Wednesday, November 24, 2004

The concrete shoes the dollar has been wearing since mid-October are getting mighty heavy today. Hopefully it's not time yet to go sleep with the fishes.
The under-fire dollar slumped to yet another all-time low against the euro in European morning trade on Wednesday as renewed oil price strength and Tuesday�s comments from the Russian central bank continued to weigh on the greenback.

Alexei Ulyukayev, first deputy chairman of the Russian central bank, hinted that Moscow would step up its ongoing policy of shifting more of its $113.1bn of foreign exchange reserves from dollars into euros. This in turn raised the spectre of Asian central banks with higher reserves still following suit.

�A move to say 40 per cent euro from possibly around 30 per cent is a notable amount and highlights the support the euro may be deriving at present when you consider other central banks may also be diversifying out of the dollar,� said Derek Halpenny, senior currency economist at Bank of Tokyo-Mitsubishi.

Neil Mellor, currency strategist at Bank of New York, raised the prospect of a potential domino effect: �Talk of central banks readjusting their reserves to encompass a greater euro weighting has been rife in the foreign exchange markets for quite some time, along with speculation that OPEC members may shift to euro-denominated oil sales.

�A dam can only take so much pressure. Russia�s stated intent to review its reserve weightings, in favour of the euro once again, could well lead to similar announcements by its counterparts across the world.�
This was always the real threat to a steady dollar decline -- that one or more major players would signal to the rest of the herd that it is time to stampede. Last Thursday I noted how, since the dollar began sliding in January 2002, the Russians have socked away $76.7bn in reserves. This makes Russia a major player indeed, although on the second tier down from China and Japan. If Russia is committed to continue swelling its reserves, then simply slowing down on their purchases of USD-denominated assets could be enough to embolden the speculators. If Russia is stabilizing its reserves, then a shift down to 60% of its holdings in dollar means it will actually be selling US T-bills, and then who knows what could break loose.

It's not only Russia that is making noise. South Korea has been selling its won for two days now, almost surely buying dollars with it. As of the end of October, the Bank of Korea had $178.4bn in reserves, by my count #4 on the global central bank reserves leader board behind Japan, China and Taiwan.

As I type, the USD is back under �103 (�102.59 to be exact) and the euro has pushed above $1.31. I've argued before that I don't think we'll see intervention by the Bank of Japan until around �100, and even then it may not be like anything we saw earlier this year. From January to March 2004 Japan spent around �15 trillion propping the dollar up above �105. Today, however,
Kaoru Yosano, policy chief of Japan�s ruling Liberal Democrat party, appeared to pour cold water on this scenario, saying: "The effects of currency intervention would only be short-lived and limited."
With the Chinese firmly committed to absolutely no near-term action on its dollar peg, it is hard to believe the Japanese will simply stand by and watch. However, this comment from Yosano may mean that the BOJ is committed only to slowing the dollar's slide rather than drawing a line in the sand which the USD shall not cross. If so, that's a dangerous game to play. Slowly pulling your finger out of the dike can invite disaster; all-out deterrence is a far better strategy.

The final piece to this puzzle is the European Central Bank. Are the export-dependent Germans willing to see the euro leap to $1.40? As Brad Setser argued a few weeks back, the Europeans may -- sooner rather than later -- get pulled (against their will) into supporting the dollar. Folks in the know think that won't happen before $1.35=�1. The ECB could even wait until $1.40=�1, but if the USD is hell-bent to sleep with the fishes, look for joint European-Japanese action to arrive just in time to save it from itself.


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