blame but themselves if they get a haircut on this stuff, and that’s pretty much guaranteed.

  • Posted by Guest

    Asia Finding Rich Partners in Mideast
    By HEATHER TIMMONS
    Published: December 1, 2006
    http://www.nytimes.com/2006/12/01/business/worldbusiness/01east.html?_r=1&ref=asia&oref=slogin

    The financial ties between the Middle East and Asia are strengthening by the day, creating a phenomenon that the banking giant HSBC calls “east-east” transactions, or deals between the Middle East and what the British once thought of as the Far East: China, Japan, Southeast Asia, as well as India and Pakistan. The traditional destinations for the Middle East’s petrodollars — the United States and Europe — may see some investment money dry up as a result, some academics say.

  • Posted by Anonymous

    Brad, you note that Chinese exports to Europe are about equal to their exports to the US. What is a reliable source to see how the country breakdown of China’s exports has changed over time? Thank you.

  • Posted by Dave Chiang

    The starting point to resolving Global Economic imbalances is for the major exporting nations each to unilaterally require that all its exports be payable only in its currency, so that the global finance architecture will turn into a multi-currency regime overnight. There would be no need for reserve currencies and exchange rates would reflect market fundamentals of world trade. Would the Washington Consensus also agree to permit the global sales of oil from the Arab Gulf states to be made in Japan yen, Euros, British pound, and Chinese yuan? We clearly need to promote a new global finance architecture away from a dollar hegemony that forces the world to export not only goods but also dollar earnings from trade to the US.

    The adverse effect of this type of globalization on the US economy is also becoming clear. In order to act as consumer of last resort for the whole world, the US economy has been pushed into a debt bubble that thrives on conspicuous consumption and fraudulent accounting. The unsustainable and irrational rise of US equity prices, unsupported by revenue or profit, has merely been a devaluation of the dollar.

  • Posted by bsetser

    anonymous — look at China’s trade data. Or look at imports from China as reported by eurostat/ the ECB and the US department of commerce. Or look at one of my old blogs on the topic … if you consider me reliable.

  • Posted by tmcgee

    hey brad — so what do you think about the role that china has played in this dollar break lower? is it just a coincidence that china was forced to let the yuan appreciated rather sharply so the inaugural one-year swap with the big chinese commercial banks expiring last weekend could end close to the 7.85 level that was the original target (so no one was too big a looser?) also it seems it was just china among asian central banks using DNT options to keep currency volatility contained (or to target certain secret bands). it seems that once china did, other asia c.banks were pretty much forced to do the same. perhaps too conspiracy minded, but interesting nonetheless…and what role do you think the pound plays in china’s FX basket? chrs

  • Posted by Laurent GUERBY

    Chris Dillow has an interesting graph on GBP/USD and USA/UK house prices:

    http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2006/11/house_prices_an.html

  • Posted by bsetser

    What role for the pound? Good question. I presume that China likes it for the same reasons that other central banks like it (higher carry and moves like the euro) and assume that its role in China’s reserves has grown along with its role in global reserves. But that is just a guess — i find it hard to try to seperate out pound/ euro flows using the (very rudimentary) techniques available to me.

    Re: the options — hadn’t thought about the swap; good theory. Problem is that the recent acceleration in the RMB’s pace of appreciation is over-determined (basket peg and euro move, Paulson’s trip to China, etc).

    As for China’s DNT options (and other Asian CB options), you clearly know more than I do … keep chiming in tho, as I need to learn a bit more about central banks off balance sheet intervention. I have heard rumors that a few CBanks have used swaps to reduce their effective dollar exposure without it showing up in the flow data. But those are just rumors. And it isn’t obvious to me why those kinds of swaps would reduce volatility.