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Is the dollar correction over?

V. Anantha-Nageswaran

IN recent days, the US dollar had clawed its way back against the euro and the yen. This has provided a small alley for dollar bulls to push the case for the greenback again, citing the near paralysis in the economies of Europe and Japan. The argument is not incorrect, but incomplete. In the summer months, it is well possible that the currencies that appreciate against the dollar change order. But the long-term unwinding of the dollar's strength of the last several years is not about to end anytime soon. Should the market defy this prediction and send the dollar higher, economic fundamentals dictate that the next round of correction would be far more painful and globally instable.

Why should CHF and SGD outperform in the short-term?

In a risk-averse environment, currencies that do not rely on global capital flows tend to outperform those that do. One of them, for instance, is the Singapore dollar (SGD). In the long-term, the SGD is likely to be range-bound (with a slight and gradual bias to weaken) as conflicting forces act on the currency. One is its tendency to appreciate, given its strong forex reserves and the current account surpluses it earns every year. On the other hand, is the weaker growth potential compared to the past. Of course, one can go into a whole gamut of influences on the exchange rate. But for the time being, the above two arguments capture the essence. Therefore, the currency is likely to trade in the 1.75-1.80 range in the medium-term (next 6-12 months). In the short-term, however — because of WorldCom and Vivendi — one expects a continued rise in risk aversion through the summer until end-August.

The huge losses bond-holders and banks have suffered in these two issues (not to mention other companies such as Ericsson, Vodafone whose bond prices have declined steeply in recent days) would have clearly scared and scarred credit markets.

When risk aversion rises — global capital flows do not take place — countries that do not depend on foreign capital flows see their currencies do better. The Swiss franc and the SGD present themselves as clear alternatives in such a scene.

Of course, if the expected rise in risk aversion does not materialise, then the appreciation potential of these two currencies in such an environment would also be realised with a delay.

Why should the Australian dollar and the New Zealand dollar underperform in the short term?

The reverse of the above argument applies to AUD and NZD in the short-term until end-August or thereabouts. They rely on global capital flows and, if in the short term, global capital flows dry up, the AUD and the NZD will suffer or, in other words, they consolidate.

Why is one bullish on them in the long term?

  • The interest rate differential with US assets is too high for these currencies (see graph). Consequently, speculation against them is costlier. Plus, in an uncertain environment for equities globally, more serious investors find the higher yield, the safety of investment grade and the undervalued currencies, attractive.

  • These economies enjoy good growth rates with relatively (relative to history) low inflation. Their central banks have been proactive in anticipating a cyclical rise in inflation and already raised rates 0.5 per cent and 1.0 per cent respectively in Australia and New Zealand.

  • Australia has current account deficits. Hence, it relies on external capital. All these years, such external capital was hard to come by, as the US attracted all the footloose capital to itself. That is changing, for all the reasons which are by now familiar to most of us. This trend is unlikely to reverse in the near future as the scales have fallen from investors' eyes.

    Hence, the case for a stronger AUD does not rest solely on global growth and commodity price upswing but also on a more balanced flow of global capital.

    Does the EUR deserve to appreciate against the USD?

    On the EUR, I do agree that for every scandal that has been unearthed in the US, there has been one from the side of Europe. That is what allies are for!

    On top of it, there is the overhang of debt in the Telecom sector — France Telecom and Deutsche Telecom — and political change overdue in Germany and the uncertain policy outlook in its aftermath. Cyclical growth outlook too remains uninspiring, compared to the US. Indeed, but for the US woes, the euro could probably be wallowing in the mid-1980s.

    However, much of the above sorry tale on Europe is well factored in to market prices. Until now, that was the only `known' or `certainty' for the market. The US was deemed invincible. But at the margin, this has changed. Had there been some positive improvement on the side of Europe, the euro would be probably well above 1.05 already.

    Collectively, the Eurozone exports two-third within itself. So, the export growth concern is not so strong as they were when we had twelve separate currencies. It is, at the margin, a concern, but not a big one. Only when the EUR starts to move higher than 1.05, it would really start to hurt, if, by then, the ECB had not lowered rates quickly and by enough to offset export slack with domestic demand.

    In any case, with the Eurozone being a net crude oil importer, the strength of the euro against the dollar makes their imports of crude oil cheaper and, thus, offsets whatever exports drag there is, in the short term. The price of crude oil is, on average, more than 25 per cent higher this year than that of last year.

    Also, strategic geopolitical considerations dictate that the perception of a weak EUR is removed. It needs time. Hence, it would be foolish for Europeans to react negatively to EUR strength. A weak euro strengthens the image of a continent that lacks dynamism and excitement.

    Absolute economic disparity does not matter at the margin

    Many point to the Eurozone economic paralysis and political confusion and wonder why the dollar deserves to weaken. The question is reasonable but misses a deeper motivation for the dollar's weakness. With the economic disparity between the Eurozone, Japan and the US, it is clear that the first two still lag behind the US, assuming that what we see is what we get, in the US. A big assumption these days!

    However, one does not explain these currency moves based on absolute differences in growth or other economic conditions between these major economic players but based on what has changed at the margin. If in 2000, the US had 100 points (priced for perfection), the Eurozone had 50 and Japan had scored 20, possibly, the gap now is something like 60, 40 and 10, respectively. The gap has narrowed. That is what matters to the Foreign Exchange market. `Priced for perfection' was clearly appropriate for the dollar and US stocks. As markets realise that the place is far from perfect, capital flows begin to dry up.

    Even in July-October 1998, right in the middle of the technology, productivity miracle of the US, the dollar dropped 16 per cent or 19 per cent (depending on how you look at the currency) when the collapse of LTCM and Russian bond default struck global financial markets. Further, foreign interest in US assets does not have to turn negative for the dollar to weaken. It simply has to wane a little since the country requires $1.5 billion per day to finance its current account deficit this year and more, next. Net foreign purchase of US equity is half of what it was in the first four months of last year and one-third of what it was, in the year 2000 (see chart).

    Given the huge US current account deficit, it is not necessary for the world to withdraw capital for the dollar to fall. All that is required is that the world supplies the US with less capital than it needs. The rest has to be paid for through one's own exports for which the country requires a weaker currency, among other things. That is why the dollar is falling. That is why it is poised to continue to drop.

    (The author is the Regional Head for Investment Consulting in Credit Suisse, Asia-Pacific. The views expressed are personal. Feedback may be sent to nageswar@singnet.com.sg)

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