Friday, November 30, 2007

If it makes it as a publication cover, the move is over


There is the old adage that if an investment story makes it as a cover of a business publication its trend is over. Well, the Economist came out with its cover for the week highlighting the panic of the dollar. What happened today in the currency markets? We had the strongest dollar rally in the last two days since the beginning of the credit crisis. While I still may not be convinced that the cover story adage is worth committing capital, markets do move to extremes and see rebounds. After a strong month, this may have been the time for a small dollar rally.

Surprisingly, the dollar rally has come at the same time as the US economic news has been poor and the Fed has been telegraphing another rate cut. One would expect that the dollar would further decline on the expected further decline of US interest rates but other factors seem to be in play. The dollar rally has been matched by a significant sell-off in crude oil. Crude and the dollar have seen a negative correlation in 2007, so an almost $10 per barrel decline may be the best tonic for an anemic dollar.

Wednesday, November 28, 2007

Carry trades and volatility –

Carry trades have declined with the increase in interest rate volatility. This relationship is actually predicted when tests of unbiased forward rates are adjusted for changes in volatility. One of the empirical relationships which have driven carry trades is the fact that the forward rate is a biased predictor of future spot rates. Given the strong evidence of this bias, there is a strong level of confidence with the doing carry-type trades. However, recent research from the Koopmans Research Institute suggests that the results that reject uncovered interest rate parity are themselves biased by the differences in volatility of interest rates.

http://www.uu.nl/uupublish/content-cln/06-162.pdf

The result of the research by Hadzi-Vaskov and Kool show that uncovered interest rate parity cannot be rejected during those periods when the anchor interest rate is highly volatile. This could simply be a result of the estimation procedures used but previous researchers, but I would suggest that it is also related to the fact that investors do not want to undertake carry trades during periods of high volatility. The risk from holding carry trades is higher so there is less pressure pushing rates away from uncovered interest rate parity.

Currency overshooting and the overvalued dollar


Currency overshooting was a key area for policy discussions and research concern in the 1970’s and 80’s by government officials and academics. The concern especially in the 1980’s was the significant overvaluation of the dollar in the mid-1980’s. These wide deviations from fair value were the main reasons for the Plaza and Louvre Accord for coordinated central bank intervention. It was believed that the deviations could not be solved without coordinated activity. The talk of overvaluation of the dollar and coordination is again evident.

The figure from Bank of America shows the size of deviations from fair value for the dollar relative to a basket of developed countries. There has been a significant change from overvaluation in 2000 to the current undervaluation. The Bank of America data does not show the dollar to be at all time extremes; however, it has levels which suggest that a revision is much more likely. Nevertheless, one of the problems with finding the fair value of any currency is that there is no consensus on what is fair value. Most banks will use multiple models to determine the deviation from fair value, so, at best, we can say there is a tendency for movement from equilibrium but we cannot say the amount of deviation with any precision.

We can see why there has been a recent strong dollar decline by using a classic overshooting model. The most widely used model of currency overshooting is based on the idea that exchange rates see more volatility as a response to some monetary shock because prices for good are relatively sticky. For markets to clear, there has to be an over-reaction in exchange rates. Some of the recent move down in the dollar is consistent with the Dornbusch sticky-price overshooting model. The Fed has increased money in response to the credit crisis. This monetary shock, it really was not expected before the credit problems of August, caused short-term rates to decline and led to a depreciation of the dollar. We can see that real rates have declined relative to the rest of the world and the dollar depreciation matched the change in real interest differentials. While these links are not perfect, the recent dollar decline should not be overly surprising.

Tuesday, November 27, 2007

Fixed income sending bad news signal

Market prices convey signals on what investors are thinking. In the bond market, fixed income traders are not happy. Look at money markets. Short-term LIBOR rates shot up during the credit crisis in August but moved down after action taken by the Fed and a general perception on the limited extent of the crisis. However, credit crisis uncertainty has not abated. The crisis has lead to continued write-downs of CBO’s and a lack of liquidity in the commercial paper market. LIBOR rates are again on the march upward. The spread between Fed funds and LIBOR has actually increased and now moving back to the highest levels since August. Now it is natural that the spread will increase after a Fed action. LIBOR will usually follow Fed funds and not lead the rate, but currently, short-term LIBOR spreads are moving higher on growing credit risk. There seems to be special concern about the year-end turn.

The Treasury curve is signally a significant slowdown in growth. The curve changes have not been driven just in the front-end but have been a general parallel shift down in rates. Treasury yields are actually lower than Fed funds across the board which is out of the ordinary. By this standard, the Fed is actually tight with monetary policy. Put another way, the fixed income markets have a significantly less rosy picture on the economy than anything that is being forecasted at the Fed. We know that the Fed has a relatively rosy picture because their latest forecast as part of the new transparency does not show any recession but just growth below trend for the next two years.

The Fed has responded with a temporary injection of funds of approximately $8 billion which is similar to recent action taken. The objective is to ensure liquidity through the end of the year. Year-end volatility may be especially large this year because of clean-ups of the balance sheet. More Fed action will be needed to alleviate fears in the fixed income market.

Monday, November 26, 2007

China and India as global drivers

China and India are more important than ever within the global economy. With the US starting to slowdown, these countries will now be the global growth engines for the rest of the world. But, the importance of these countries even within the United States because of their job impact on the domestic economy. The outsourcing of jobs is a major domestic policy issue especially if the unemployment rate is rising. While there has been discussion of outsourcing and talk of trade restrictions, there have not been any specific policy actions to reduce the flows in human capital. Finally, the international fiancé implications from savings imbalance are significant especially with respect to China.

So how do you get to know the economics of these countries and the key economic issues? One of the best books on the topic is The Elephant and Dragon: The Rise of India and China and What It Means for All of Us by Robyn Meredith, a well-respected business writer. She makes a balanced presentation on the positive and negatives of the global impact of these countries on the United States and the rest of the world. Meredith does not argue solely for free trade not does she suggest that barriers need to be in place to stop globalization.

China and India are not the same. Their government policies are different and the areas of growth by each have been different. China has become the manufacturer of the world while India has transformed itself into an IT service center. China has been able to build the infrastructure to produce gains in manufacturing. India has not matched this capital expenditure. These are complex countries that cannot be easily described in the same manner.

The continued decline in the dollar and the slowing of the economy is going to make relationships with these countries all the more vital for overall global growth.

Friday, November 23, 2007

New Fed format does not forecast recession

The Fed has provided its new US economy forecasting format. This forecast will be presented to the public four times a year. The increased level of information is an effort by Chairman Bernanke to enhance the transparency of the Fed. The new format is easy to read and provides detailed information on the dispersion of forecast opinions within the Fed. The dispersion of opinion is useful information on whether there is a consensus within the Fed.

http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20071031.pdf

Without making a value judgment on the quality of the forecast, the reader can see a Fed with a central forecast of slower growth in 2008. Growth is going to be below trend for the next two years, but there is no suggestion of a recession. Inflation is expected to moderate to levels which are at approximately the Fed target of 2 percent. There are clear differences of opinion with more risks to the downside for the economy, but there is a view similar to those expressed by private economists of a “Goldilocks” economy of slow growth and controlled inflation. However, that was the consensus pre-credit crunch. Clearly, it is hard to get an economy to show negative growth. The US economy is more diversified than in the past so there usually are some sectors which will take up the slack of underperforming industries or regions.

There is no financial doomsday for this economy from a credit crunch; consequently, Fed cutting interest rates ahead of the curve does not seem to be in the cards. There seems to be a significant disconnect between what Wall Street economists are thinking and the Fed. The bond markets and dollar are giving us a strongly different view.

Tuesday, November 20, 2007

CBO forecasts are good predictors

The Congressional Budget Office produced their economic forecasting record this month and compared its numbers with the Administration and Blue Chip Consensus from 1982 to the present. When looking at their numbers, you see an organization that does a good job of forecasting relative to the other alternatives. In fact, it is impressive that they are willing to do the self-evaluation of comparing their forecasts with other alternatives in an easy to read document. How many banks provide their forecasting record over two decades?

http://www.cbo.gov/ftpdocs/87xx/doc8713/11-14-Forecasting.pdf

While there are still errors in their forecasting especially when there are business cycle turning points and unique price shocks, the CBO does a very professional job of calling the economy and should be given equal weight to private forecasters. The CBO is worth following.

Monday, November 19, 2007

Dollar flows underwhelming

If you vote with your feet, the financial flows from the Treasury TIC report last Friday shows that global investors do not want to hold dollar assets. While the net long-term inflows were positive, the size was less than expected from survey data prior to the announcement.

http://www.treasury.gov/press/releases/hp685.htm

It is hard to use this flow data to forecast the direction of the dollar but it does provide strong confirming evidence on the dollar decline. Without new purchases by foreign investors there will be a dollar price decline. The trends are not very positive. Even with a rebound in many financial markets, foreign buyers stayed away from the US. Of course, there has been continued uncertainty over the credit markets, but this data shows that investors have become more risk averse over the prospects for US financial markets. Official net buying of Treasuries was the only bright spot. It rebounded after two negative months, but this change is a long way from saying central banks want to hold dollars.

Dollar policy dunces?


Trevor Manuel, South Africa’s finance minister and the G20 meeting host, said delegates did not play a blame game but made clear the dollar’s weakness had been hotly debated. “We didn’t give Ben Bernanke [Fed chairman] or Hank Paulson [Treasury secretary] lines to write or make them stand in the corner. That’s not the way these things work,” he said.

Sorry, but there is a lot of blame going around. The Fed and Treasury have just not been interested in a strong dollar. The cutting of interest rates is a reflection of a domestic policy focus and not a concern about the dollar. The Treasury has been involved in the credit crisis and has not commented about the dollar decline with any fervor.

The global imbalances have not been resolved from any action by the United States; therefore, the dollar has trended down. Most of the actions that would solve the imbalances would have included higher rates and slower growth. In fact, we would argue that the administration likes the lower dollars because of the strengthening of exports. A dollar decline was how the current account balance was to be reduced.

Policy dunces – hard to argue that they made a mistake except if you are a foreigner holding dollar assets.

The new dollar analysts -


When your currency is trending down everyone wants to get into the act of forecasting. The latest dollar forecasters are the presidents if Iran and Venezuela at the OPEC meetings this week-end which overshadowed the G20 summit in South Africa.

“They get our oil and give us a worthless piece of paper,” Mahmoud Ahmadi-Nejad, Iran’s president said. “We all know that the US dollar has no economic value.”

“The dollar is in free fall, everyone should be worried about it,” Mr. Chávez told reporters here. “The fall of the dollar is not the fall of the dollar — it’s the fall of the American empire.”

Mr. Ahmadinejad said that oil, which was hovering last week at close to $100 a barrel, was being sold currently for a “paltry sum.” And Mr. Chávez predicted that prices would rise to $200 a barrel if the United States were “crazy enough” to strike at Iran, or even at his own country.

“OPEC should set itself up as an active political agent,” Mr. Chávez said, addressing about 1,000 guests in a conference center by the royal quarters.

While these comments were dismissed by the moderates in OPEC, the dollar talk forces the discussion of pricing of oil in dollars. While there is not a desire for OPEC to change pricing policies, the talk of the UAE to switch away from a dollar peg should be concerning for the US. The dollar decline has been less of a major issue for US oil imports because it is priced in dollars. The real price would be ten percent higher if it was priced in euros. Of course, the rising cost of oil for countries with appreciating currencies has been blunted.

Thursday, November 15, 2007

Federal Reserve changes forecasts - is more information better?

One of the key themes of the Federal Reserve under Chairman Bernanke has been the increase in transparency concerning central bank operations. Greater clarity about policy-making should decrease the uncertainty concerning interest rates and lead to smoother functioning markets. To reach this goal, the Fed announced yesterday that it would increase the number of forecasts from two to four a year. The forecast projections will also be extended to three years from two. Along with these forecasts will be greater explanation and summaries of the numbers. There will also be more detailed descriptions of the risk concerning the forecasts

As stated in the press release, “These descriptions will provide a fuller discussion of the projections, covering not only the outcomes that most meeting participants see as most likely, but also the risks to the economic outlook and the dispersion of views among policymakers.”

The first of these new information packages will be presented on November 20th. You could not ask for a more interesting time to provide more information on Fed thinking. With the current credit and housing crisis still working through the economy, there is a lot of uncertainty on what will be the direction of growth in 2008. While there is general agreement of a slowdown, the size is still uncertain and the potential response of the Fed is also unclear.

Providing more information is a positive, but it will have to digested and discounted by the market. New information is by definition surprising and uncertain information. We also know that the quality of the Fed forecasts are not really better than what we see from other forecasters. It is not clear whether we are better off with three year projections other than we will know what the Fed is basing their decisions.

We expect there will be a strong initial market reaction to the release on the 2oth but ultimately not much change in market directions.

http://www.federalreserve.gov/newsevents/press/monetary/20071114a.htm

Tuesday, November 13, 2007

The dollar has moved to an extreme and policy-makers are not going to take it

“The dollar is our currency, but your problem,” John Connolly, Richard Nixon’s Treasury Secretary famously said. Unfortunately, the financial isolationism of times past by the United States is not going to acceptable to the rest of the world, but rhetoric will not be the solution. Financial leaders are starting to rise up and complain that the dollar decline has gone on too long.

Yesterday, Japanese Prime Minister Fukuda talked about the yen appreciating "too fast" and speculators needed to "be careful" to avoid the possibility of intervention. ECB president Trichet commented last week on the brutal move of the dollar and this should not persist. Anonymous Canadian officials are stating that they are bearing the brunt of the dollar decline and will discuss this at the G20 meetings. President Bush is “satisfied that we have a strong dollar policy” but that the market is the best place to set exchange rates. G20 meeting will be held in Cape Town this week and should have lively discussions on the currency markets, but discussions without action will not change the course of the dollar.

Does this rhetoric matter? In the short-run, yes. The talk of policy-makers will increase volatility and causes some changes in the direction of exchange rates but these changes will be short-lived. These comments may even reduce the view that the dollar decline is a one-way bet, but fundamentals will make the difference in trend. Until there is more clarity on the credit crisis and whether inflation will be controlled, the dollar decline trend will continue.

Sunday, November 11, 2007

More commodity indices – when will it stop?

Dow Jones reported the launch of a new JP Morgan commodity index. This new index will include 33 commodities and tries to reduce some of the problems that have cropped up with other commodity indices. Bloomberg also reported this week that BNP has launched a new commodity index. Right now, if you are bank and you want to be serious about commodities, it seems you have to have your own commodity index.

The new JP Morgan index tries to solve three problems, diversification, weighting, and rolls. It adds more commodities to increase the level of diversification to the index. There are more markets in it than many other indices. Given the low level of correlation across commodities, there will be a significant risk reduction from adding these markets. Second, the index has a new weighting scheme which provides for more equal weighting across the commodities. This again will increase the level of diversification in the index. There will be less depends on the energy complex. The third major feature is that the allocation within a commodity market is across different contract months which will diversify the exposure to the commodity across time. This time diversification will reduce the problems associate with rolls and issue of contango. Indices which are based on futures will underperform the spot market changes when the futures are in contango and outperform the cash market when futures are in backwardation.

The range in performance of all these indices is large. Year to date, the high return index is the Deutsche Bank liquid index which is up 37.17 percent. The lowest return is with the DJ-AIG index which is up 15.42 percent. There is over a 100% difference from the low to high return. This is a fairly large difference relative to what is seen in the equity and fixed income markets. This is due to the fact that there are no agreed upon standards for an index. Some are liquidity weighted while others are production weighted. Some have a focus on nearby contracts while others are divided across maturities. This hodge-podge of indices will become a greater problem for investors because a true benchmark has not been established.

The commodity markets need some standards for benchmarks which can be agreed upon by all market participants. This will add depth to the market and make it more acceptable to institutions. Adding more indices is not the answer.

Land reform- a key for currency reform

One of the most important current issues in international finance is the overvalued Chinese yuan. While there is disagreement on the extent of the overvaluation, there is general agreement that the Chinese currency, by not floating, is affecting the trade and capital flows not only of the United States but now Europe. Unfortunately, this is an issue that will not be easily resolved for the simple reason that a significant change in the currency rate will have a large negative impact on internal growth in China.

The high Chinese economic growth is driven by the strong export business along the coast. High growth expectations with the chance of employment are causing a mass migration from the rural areas to the urban centers. Any slowdown in growth may lead to significant civil unrest from this migration. External pressure on currency reform is not going to solve the migration problem. However, there may be alternative approaches which will help reduce some of the migration pressures.

Land reform can solve some of the problem. While there has been some movement to improve property rights, the current leasing arrangement create a level of uncertainty which leads to migration. If there is uncertainty concerning property rights there will be less desire to stay in the countryside. Property reform laws were enacted in March of 2007 but the most important step is implementation and enforcement of the laws. Laws unenforced continue the cycle of uncertainty. See http://ww.cato.org/pub_display.php?pub_id=8745 for a detailed history and analysis of land rights in China since its inception.

Property rights issues are complex, but increasing the strength of land claims will reduce the desire for many to move and will increase the growth rate of foodstuffs. The reduced migration problem and a means to reduce potential food price shocks will allow an easier transition of exchange rates to something that is closer to fair value and floating with other world currencies.

Friday, November 9, 2007

Trade balance improving

The dollar decline is having some positive effect on the trade balance. Trade balance does not change immediately, but there has been improvement. Exports are up so the trade gap is closing and the service surplus is widening. The numbers look stronger when petroleum imports are excluded. The trade deficit in good has closed by over $5 billion since a year ago because exports are up over 13% YOY. While food exports are very strong, we are seeing double digit increases in some manufacturing sectors.

Since May exported ex petroleum are up 5.66% while imports are up only 2.34%. The slowing of imports is also associated with our slowing economy but the export business is related to strong growth in the rest of the world as well as the dollar decline.

Seems like we have forgotten the strong dollar policy.

What do policy-makers tell us?

What do policy-makers tell us with their comments? Often, not much. But markets often need government officials to state the obvious to cause a reaction. Sometimes markets do not have enough confidence in the numbers to make their own decisions. Nevertheless, when Fed officials state the obvious we know for sure that they have taken note.

Ben Bernanke stated that the economy will “slow noticeably”. What does it take for a slowing economy to be noticed? Housing in the tank, oil prices near $100 per barrel, and slowing consumer sales would seem to be enough. What were the give-away signs for Bernanke? Asked about stagflation, Bernanke stated,”we don’t see anything approaching the period in the 1970’s”. This is small comfort for home owners or consumers who use food and energy.

ECB head Trichet stated “undoubtedly sharp and abrupt brutal moves are never welcome”.” This is not the type of statement that will calm markets. While the dollar move has been especially strong in the last three months, the decline should not have been unanticipated. The strong decline came with the credit crunch in August. This was the catalyst. The change has not been abrupt as much as relentless. The issue is what can the ECB do about this? With inflation moving upward, a rate decline is not feasible.

Official comments are often just catalysts for what is being displayed in the numbers. Unfortunately, there are limits to what governments can do in the current situation.

Wednesday, November 7, 2007

Portfolio rebalancing is the dollar driver

“We will favor stronger currencies over weaker ones, and will readjust accordingly,”Cheng Siwei, Vice chairman of the standing committee o the National People’s Congress.

“The dollar is losing its status as the world currency,” Xu Jian central bank vice director

While they did not state that they are moving money out of the dollar or whether there is a specific target for dollar holdings, the message is clear. China does not want to hold dollars in their portfolio. Of course, given the size of their positions, they cannot sell their holdings. The impact would be too great and the euro may not be the best alternative. Nevertheless, any cut in the Chinese dollar holdings will have an impact.

Portfolio rebalancing for strategic reasons will drive the dollar lower even if economists suggest that the dollar is currently oversold. This is a classic price pressure liquidity effect. The declining dollar trend will not change until there is evidence for a more stable dollar. That evidence is unlikely until the uncertainty concerning credit issues in the US are resolved. The additional problem is that carry trades do not favor the dollar as US interest rates decline. No change in this trend.

Tuesday, November 6, 2007

Oil prices – what supply shock?

If prices go up, demand should go down, right? This is not the case for many countries where the governments subsidize energy. Demand has moved with overall economic growth and been insensitive to the world price of crude. The combination of lower prices not attached to market movements and strong growth has caused higher demand for gasoline. The world is not facing a supply shortage but a demand shock. The current supply cannot keep up world demand. Of course, part of this problem is always supply. Capacity utilization for OPEC oil is down from its high, but if the cartel is wrong about their demand estimates, that is, there is a demand shock, there will be a spike in prices. It takes some time to increase production.

Governments are trying to put market forces back in place by raising the price of gasoline. China announced a price increase of 10% on gasoline because they are in the extreme position of seeing shortages. These shortages are not from the high price but from cut in refining. The refiners take it on the chin when crude prices rise. They buy on the open market and then have to sell at the subsidized price without being compensated by the government for the difference. You cannot make it up with volume, so you might as well cut refining production.

Most of the BRIC’s have subsidized oil prices. Nevertheless, India is also thinking of raising prices. Gasoline is subsidized in OPEC countries which have also seen significant growth. Prices of gasoline in Iraq and Iran are less than 50 cents a gallon. These drivers have not felt the pain of higher prices. (It was reported that Hummer sales in Venezuela were strong because of cheap gas prices.) McKinsey has actually concluded that if subsidies were eliminated in many developed countries the savings would be approximately 3 million barrels a day.

Market forces will allow for demand to decline and force prices down. Any changes in pricing in developed countries will cool the oil market. Look for any news of changing government policies as means of reducing the demand shock.

Monday, November 5, 2007

New commodity weights for GSCI

The new weights for the GSCI have been announced for 2008. There were few surprises accept for the large change in unleaded gas which increased 330% over last year. This will bring sizable amount of open interest to the contract as well as more trading volume especially during roll periods. Grains showed increase percentages across the board except for Kansas City wheat. Softs and live stock markets remained the same. The energy complex overall remained close to last year except for the relative change with gasoline. Gold showed a slight decrease in the metals sector.

While not the same as the issues with additions and deletions of the S&P 500, there will be an effect from changing weights. There should be upward pressure on those commodities that have weight increases and downward pressure on those with declining weights. The impact will be greatest during roll periods.

Index volume has continued to explode with strong interest across all of the major markets


Following is a table showing the commodities weighting in
percent of the total GSCI index for 2007 and 2008.
                                                                PCT        PCT
COMMODITY                                       2007       2008
Wheat ( Chicago )                                                 3.14       3.40
KBT Wheat ( Kansas )                                           1.12       0.79
CBT Corn                                                              3.27       3.30
CBT Soybeans                                                      1.79       1.84
ICE US3 Coffee "C"                                                0.70       0.69
ICE US Sugar #11                                                 1.22       1.23
ICE - US Cocoa                                                     0.21       0.22
ICE - US Cotton #2                                                0.87       0.90
CME Lean Hogs                                                   1.54       1.53
CME Cattle (Live)                                                  2.72       2.74
CME Cattle (Feeder)                                             0.62       0.54
NYM/ICE Oil (WTI Crude)                                     35.12      35.32
NYM Oil (#2 Heating)                                           5.76       4.68
NYM Oil (RBOB)                                                 1.37       4.55
ICE - UK4 Oil (Brent Crude)                                14.62      13.04
ICE - UK Oil (Gasoil)                                          5.01       4.55
NYM/ICE Natural Gas                                       7.71       7.48
LME Aluminum (High Gd. Prim.)                       3.41       3.49
LME Copper (Grade A)                                    4.05       4.01
LME Standard Lead                                        0.52       0.52
LME Primary Nickel                                       1.62       1.64
LME Zinc (Spl. High Grade)                            1.28       1.29
CMX Gold                                                      2.04       1.95
CMX Silver                                                     0.29       0.29
Source: Standard & Poor's.

Can we learn to love a bubble?

David Goss, the author of a witty short book called Pop! Why Bubbles are great for the Economy provides an alternative to all of the negative comments on bubbles. Unfortunately, there is no good way to spin the bad news from a bubble. He argues that there has been a significant amount of good which has resulted from bubbles. The capital invested has not been completely wasted but has provided powerful long-lasting effects. An interesting argument, but there is no documentation of the huge toll associated with the wild swings in asset prices and the bust when the markets fall.

He reviews the following bubbles and always found a silver-lining:

The telegraph – the country got wired (19th century version).

The railroads – the country got connected.

The financial services – the country got regulated.

The internet – the country got wired (2oth century version).

Real estate – the country got housed.

Alternative energy – the country will get fueled.

In all of these cases, the capital stock did not go away, but this growth could have been more efficient. Is there good that could come from the housing crisis? Building will not be destroyed but households have been. If the capital was placed in other areas, the pay-off would have been stronger. The down-side price of the combined housing and credit bubbles has still not been determined. We do know that it has started to help clean house of executives not minding their risks. So something may be positive from all of this.

Financial statecraft and the declining dollar

The broader policy ramifications from a declining dollar have been ignored by the Treasury department and presidential candidates. While the declining dollar seems to be having a positive impact on manufacturing exports, the financial capital flow issues are more important. The financial power of capital flows is more important than trade because it is so much bigger.

The importance of a stable dollar goes beyond the cost of financing our debt. The power of the United States around the world will decline with the dollar. A lower dollar reduces the ability of the United States to use its financial influence or policies to affect world affairs – the use of dollar financial hegemony. Another way of putting this dollar influence is as a form of financial statecraft.

Foreign governments have less demand for dollars which are declining in value, so the financial clout of the United States is reduced. The dollar decline has strained relations for all those countries which have tied their currencies to the dollar. This is having significant implications in the Middle East where the declining dollar has cause more internal inflation and financial stress. Oil is sold in dollars but imports are often in euros. The creditability of the United States in a financial crisis will also be hurt. It is a hard to have other countries accept American advice if its high current account deficits are forcing the dollar lower. Regional and bilateral solutions will be more likely where the US does not play any role in negotiations.

What is financial statecraft? A good description can be found in the recent book by Bevan Steil and Robert E Litan of the Brookings Institute in Financial Statecraft: The Role of Financial Markets in American Foreign Policy. It is the application and extension of economic policy through capital markets. Steil and Litan provide a nice table contrasting economic and financial statecraft.

Economic statecraft

Financial statecraft

Trade privileges, tariffs and quotas

Capital flow guarantees and restrictions

Trade sanctions

Financial sanctions

Foreign Aid

Underwriting foreign debt in a crisis

Regional trade agreements

Currency Unions; dollarization

Financial statecraft for the United States is important at this time because its ability to influence the rest of world through diplomatic or military means has diminished since the Iraq War. Arab countries have been hurt internally by the declining dollar. Discussions between Asian countries have increased the likelihood of regional solutions without the United States. Latin America countries have a greater desire to take advantage of stronger growth without interferences by the IMF or the United States. America's ability to use the dollar as a source of aid is hampered by its lower value in the world market. Higher growth around the rest of the world reduces the ability of the US to use the dollar to influence economic policies.

There is not much investors can do about the implementing of financial statecraft, but being aware of the greater ramifications beyond changes in price will provide a better landscape of what could happen in financial markets. Generally, the role of the dollar will be diminished and the rationale for holding dollar assets will also decline. Portfolio adjustment will cause further dollar deterioration.