Posted on Thursday, August 21st, 2008 by bsetser
Macro Man is back from vacation, and I have little to add to his explanation for the dollar’s rebound.
The gap between the United States economic performance and the rest of the world’s economic performance looks set to narrow — which makes the dollar a bit less unattractive and other countries’ assets a bit less desirable. The gap between US rates and other large countries interest rates may fall, as other G-10 central banks start to ease. Finally, I have long been convinced — in part because of a good Goldman Sachs paper on the topic — that high oil prices are bad for the dollar. A weak dollar may also be good for oil, though I am less convinced on that point. I would put it differently: the Fed’s easing was bad for the dollar and it was good for oil, in part because a host of rapidly growing countries with subsidized oil prices followed the Fed and adopted extremely easy monetary policies that helped (for a while) spur oil demand.
UPDATE: Things look a bit different on Thursday than on Wednesday, with oil back up ..
That said, the US external deficit remains far larger than the deficit private investors abroad want to finance at current US interest rates. The June TIC data (released last Friday) was rather weak. Indeed, right now the US is having trouble consistently producing assets the rest of the world wants to buy. But CDOs composed of tranches of mortgage backed securities based on subprime loans practically have to be given away. The stock of US banks and broker dealers hasn’t seemed like such a good deal recently. Foreign demand for US stocks has dipped recently.
Of course, the US doesn’t rely exclusively (or even heavily) on private demand for its debt and equity for financing. In some sense, it cannot. Not when a set of surplus countries’ still have undervalued currencies. The FT leader notes: “global imbalances between the US and currencies pegged to the dollar are not yet fully resolved. A faster appreciation of Asian currencies still makes a lot of sense, as does a re-peg of oil exporters’ exchange rates to a basket of currencies.” The big surplus countries right now — China and the oil exporters — channel almost all of their surplus into their central banks and sovereign funds. The growth in China’s government assets exceeds its (still large) current account surplus. The same was true of Russia in the second quarter (the third quarter may be different). And almost all of the Gulf’s oil surplus is channeled through SAMA and the Gulf’s three big sovereign funds (ADIA, KIA and QIA). The concentration of Chinese and Gulf foreign assets in state hands implies that the buildup of official claims from the surplus countries will play a large role financing the deficits in the deficit countries.
Central banks aren’t quite as keen on Agencies as they used to be. But central banks still are buying a lot of Treasuries.
Macro Man’s notes one additional reason for the dollar’s rally: central banks are not selling dollars for euros quite as rapidly as they once did. He calls this “addition by subtraction.”
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Posted in Exchange Rate, central bank reserves | 21 Comments »
Posted on Friday, August 8th, 2008 by bsetser
The big financial story today is the dollar’s rally –
The dollar fell when oil rose, and now it is rising as oil falls.
Plus, a couple of the key factors that have supported the euro against the dollar — the ECB’s tightening bias and Europe’s resilience (and specifically Germany’s resilience) in the face of the US slowdown — seem to be withering away. I agree with John Jansen: this is more a story about incipient weakness in Europe than strength in the US. Only yesterday US Treasuries rallied (i.e. yields fell) on the back of bad US news.
A dollar rally is one way for the RMB to strengthen against its largest trading partner — though at the end of the day, the RMB needs to strengthen against both the euro and the dollar to help reduce the world’s imbalances, not just to strengthen against one or the other.
Most of the data I follow looks back not forward — even the weekly custodial data reported by the New York Fed. I though was struck by the strong increase in the Fed’s custodial holdings (money the New York Fed holds for foreign central banks) last week: Total custodial holdings were up $24.5b, with a $25.6 increase in the Treasury holdings and a slight $1.0b fall in custodial holdings of Agencies.*
The $24.5b weekly increase is almost as large the $29.1b increase in July. And the $25.5b in Treasury purchases isn’t that much smaller than the roughly $35b sovereign funds have invested in US financial institutions.** It is a huge number.
Right now there are only three countries adding to their reserves at a rate than could explain this kind of growth: China, Russia and Saudi Arabia. Of course, a large country that isn’t adding to its reserves could also shift funds over to the New York Fed, increasing its custodial holdings in the absence of an increase in its overall reserves — but I suspect that at least one of the countries now adding to its foreign assets at a rapid clip is making heavy use of the New York Fed’s custodial accounts.
And it is striking that all the increase went into Treasuries. Treasury Secretary Paulson is in Beijing for the Olympics. I would be a bit surprised if he also doesn’t swing by SAFE and explain how the US government plans to backstop the Agencies …
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Posted in Exchange Rate, central bank reserves | 33 Comments »
Posted on Tuesday, July 8th, 2008 by bsetser
The FT’s leader concisely summarizes the arguments against the Gulf’s peg to the dollar.
“The UAE either keeps its currency pegged to the dollar, in which case too many dirhams will chase too few goods, and prices will inevitably rise; or else revalue the dirham so each one is worth more dollars.
Both options achieve the same end result but inflation has greater drawbacks. First, it is slow, whereas revaluation is instant. Second, once started, inflation is hard to stop because workers demand higher wages to compensate. Third, there is a risk of asset price bubbles in the Gulf nations because high inflation means that real interest rates are too low. Fourth, inflation hurts the poor (who do not have direct access to oil revenues), and so harms political stability.
There is also a specific problem with pegging to the dollar. Gulf currencies have actually had to depreciate against the euro in order to follow the dollar, the exact opposite of what they need, and a shift that will cause even more inflation.”
Alan Greenspan has suggested that the Gulf should allow their currencies to float. It would be hard, though, for the UAE and Qatar and Kuwait to float if Saudi Arabia remains pegged — especially if they aspire to form a monetary union. If the Saudis floated, the rest of the Gulf could peg to the riyal, but that also seems like a remote possibility.
The FT suggests that the GCC shift to a basket peg. The risk of shifting to a basket peg now though is that it locks in the Gulf’s depreciation against the euro. If the dollar were to rebound against the euro, a basket peg would imply that the Gulf’s currency would need to depreciate against the dollar to avoid appreciating against the euro by too much — no matter what happens to the price of oil. That doesn’t make much sense. A basket peg protects against further dollar depreciation, but it doesn’t address the core problem: the Gulf, like China, needs to appreciate against the ensemble of its trading partners.
The FT suggests addressing this by combining a revaluation with a basket peg. It then goes one step further and suggests that the Gulf should consider including oil in their basket.
“The Gulf needs to peg to something. A first step (after revaluation) would be to peg to a basket of currencies that included the euro and the yen. A bolder step would be to include the price of oil in that basket, so that currencies would appreciate when oil is strong, and depreciate when it is weak. That would make for smoother adjustments than double-digit inflation.”
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Posted in Exchange Rate, oil | 40 Comments »
Posted on Wednesday, June 18th, 2008 by bsetser
I did a podcast for cfr.org that presents my thinking on this topic.
The simplest reason why oil is up and the dollar is down is that the world economy has been far stronger than the US economy. Weakness in the US economy translates into a weak dollar. Still solid global growth translates into strong demand for oil at time when supplies are a bit tight.
It is also striking, at least to me, that the countries that subsidize oil consumption the most also tend to peg to the dollar or manage their currencies against the dollar. US economic weakness consequently has translated into low US interest rates — and low US rates have translated into low nominal rates - and even lower real rates — in the other, booming dollar zone economies. See Martin Wolf. Combine low real rates with subsidized (or at least below-world-market-prices) oil and there has been a big increase in demand for oil in many countries that peg to the dollar or manage their currencies against the dollar.
I also was persuaded by the analysis of Goldman’s fx team. They argue that there are fundamental reasons to think that a rise in the price of oil should be bad for the dollar. The US economy is energy and oil intensive. The US has the largest existing external deficit of any major oil-importing region. The US exports relatively little to the oil-exporting economies. And the oil-exporting economies seem a bit less inclined to hold dollar-denominated financial assets than in the past.
That said, I wish I had concluded by noting that there are two clear paths that could end the current “oil up, dollar down” pattern.
Weakness in the US economy could drag down global oil demand, pulling both the dollar and oil down. Asia’s 1997-98 crisis led both Asian currencies and the price of oil to fall.
Or a rebound in the US economy could push up the dollar while adding to oil demand. In 2000, a booming US pushed up oil prices and the dollar.
The dollar isn’t always weak when oil is strong. And the dollar isn’t always strong when oil is weak. But so long as global growth is far stronger than US growth, there is reason to think that oil prices will respond to global demand while the dollar will reflect conditions in the US.
Posted in Exchange Rate, oil | 36 Comments »
Posted on Friday, June 13th, 2008 by bsetser
The rising cost of transportation makes goods produced closer to their final market cheaper relative to the goods produced a long ways away. Today’s Wall Street Journal reports that rising transportation costs are having an impact: DESA LLC has decided it makes more sense to produce heaters in Kentucky than in China; Breman Castings Ince is getting “work back from China” and Craftsman Furniture (now Chinese owned) is scaling back plans to shift its furniture production to China.
Adjustment in action. Good news too, even if consumers have to pay a bit more. Adjustment doesn’t always work to the benefit of consumers at the expense of domestic producers.
The Journal reports that Jeff Rubin of CIBC in Toronto estimates that the rise in transportation costs has raised the effective “cost of shipping” tariff on imported US goods from 3% to 9%. DESA reports that the 15% increase in the cost of shipping goods from China contributed to its decision to produce more in Kentucky.
Makes sense.
I rather suspect that the close to 20% rise in the Chinese renminbi against the dollar (together with higher inflation in China than in the US) has also played a role in these decisions. A rise in the renminbi has the same effect as a rise in the cost of shipping. Production in the US starts to look more attractive if the cots of producing goods in China goes up.
Indeed, I was a little surprised that Timothy Aeppel’s story focused so much more on rising transportation costs than on the exchange rate: exchange rate changes were mentioned, but only in passing after the beak. The focus was on rising transportation costs
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Posted in China, Exchange Rate | 26 Comments »
Posted on Sunday, June 8th, 2008 by bsetser
It is nice to be in good company. Ken Rogoff is as confused by US policy toward dollar pegs as I am. Rogoff:
Does it make sense for the United States Treasury Secretary, Hank Paulson, to be touring the Middle East supporting the region’s hard dollar exchange-rate pegs, while the Bush administration simultaneously blasts Asian countries for not letting their currencies appreciate faster against the dollar? Unfortunately, this blatant inconsistency stems from the US’s continuing economic and financial vulnerability rather than reflecting any compelling economic logic. Instead of promoting dollar pegs, as Mr Paulson is, the US should be supporting the International Monetary Fund’s efforts to promote the eventual de-linking of oil currencies and the dollar.
The macroeconomic logic of the US position is hard to decipher.
If the US thinks monetary flexibility would help China - and the rest of Asia — limit inflation, why wouldn’t monetary flexibility help the Gulf do the same? The Gulf certainly has an inflation problem. Saudi inflation is now over 10%. Qatar’s inflation is just under 15%. I would bet the UAE’s inflation rate, honestly calculated, is just as high, if not higher.
The Gulf’s peg the dollar — which is likely to depreciate in the face of the oil shock — certainly has complicates both the Gulf’s own adjustment to higher oil prices and the broader process of global adjustment. Menzie Chinn has calculated that a 10% rise in the price of oil implies a roughly 2% real depreciation of the currencies of most oil-importing economies, including the US.
In Chinn and Johnston (1996), a 10 percentage point rise in the real price of oil induces a 2 percentage real depreciation in a typical OECD country real exchange rate.
A real depreciation in the oil-importing OECD implies an a real appreciation of the oil exporting economies. Yet so long as the Gulf pegs its currency of the oil-importing economy with the largest pre-existing current account deficit (at least among the major economies), the only way this real adjustment can happen is through inflation. In that sense, inflation isn’t a problem — it is the way the Gulf has chosen to adjust.
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Posted in Exchange Rate, oil | 13 Comments »
Posted on Friday, June 6th, 2008 by bsetser
Tim Duy, with rather impressive timing, says yes. Rising inflation in China and the Gulf, the key regions in today’s “dollar zone,” now have a large enough impact on prices in the US to limit the Fed’s ability to cut rates further. Rather than setting monetary policy for the US, Duy — who had an office next to mine at the US Treasury back when we were both very junior new hires ten years ago — claims the Fed has to set policy for the entire dollar zone. Duy writes:
Years of academic research led Bernanke to conclude that the Fed’s best response to the financial crisis is that which should have been deployed during the Great Depression. Fine on paper, but in practice he is using 1930’s monetary policy in the economy of 2008. And that 70+ year gap is exceedingly important in many respects, but perhaps none is more important than the current status of the US Dollar as a reserve currency, a status that allows the US to run a gaping current account deficit. The concern is that the Fed treats the external sector with something of a benign neglect when setting policy, effectively ignoring the reserve currency function of the Dollar. Hence, in a bow to Wall Street, policymakers unwittingly created an overly stimulative environment that feeds back to the US in the form of higher inflation.
This simply implies that the Fed does not sufficiently consider the reaction functions of other central banks when setting policy. Should they? In a world with limited capital flows, no. But in today’s globalized financial environment, the answer is increasingly yes. In effect, by encouraging open capital flows, the US has ceded some amount of domestic policy control.
It is an intriguing argument.
Once upon a time, Nouriel Roubini and I postulated that central banks would be unwilling to add ever increasing sums of depreciating dollars to their portfolios, and that the need to attract international capital to finance the (large) US external deficit could become a constraint on US macroeconomic policy autonomy. In such a scenario, US long-term rates would rise — and the Fed might need to raise short-term rates — even during a US slowdown. Rather than being able to adopt counter-cyclical policies designed to support domestic economic activity during a slowdown, the US might be forced to adopt pro-cyclical policies designed to assure access to sufficient external financing.
This scenario hasn’t materialized. US fiscal policy is now expansionary and the fiscal deficit is rising rapidly. US monetary policy is also expansionary. US policy rates are low, especially in real terms. Long-term rates are low too — though no longer quite as low as they once were. All this has been possible, in some sense, because of an absolutely extraordinary increase in central bank reserve growth (supplemented by big flows into sovereign funds). My analysis suggests central banks and sovereign funds are on track to add over $1.5 trillion dollars to their portfolios this year (after adjusting for valuation gains). The huge rise in custodial holdings at the New York Fed strongly suggests that central banks remain the key sources of financing for the US.
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Posted in Exchange Rate, Monetary policy | 44 Comments »
Posted on Saturday, May 31st, 2008 by bsetser
That at least seems to be the Treasury’s policy.
Krishna Guha of the FT reports that the US believes that dollar pegs can help countries manage commodity price volatility.
Mr McCormick said that oil producers were not in the same position as large manufacturing exporters such as China. “A commodity-driven economy with a lot of volatility in commodity prices could be a beneficiary of a pegged regime,” he said.
So much for the notion that the Treasury is open to a change in the Gulf’s peg.
And so much for any illusion that I might have some influence over US policy.
In my Peterson institute policy brief, I argued that commodity price volatility is a reason not to peg to the dollar. A peg assures that fluctuations in the dollar price of a commodity (say oil) will translate one for one into volatility in countries local currency revenues from commodities. By contrast, a currency that appreciated when commodity prices appreciated and depreciated when commodity prices depreciated would tend to stabilize a country’s local currency revenues.
And I am not quite sure how pegging to a currency that has depreciated in real terms even as oil has appreciated in real terms has helped smooth out macroeconomic volatility in the oil-exporting economies; it seems to have produced high levels of inflation, negative real interest rates and a wildly pro-cyclical macroeconomic policy mix.
It isn’t hard to see why Paulson is intent to signal that the US remains open to foreign investment from sovereign wealth funds — and why he is pushing the Gulf to allow more foreign investment in its oil sector. A sharp fall in financing for the US would be disruptive, US investment banks are keen to do business with sovereign funds and the Bush Administration is keen to spur more investment in oil production in the big oil-exporting economies. The Wall Street Journal reports (in an article that was perhaps buried a bit more than it should have been) that the big oil exporters are exporting less this year than last.
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Posted in Exchange Rate, oil | 14 Comments »
Posted on Friday, May 23rd, 2008 by bsetser
That more or less is the conclusion of this week’s Economist.
I agree.
Back in 2003 when the dollar started to depreciate, many emerging economies opted to maintain dollar pegs and follow the dollar down. The resulting increase in their reserves — and holdings of US Treasuries — altered the monetary transmission mechanisms in the US. The dollar was stronger than it otherwise would have been, notably against the Asian currencies. And US rates were lower than they otherwise would have been.
Moreover, long-term rates didn’t rise when the Fed started raising rates, keeping financial conditions looser than they otherwise would have been. And as the revised data from mid-2004 to mid-2006 comes out, it is increasingly clear that ongoing central bank purchases of Treasuries and Agency bonds are part of the explanation for the persistence of low long-term rates. The Economist:
“Emerging economies shared some responsibility for America’s housing and credit bubble. As Asian economies and Middle East oil exporters ran large current-account surpluses, they piled up foreign reserves (mostly in American Treasury securities) in order to prevent their currencies from rising. This pushed down bond yields. At the same time, cheap imports from China and elsewhere helped central banks in rich economies hold down inflation while keeping short-term interest rates lower than in the past. Cheap money fueled America’s bubble.”
The housing bubble and residential construction boom obviously have ended. The US economy has slowed sharply. And the US has cut rates.
The result is that a host of emerging economies are now importing both a weak currency and loose monetary policy from the US. Countries that peg to the dollar can easily have a looser monetary policy than the US — higher rates of inflation and the same nominal interest rate can produce lower real interest rates — but have difficulty maintaining a tighter policy. Raising rates while maintaining a de facto dollar peg would tend to attract speculative capital inflows. Ask China.
Loose monetary policy globally has helped to offset the US slowdown. Much of the emerging world is booming on the back of negative real interest rates. But it also has pushed up inflation globally. The Economist reports that the average global real interest rates is negative (”global monetary policy is now at its loosest since the 1970s: the average world real interest rate is negative”) largely because of very high rates of inflation in the emerging world.
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Posted in Exchange Rate, emerging economies | 21 Comments »
Posted on Tuesday, May 20th, 2008 by bsetser
Michael Phillips in Monday’s Wall Street Journal:
If there’s one message the Bush administration has been trying to hammer home to Chinese leaders, it is this: A major country with a huge trade surplus and rising prices should let its currency strengthen with market forces. So why is the administration nearly silent about the fixed exchange rates of Saudi Arabia and other Persian Gulf oil fiefdoms? After all, like China, the big powers in the Gulf — Saudi Arabia and the United Arab Emirates — link their currencies to the U.S. dollar, export far more than they buy abroad, and now face inflation imported from overseas.
The US policy right now is that China shouldn’t peg to the dollar but the Gulf should. In reality, neither should. Kristin Forbes — who I briefly worked for — has this right.
“Given the huge current-account surpluses and reserve accumulation in the Gulf states, it’s getting harder and harder for the U.S. Treasury to justify putting pressure on China, but not the Gulf states, to have more exchange-rate flexibility,” says Kristin Forbes, an economist at the Massachusetts Institute of Technology and former adviser to President Bush.
Dollars pegs are both inflationary and an impediment to effective balance of payments adjustment. The currencies of the countries with huge surpluses need to appreciate; the currency of a country with huge deficit not so much. And it is hard for say Chinese renminbi — let alone the Saudi riyal — to appreciate if it is tied to the US dollar.
Posted in Exchange Rate, oil | 29 Comments »
