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Tuesday, November 20, 2007

Brad Setser: "A Little Too late"

Brad Setser on the dollar:

A little too late, by Brad Setser: China's premier, Wen Jiabao, has joined the chorus voicing concern about the dollar's recent weakness. ... Wen certainly has reason to worry.  No one has made a bigger bet on the dollar that China's government. I personally suspect that China's state ... hold[s] around $1.2 trillion in fairly long-term dollar-denominated debt. ...

The capital loss on those dollars could be considerable.  ...[W]hat should really worry China's leadership is that the dollar is very unlikely to hold its value relative to the RMB.  After all, China's government has financed its dollar purchases by issuing RMB debt. ... Moreover, the Hu/ Wen policy of only allowing gradual RMB appreciation -- out of fear that fast appreciation would be disruptive -- largely explains why China now holds so many dollars. ...

The majority of China's dollar exposure comes from intervention over the last three years. That puts Wen in a bit of a bind. His [recent] comments were no doubt intended to tell Washington that it needs to start paying more attention to the value of the dollar. Yet domestic US conditions likely call for the Fed to cut rates to support the US economy, not raise them to defend the dollar. ...

Wen cannot force the US to direct its policy at defending the dollar's external value anymore than the US can force China to stop intervening in the foreign exchange market. He could, of course, conclude that China can no longer take the risk of holding so much of its wealth in dollars, and stop adding to China's dollar portfolio.

But doing so would truly cause the dollar's value to tumble. It would dramatically reduce the value of China's existing dollar holdings. As importantly, it would -- absent a change in China's currency policy -- also push the RMB down and push up Chinese inflation.

No wonder Wen is unhappy. ...

The US slowdown has brought a lot of latent tensions to the surface -- in the Gulf ... as well as in China. Willem Buiter is worried about a scenario where foreign demand for all US bonds -- not just demand for CDOs and riskier bonds -- disappears. ...

And, as Menzie Chinn notes, the US hasn't locked in low interest rates in dollars forever. What if the US turns out to be borrowing at what amounts to a low initial teaser rate? ...

[The] system where the Gulf, China and some other Asian economies intervene heavily in order to resist market pressure for appreciation ... is under a lot of strain. Both China and the Gulf are starting to worry about the all the (depreciating) dollars they now have to absorb to sustain the system, even if they haven't actually balked at buying those dollars.

It consequently really shouldn't be a surprise that a range of countries are now asking the US to take policy actions -- notably steps to defend the dollar -- that will reduce the strain that the system places on them. ...

In some sense, the current system seems poised at a knife's edge. ... There are a set of investors -- China's government, Japan's government, some large oil exporters and for that matter most domestic US investors -- that are significantly overweight in US financial assets. ... If those investors with lots of dollars decide that they already have to many and try to reduce their dollar holdings, watch out. ...

On the other hand, the dollar has already fallen rather substantially against most European currencies. ... At some point investors who are holding lots of euros or pounds might decide that the dollar is cheap. ...

I am not sure which outcome -- at attempt by those already over-weight dollars to lighten up, or a decision by others that the dollar already has fallen by too much against the euro -- is more likely. I can see the case for both, though the absence of any real signs of resurgent demand for US financial assets suggests, at least to me, that there is a slightly higher chance of even more dollar weakness. ...

Paul Krugman notes Brad Setser's question, "What if the US turns out to be borrowing at what amounts to a low initial teaser rate?", then says:

On the whole, I think people are worrying too much about the falling dollar. But it’s certainly true that Wile E. Coyote has looked down, and things will be very different from the way they were in the mid-00s.

    Posted by on Tuesday, November 20, 2007 at 04:50 PM in Economics, Financial System, International Finance | Permalink  TrackBack (0)  Comments (18)

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