US dollar and Asian devaluation hurting Europe

By Neil Behrmann

November 2007:- Alarm bells are ringing in Europe and Japan because US dollar devaluation is hurting exporters, economies and jobs. Long awaited revivals in Germany and Japan are in danger of being snuffed out.

Dollar weakness in the past four years is at last beginning to reverse the US ' trade and current account deficit by boosting American exports and lowering imports. 

Big depreciation against Europe

The US trade and current account deficits have remained at near record levels simply because of inadequate US dollar depreciation against the Asian bloc, which is the cause of the biggest proportion of the current account deficit.

Since the greenback peaked early 2002 to end October 2007,  the trade weighted dollar index of the Federal Reserve Bank of Atlanta has fallen by 26 per cent; but the devaluation against European currencies has been a whopping 37 per cent, against 16 per cent for the Asian Pacific region.  Of course the dollar could overshoot further in the short term, but it is dangerous to become a greenback bear late in the cycle.

Asian nations much more competitive against Europe

Indeed Asia , excluding Japan, is effectively part of the international US dollar bloc because currencies are carefully managed to keep China and other nations competitive with the US. The dollar has depreciated by 17 per cent against Asian Pacific currencies, including the Australian dollar, but excluding the yen. The euro, sterling, Swiss franc, Scandinavian currencies, however, have soared against these currencies.  Thus any country that is effectively a member of the dollar zone, including Middle Eastern nations and commodity producers such as South Africa, gain at the expense of Europe and to a lesser extent Japan.  Their exports become more competitive.

The EU ran a trade deficit of €128 billion ($175 bn) with China last year and this is likely to balloon to €170 billion ($252 bn) in 2007 on current trends, according to EU statistics.  Thousands of jobs are outsourced from Europe to cheaper currency Indian and Asian nations, increasing the prosperity of those regions at the expense of Europe .  Inflation should be a disadvantage for those choosing the currency devaluation route, but there hasn't been a marked increase. 

Asian currencies linked to US dollar

A fascinating paper by Stephen Jen, an economist at Morgan Stanley, spells out why an analysis of the greenback outlook should consider the global dollar zone of the US , Asia , Middle East and other nations. Virtually all of the intra-regional Asian trade is priced, invoiced and settled in US dollars, and this is not likely to change any time soon, not even with some adjustments in the exchange rate vis-à-vis the dollar, contends Mr Jen. In other words, there are ample reasons to believe that much of Asia will remain in this de facto dollar zone. 

The US trade deficit as a percentage of gross domestic product, was 6.6 per cent in 2006, but when you include the Asian bloc, the effective trade deficit, that has an impact on the dollar, is a much smaller 2.7 per cent, calculates Mr Jen.  Including Middle Eastern nations the deficit dwindles to a mere 1.9 per cent, which is easily manageable.  With countries such as South Africa and others that price their commodity and other exports in dollars, the effective dollar bloc trade deficit is even lower. Brendan Brown, London based head of research at Mitsubishi UFJ Securities International estimates that the total current account deficit has since fallen to around 5.5% of GDP or around $750 billion.  By next year, given the slowdown in the US economy and surge in exports, the deficit could shrink below 5% or around $650 billion.

Suits China and Asian nations continue to hold dollars

It can be argued that dollar zone central banks will continue to diversify and place a growing proportion of their assets in euro, yen and other currencies.  But such is the flow of dollars and size of their monetary reserves, that they are limited in what they can do. Foreign exchange reserves of the US amounted to US$38 billion at the end of 2005.  This compares with China 's official reserves of US$854 billion and the rest of Asia , excluding Japan , US$620 billion.  The Gulf Co-operation Council that includes, Saudi Arabia , United Arab Emirates and Kuwait held US$66 billion at the end of last year.

The Asian Development Bank has been investigating whether an Asian Currency Unit, or ACU, should be formed as a bulwark against a sagging greenback.  But Mr Jen believes that it will take at least a decade before that index is manageable and can absorb sizeable volumes. Like it or not there is little alternative, but for Asian central banks and other investors to keep the bulk of their reserves in dollars.  Indeed IMF figures show that in the past two years, diversification hasn't been extensive.  The greenback accounts for 67 per cent of total global central bank reserves, compared with 24 per cent for the euro and small allocations to the yen and sterling.

Big flows into euro would hurt European economies

Assume there were to be sizeable allocation of funds into the euro, the inevitable currency surge would cripple the German, French, Italian, British and other European economies, ending in a terrible currency crash and the possibility of dissolution of the euro currency bloc.  Gold enthusiasts have recommended a move into bullion, but the price gyrations of the past few weeks illustrate that the market is too narrow, relative to currency markets, to accommodate huge flows.  The same applies to emerging Asian currencies.

Dollar has fallen because of monetary & cyclical factors

The dollar has fallen sharply because of the slow down in the US economy and expectations of lower interest rates. Other factors include geopolitics e.g. Middle Eastern countries, such as Iran , deciding to dump dollars when they fear confrontation with the US. But the current account is beginning to improve as exports are rising and the slowdown is beginning to cut imports.

(See:- asset allocation research)

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