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Friday April 21, 2006 - 12:24:11 GMT
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Forex: G7 Goes NIMBY On Weak Dollar Call

Maybe it is a sign of years in the market, but veterans like myself feel that G7 meetings at times marked major turning points in currencies, and behind activist policies agreed to by finance ministers and central bankers (more the former than the latter).

But the last meaningful G7 meetings (that moved the dollar) were in September 2003 in Dubai and in February of 2004 in Boca Raton when the yuan was causing concern for monetary authorities. Here we are some 26 months later and the yuan is still a problem. The difference this time is that the global imbalances that China contributes to via cheap exports is an even larger problem. It has become unsustainable...well the consensus thinking from finance ministers to central bankers to academic economists to currency and bond traders. Moreover the longer the adjustment process is delayed, the greater the risk of a disorderly outcome...Iceland and New Zealand this year offer a glimpse of what the US$ could experience unless adjustment starts soon.

Enter the IMF. With finance ministers, led by the US Treasury, calling for reform at the IMF and a beefed up currency monitoring and remediation function, Director Rato and his staff have done what G7 has to date avoided...gone on record calling for the obvious...a lower dollar (orderly decline). G7 can't agree to a weaker dollar because the Treasury worries that it is a slippery slope and could ignite a much more rapid move down than desired. European finance ministers say not in my back yard. The weakness in the dollar from 2001-2004 was born by the euro, not the yen. And 2006 looks like deja vu. So why should Europe agree to a weaker dollar when Japan's currency is at a record low versus the euro? French Finance Minister Breton implied this Wednesday in a Bloomberg interview. Japan meanwhile also uses NIMBY by pointing to the undervalued yuan. Why should it risk losing market share in Asia by endorsing a higher yen versus the dollar which implies a higher yen versus the yuan?

Then there is headwind to be concerned about from record oil price, though a weaker dollar would offset some of this pressure for Europe and Japan. And let's not forget what record oil does to the US external deficit.

But Rato was right - the days of G7 currency accords are long gone. However, the notion that officials ignore misalignments like an overvalued dollar is untenable when global imbalances are so severe. Think about it - developing world is financing US consumption. China, OPEC and Russia need investment, not US Treasuries. When the third world is financing growth in the first world something is wrong. Yes US savings are dreadfully low - baby boomers will by necessity work well into their 70's if not beyond to pay for a lifetime of consumption. But Chinese reserves approaching $1 trillion is equally distortionary. Rato (and just about every respected academic macro economist) believes that the longer the adjustment process is put off, the greater the risk of a disorderly outcome.

I would argue that G7 has to think globally and act locally and waiting for markets to get it will be too late and we will enter the most significant unwinding of asset prices since the 1930's. The stakes have not been higher in my lifetime and yet the Group of Seven can only hope and pray that the adjustment process starts on its own and remains orderly. Talk about a buried head in the sand.

My concerns are indeed high, my expectations however are low. It is quite probable that on Friday G7 does nothing new on global imbalances and the dollar. And it is also probable that the dollar recovers a good deal of its declines in the last week and we slip back to range trading. But then again, G7 could empower the IMF as the new watchdog of FX and in doing so implicitly endorse the WEO which has this one right. It is a tall order from an organization that has evolved into little more than a ritualistic photo op and asleep at the wheel as a global financial storm gathers on the horizon.

David Gilmore


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