Dollar fall heralds a tough year ahead for emerging markets, says Economist Intelligence Unit
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Emerging Markets

Dollar fall heralds a tough year ahead for emerging markets, says Economist Intelligence Unit

EIU Country Risk Alert - December 1st 2004

OVERVIEW

The Economist Intelligence Unit today discusses the weakness of the dollar and the implications that it has for the US trade and current account deficits, US Treasury yields and the outlook for the world economy in 2005. Our view is that further depreciation of the dollar is prospect, accompanied by a rise in US Treasury yields and a softening of US demand. This will contribute to a gradual unwinding of global imbalances over the medium term. However, there is a risk that the decline in the dollar could become disorderly, triggering a larger than expected rise in US Treasury yields and a sharp slowdown in US demand. This scenario would exacerbate problems of excess capacity in the world economy, given the central role played by the US in sustaining global demand in recent years. It would also create strains in the world's financial system owing to the large stocks of US Treasuries and other dollar assets in the hands of foreign central banks and commercial banks.

ANALYSIS

While it is dangerous to read too much into short-term movements in the foreign exchange market, the intense downward pressure on the US currency since late October appears to mark a new phase in the dollar bear market following a respite in the second and third quarters of this year. The dollar is being sold on foreign exchange markets because of concerns that the US will struggle to finance its large current account deficit, which we estimate will reach around US$640bn (5.5% of GDP) this year. These concerns are overshadowing factors which would normally be considered supportive of the dollar: stronger economic growth in the US than in the euro zone or Japan and clear signals from the US Federal Reserve that further monetary tightening is in prospect.

Recent comments by US officials have persuaded financial markets that the US administration favours a weaker dollar. The US Treasury secretary, John Snow, who is responsible for foreign exchange policy, while maintaining the "strong dollar" rhetoric of his predecessors, has made it clear that he is against any attempts to intervene in the markets to support the dollar. Alan Greenspan, the chairman of the Federal Reserve, who rarely comments on the foreign exchange market, has warned of the risk of financing constraints if the US current account deficit does not ease. Mr Greenspan's warning is particularly revealing, as in the past he has tended to stress the depth and flexibility of US capital markets.

Statements by officials in favour of a weaker dollar undermine a view expressed by some academics recently that the US current account deficit is not a problem and provides an necessary outlet for excess savings in the rest of the world-particularly Asia. They argue that the current equilibrium-supported by managed exchange rates in Asia-represents a reprise of the fixed exchange rate system that contributed to global stability in the post WWII era up to the early 1970s and is sustainable for the foreseeable future. But this ignores the fact that the status quo may not be politically acceptable to the US given the threat it poses to jobs in the tradable sector and the growing level of net foreign claims on the US which are now equivalent to more than 25% of GDP.

As was the case in 2003, the euro has borne the brunt of the dollar's recent fall. This has provoked calls for intervention from some European politicians. But Claude Trichet, the governor of the European Central Bank (ECB), while complaining of abrupt movements in the dollar:euro rate, has refrained from any suggestion that the ECB will intervene to support the dollar. Recent comments by officials at the Bank of England and Bank of Canada have indicated that they expect further dollar depreciation. Episodes of intervention to prevent the dollar's fall from becoming a one-way bet cannot be ruled out, but the remarks made by these officials suggest a growing consensus about a further decline in the value of the dollar.

Yet it is the attitude of officials in Asia to the value of the dollar which is arguably most crucial, for two reasons. First, it is with Asia that the US runs the bulk of its trade deficit (US$352bn of a total deficit of US$581bn in 2003). Second, managed foreign exchange regimes are widespread in Asia, either in the form of dirty floats (with central banks typically intervening to hold down the value of the local currencies) or formal pegs to the dollar, most importantly that operated by the Chinese authorities. This policy of currency management has seen Asia's foreign exchange reserves almost triple from US$825bn at the end of 1999 to US$2.4trn. Around four fifths of the total are estimated to be held in dollars, of which a large part in US Treasuries. These dollar purchases have played an important role in financing the US current account deficit in the face of a decline in private capital inflows since 2001.

The Bank of Japan has confounded expectations and let the yen dollar rate fall below Y103:US$1 without intervening. This contrasts with its behaviour in the period between January 2003 and March 2004 when foreign exchange intervention operations authorised by the Ministry of Finance amounted to Y35,256bn, equivalent to around US$315bn at average exchange rates. The lack of intervention has led some to believe that the Japanese finance ministry believes that the economy is now sufficiently robust to cope with a stronger yen, despite recent data pointing to a sharp deceleration in economic activity. However, Japanese officials may also be reluctant to add to their existing stock of US$820bn of foreign exchange reserves amid a growing consensus on further dollar weakness and the risk of a rise on US Treasury yields. Such a combination would leave the Bank of Japan with large revaluation losses on its balance sheet.

The Chinese authorities have said that they will not be hurried into any change in the dollar:renminbi peg, either through a widening of the trading band or a shift to a peg against a basket of currencies. They are cautious about moving off the peg because of the weak state of the financial system and fears that any adjustment in the exchange rate would simply attract more speculative inflows betting on further revaluation. But maintaining the peg also carries risks for China's financial system, as the accumulation of dollar assets creates excess liquidity which banks have channelled into investments offering sub-market rates of return. This has contributed to problems of excess capacity in some sectors. Despite the denials from the Chinese authorities about a change in the peg, a 5% revaluation of the renminbi has been priced into non-deliverable 12-month forward contracts on off-shore markets in recent weeks.

Elsewhere in the emerging world, expectations of further dollar weakness have been reinforced by the actions and statements of some central banks. The Russian Central Bank is reportedly considering increasing the share of euro assets in its foreign exchange reserves. And the Indian government has announced plans to earmark part of its foreign exchange reserves to invest in public infrastructure. There have also been reports that some OPEC countries favour switching to euros for part of their oil export earnings. While it would be premature to say that the dollar's role as the world's reserve currency and preferred means of transaction is under threat, this is evidence that the capacity or willingness of central banks to absorb more dollar assets may be reaching its limit.

If Asian and other central banks do cut back their purchases of US assets and private investors do not fill the gap, there appears little to stand in the way of a further decline in the dollar. However, it is far from clear how much impact this will have on the US current account. This is because import demand in the US is much more responsive to changes in domestic demand than the exchange rate. This is illustrated by the US' bilateral trade deficit with Western Europe which has widened since 2001 even as the dollar has fallen by one-third against the euro. Also, given that the US import bill far exceeds export earnings, very large changes in their respective trends would be necessary for the trade and current account deficit to start to narrow. The implication of this is that global imbalances are set to persist even with a lower value for the dollar unless US demand weakens significantly and savings rise from current, very low rates.

The Economist Intelligence Unit is forecasting that US growth will slow to 3.2% 2005 from 4.4% this year. However, we believe that risks to this forecast are skewed to the downside and that any benefits to the US economy from a more competitive exchange rate could be outweighed by monetary tightening. Domestic demand could also be curbed if the government delivers on its pledge to cut the federal deficit in half by 2008. The Federal Reserve has warned that further increases in short-term rates are in prospect. Yet this has not been priced into the bond market where yields on 10-year paper are currently around 4.3%. So far US Treasury yields have proved remarkably resilient both to the start of the monetary tightening cycle in the US and to the downward pressure on the dollar. But there is a risk that yields could rise sharply in the coming months, particularly if foreign official purchases of US Treasuries diminishes. It should be borne in mind that central banks might not have to sell any of their large holdings for this to occur. Simply slowing the rate at which they increase their holdings would have the same effect in the absence of an offsetting increase in appetite from the private sector.

Even under our central scenario of an orderly decline in the value of the falling dollar, the global environment is likely to become more testing for emerging market credits in 2005. The pace of world growth will slow. Financial conditions will become tougher as the monetary tightening cycle in the US proceeds and the proportion of revenues which governments have to allocate to interest charges could be significantly higher than budgeted for. Also, a possible downturn in investment in China could create an adverse terms of trade shock for commodity producers. However, if the decline in the dollar becomes disorderly and turbulence in the foreign exchange market spreads to other asset classes, a sell-off of emerging debt could be in prospect. With the spread on the Emerging Market Bond Index now around 380 basis points, tighter than that prevailing prior to the emerging market crises of 1997-1998, emerging market debt is far from adequately pricing in these risks.

THE BOTTOM LINE

Financial markets are becoming increasingly concerned about the US current account deficit and possible financing constraints. US policymakers appear to favour a decline in the value of the dollar, particularly against Asian currencies. This is a necessary but not sufficient condition for the US current account deficit is to narrow to more sustainable levels from the current level of 5.5% of GDP. Concerns about financing may therefore persist. This could create the conditions for a disorderly decline in the dollar, in which other asset markets, notably US Treasuries, sold off. A sharp back-up in US Treasury yields would push up the US savings rate but at the cost of a slowdown in US demand. This combination would create much more challenging conditions for emerging markets in 2005-06. We would expect a partial reversal of some of the improvement in credit ratings which has occurred during the cyclical global upturn and extraordinarily favourable financing conditions of the past two years.

END


Contact:

John Bowler

Director, Country Risk Service

+44 (0)20 7830 1107

johnbowler@eiu.com

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