Tuesday, October 19, 2004

In comments yesterday, calmo asked a good (set of) question(s):
"Instead the real risk is that private capital starts pushing the dollar down, daring the central banks to rescue it."

What do you have in mind here? Heavy fx bets against the dollar? China and Japan are the central banks that are creating an artificially high dollar --the current rescue, no? The withdrawal of private capital would be met with further support from these 2 sources, no?
Except for a brief hiccup here and there, foreign central banks are indeed charging ahead in their tireless quest for dollars. They have net purchased US treasuries for 12 straight months and 22 of the last 23 months. Purchases were especially high in the first four months of 2004 when foreign central banks bought net $99bn in US treasuries. Much of that was thanks to the Bank of Japan which spent some �15 trillion to prop up the dollar, following on the �20 trillion spent in 2003 to do the same thing.

Thus as of August 2004, Japan was the #1 foreign holder of US treasuries, at $721.9bn. China (including Hong Kong) was a distant #2 at $221.7bn, and the UK in show position at $134.8bn.

The question most interesting to me now is not so much whether Japan and China are willing to prop up the dollar, but whether they are able to do so. In short, what is the ceiling on Japanese and Chinese currency intervention? Particularly (as suggested by the August data) if private capital is no longer an ally of the Asian central banks helping support the USD, but an adversary trying to push it down?

Back in early April The Economist was asking the same questions:
"THIS intervention is stupid," said Fumihiko Igarashi, an opposition politician in Japan�s lower house of parliament. "It�s a fight we can�t win." Indeed, on the day he spoke, Wednesday March 31st, the Japanese monetary authorities ceded one round in their fight with the currency traders. They watched the yen strengthen past �105 to the dollar, having intervened furiously in the markets only last month to keep it from crossing that threshold. The defeat became a rout as the yen pushed on to reach a four-year high, at �103.4 to the dollar. . . .
As it turns out, early April was the high point for the yen against the dollar, which is now worth around �109. Perhaps the BOJ really did defeat the currency traders. But at what cost?
Japan�s deflationary dilemma is the converse of this: not enough money, chasing too many goods. The Bank of Japan is doing its best to fix the first part of this problem, flooding the banking system with reserves. But as Andrew Smithers, an independent financial analyst, points out, this policy is fraught with difficulty, because one never really knows how much money is enough. The right amount will vary as the economy grows, and as the demand for money fluctuates. . . . In an ideal world, he says, the ministry would go on selling until the currency was thoroughly debauched and the economy decisively reflated.
This analysis suggests the Japanese appetite for USD may really be infinite. The end of Japanese deflation is the most likely dinner entree to satiate the Bank of Japan. As Smithers points out, Japan could use to reflate its economy, and printing trillions more yen is a way to do it. If inflation returns to Japan, printing infinite amounts of yen suddenly has domestic costs that the BOJ won't be willing to pay if currency traders decide to start pushing down the dollar. While the high price of oil is driving producer-level inflation in Japan, it still cannot break through into retail prices, mostly due to big wage cuts pressing down domestic demand. Something to watch.

For my $0.02, the real risk of being unable to support the dollar is located in China. While Japan's appetite while in deflation may be infinite, China's is not. Massive growth in the Chinese money supply and the incomplete sterilization of its reserve buildup means fuel for Chinese consumer inflation (which remains high), commodity inflation and asset bubbles. Just as deflation is acting as an appetizer for Japan, inflation will limit China's appetite in the face of currency traders determined to push the dollar down.

Also in comments, fatbear wondered whether a little rerun of petrodollar recycling might be in store. In the 1970s the oil producers, rich off of quadrulpled (and then octupled) oil prices, poured huge amounts of money into developing countries which then found themselves in a nasty debt crisis in the early 1980s when the oil market crashed and US interest rates went through the roof. If Japan and China decide to opt out of Bretton Woods 2, will OPEC be our new sugar daddy?

Certainly OPEC, which prices oil in dollars, doesn't want to see their (and our) currency take a spill. But are they rich enough to float our massive debt needs? As of August 2004 OPEC owns only $43.1bn in US treasuries, and so far they have put none of their oil windfall into propping up the dollar (in November 2003, at the start of the oil price rise trend, OPEC owned $42.8bn). Without the ability to print money with infinite reckless abandon, I don't think we can count on OPEC.

So, after all these paragraphs of analysis, let's hear three cheers for Japanese deflation!!

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