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Wednesday November 24, 2004 - 13:52:00 GMT
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Forex: G7 Plus China, Dollar Dysfunctional

G7 Plus China, Dollar Dysfunctional

In the wake of the acrimonious G20 meeting (G7 ministers split over the weakening dollar) and presumably an at times prickly APEC meeting (Bush and Hu debated yuan policy), there are growing signs of disharmony in international economic relations. And the point of contention is the apparent private wishes of the Bush administration for an orderly dollar decline. If history is anything to go by, currency discord at the G7 level has in the past begun significant trends or exacerbated existing trends. Probably the best example occurred in the fall of 1987 when then Reagan administration decided that German and European policies were too restrictive and not contributing to global demand to the extent that the US thought it should be. As such then Treasury Secretary Baker began talking down the dollar out of frustration over mainly restrictive German economic and European policies were too restrictive and not contributing to global demand to the extent that the US thought it should be. Well we all know what happened to the dollar and eventually US stocks.

Today's op-ed by PBOC Deputy Governor Li was a surprise. The tone was anything but friendly. Anyone in touch with US Treasury before today's PBOC editorial would have been very sure that US-China international economic relations were going swimmingly well. We are talking more than cordial...real understanding and coordination. Li's article basically told the Bush administration to go to you no where (my attempt to be MC...morally correct) on the yuan peg...not the source of the US current account imbalance. There was nothing cordial and certainly nothing collegial (reminded me of me...a rant). Li essentially said the more the US presses for currency flexibility the more it gets delayed. After reading Li it is hard to imagine a widening of the band in Q1 of 2005. This tells me two things. One is the short dollar, short euro and long Asia bloc trade is vulnerable (bounce in euro/yen today may have been a reflection of this concern). Another is that the longer China puts off a reval, the more the weak dollar trade gets funneled into euros, Swiss franc, sterling, C$, A$ and NZ$.

And Japan? Because Bush and Koizumi are more or less joined at the hip on major geopolitical issues, the likelihood that dollar/yen gets in the way of this relationship is slim to none. Japan will have to free-ride Euro Zone officials in calling on the US to intervene on behalf of the dollar. While the US is not eager to see Japan reengage massive currency intervention, there will be some tolerance for unilateral, albeit discreet, smoothing of yen gains versus the dollar in the near future...tactical use of currency intervention as opposed to strategic use which ended in March of this year).

Dysfunction is also raising its head within the Euro Zone...okay always present. Italy's controversial Prime Minister Berlusconi is on a mission to get the ECB to intervene unilaterally in euro/dollar and get the EU to "ixnay" the Growth and Stability Pact. As usual only Berlusconi is listening. But surely other government officials in the 12 nation monetary union are eager to see the ECB act...some would even applaud a rate cut (Snow and Taylor would for sure). And who can forget German Chancellor Schroeder's appeal for US support for the dollar at the Berlin G20 meeting. The ECB surely feels pressure from finance ministers to act. And like China's central bank, external pressure typically delays action.

Disharmony, in this instance, will delay intervention, delay a yuan reval and accelerate the dollar's trend lower. If I had to guess, the next G7 meeting in February will be lively...euro/dollar approaching 1.40 and dollar/yen well under 100 and markets punishing dysfunction.


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