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Wednesday July 1, 2009 - 20:59:14 GMT
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Forex Blog - China Call for Supranational Reserve Currency Hollow. But Shows Vulnerable US$.

 What is interesting today for the dollar decline is not so much that headline China allegedly requested the July 09 G8 (plus G5 and Egypt) heads of state summit address the question of creating a new world reserve currency to replace the greenback (almost a daily event), but the fact that the dollar weakened at all on the news.  Indeed the likelihood that the USD will be replaced by the IMF’s SDR anytime soon is laughable.  What is not so easy to brush off is the fact that the USD is extremely vulnerable to even the most preposterous of stories.  Maybe this is the side effect from having ultra loose monetary and fiscal policy and no clear exit strategy much less tactics in place from debt monetization and deficit spending on steroids. 

It has also occurred to me that the single major prop for the dollar, and a mighty one at that through early March, is more or less going, if not gone, away…buying dollars out of fear as the world teetered on the edge of a financial panic.  Well the real economy may not be healed but the banking system has been bailed out and ensured against any future run (the too big to fail banking system).  Risk aversion tied to a financial panic risk is no longer a valid concern.  Risk aversion tied to a prolonged economic slump is a valid concern, but this was never really the key driver in the risk aversion driven USD rally from July 2008 through February 2009. 

Is it any wonder that the risk aversion crowd theme has failed to really sustain a decent USD rally in the last few months – the financial panic motivation was far more powerful driver of risk aversion than weak economic data from the US. 

So the dollar has been virtually cut loose from the panic and it is looking quite vulnerable to public worries (regardless of the motivation or imminent threat) from reserve managers (USD accumulators like China and Russia), signs of economic recovery and an absence of clarity on how the US government and Fed will thread the needle of exiting this unprecedented monetary and fiscal policy accommodation. 

What will happen to the dollar say in the next few months if there is a failed US Treasury auction (less than 1 bid-to-cover)?  It is conceivable – it happened in a UK Gilt auction in May.  Again the dollar is vulnerable to shocks now that its key prop, financial panic, has largely been removed. 

In terms of China calling for G8 to take up its call for forming a new supranational reserve currency, the politics seem paramount motivation…trade tensions are rising, China wants more say in international affairs and the dollar indeed has a real problem…US credit worthiness is not a guarantee nor is Fed credibility in securing price stability ahead. 

Some analysts today noted that China is not in G8 and therefore can’t influence a G8 agenda.  This is more or less true, especially when the majority in G8 (Russia the exception perhaps) would oppose the proposal.  But G8 is also morphing into a larger amalgamation – July 09 meeting in Italy is G8 plus G5 (Brazil, China, India, Mexico and South Africa) plus G1 (Egypt).  Indeed there is growing momentum to fold G7 into G20…the number after G is increasingly irrelevant.  Italy is the host nation of the July heads of state summit and plays the primary role in setting the agenda, drafting the communiqués and coordinating this with the rest of the body.  Any country at G8 (in this case G14) can raise any issue it so desires as part of informal talks at the gathering and in sidebars around the gathering.  So China, and perhaps with Russian backing, could pursue this debate more vigorously if it so chooses. 

It has also been pointed out that G8 central bankers will not be attending and this makes currency policy discussions all the more difficult to hold. 

Finally China is in no position to abandon the dollar or even reduce its significance in its reserve mix.  China chooses to peg the yuan to the USD (ended crawling appreciation a year ago and now pursues a stable currency – versus the USD) and as long as this policy remains intact, the authorities in China will directly or indirectly be large accumulators of USD in light of the large trade surplus China runs with the US.  China could just as easily (well with some serious pain and potential for unrest) could choose to float the yuan ending any need to buy dollars.  And data bear out that since May China (and the rest of BRIC) have been accumulating FX reserves (mainly dollars) at a record rate. 

Back to the vulnerable USD…I find it troubling that US officials are tone deaf to the downside risks facing the USD.  The approach in Washington is to focus on achieving a strong economy and as this unfolds the dollar will strengthen.  Well if monetizing the debt and blowing out the fiscal deficit is the way to achieve a sound economy and currency, no wonder there are some dollar doubters out there, including China and beyond.   

If the US is truly interested in having the world focus on the longer-term US economic potential it is high time officials at the Fed and in government (White House and Congress) develop an exit strategy and tactics from the current risky, albeit necessary, policy mix so the world can believe in a viable long-term sound US economy and currency.  So far the US roadmap out of here is as vacant as China’s calls for an alternative reserve currency.

David Gilmore


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