-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

November meetings of leaders from the Group of 20 industrialized nations may not have had exchange rates on the agenda, but the notes prepared by the International Monetary Fund included some meaty foreign exchange references.

The first is the view that although the dollar has moved closer to medium-term equilibrium it “still remains on the strong side”.  The second is the (widely held) view that the dollar “is now serving as the funding currency for carry trades” which has contributed to upward pressure on the euro.

The third was the acknowledgement that the Chinese renminbi has depreciated in real effective terms and remains significantly undervalued from a medium-term perspective.  To deal with the latter the IMF prescribed the usual recipe; namely that “exchange rate appreciation would help limit capital flows” and “facilitate a shift towards domestic consumption that is needed in many emerging economies, notably those with large external surpluses”.

None of the points put forward by the IMF on foreign exchange are ground breaking.  However, the fact that the IMF judged it appropriate to outline these issues ahead of the G20 meetings is suggestive of the economic and thus political relevance of these issues.  China’s exchange rate peg is clearly at the forefront of these issues.

Also significant is the IMF’s mention of the upward pressure on the euro, which could be seen as acknowledging that the euro (along with the yen) is bearing the brunt of the dollar’s downward adjustment.  By recognising that the dollar is “still on the strong side”, the IMF may be warning that the upward pressure on the euro may have further to run.

Now that the euro/dollar is back at 1.500, the market will again begin to wonder whether at some point the authorities may act to stem the appreciation of the euro/dollar.  Intervention in euro/dollar cannot be completely ruled out but it remains a remote possibility because it would avoid the real issue.  The dollar’s decline is being driven by inflows into higher yielding markets which is unlikely to be turned around by intervention in euro/dollar as long as the market is forecasting low Fed rates and as long as risk appetite holds.  The rise in the euro vs the dollar is merely a symptom of these flows but the appreciation of the effective euro (and that of the yen) is being compounded by the fact that as the euro rises vs the dollar it also rises vs the renminbi.   At present, the effective euro exchange rate is creeping back to its December 2008 high which represents an all time high.   Rather than seek to rebalance euro/dollar, officials should be increasing pressure on China to address its policy regarding its exchange rate.

It is not just the Europeans and the Japanese that should be worried about the impact of non-flexible exchange rate policies.  The World Bank last week warned that asset price bubbles in parts of Asia are being driven by a rapid increase in equity and house prices notably in China, Hong Kong and Singapore.

The World Bank advised that policy should be tightened by “removing some of the support for liquidity in domestic and foreign currencies”.  Calls for the breaking of some exchange rate pegs within Asia are becoming more commonplace and China’s size will mean that its exchange rate policy will garner most attention.

The issue of exchange rate flexibility in parts of Asia is promising to be one of the most dominant foreign exchange topics of 2010 and President Obama’s visit to Beijing this week could kick it back into the headlines.
ResearchEMEA@forex.com

-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

The discrediting of the efficient markets theory in the aftermath of the financial crisis appears to have been accompanied with growing support for the view that rather than efficient in nature, financial markets are predisposed towards the formation of bubbles.

A bubble can simply be defined as an occurrence that begins when the price of an asset has been driven significantly above it "fair" value. According to the efficient markets theory this would not happen.

If bubbles are a natural outcome of financial market activity it is relevant to ask whether the very loose fiscal and monetary policies of many central banks and governments are presently sowing the seeds of the next bubble.

Even though the real economies of the U.S., UK, Eurozone and Japan continue to be defined by expectations of rising unemployment and falling real wages, access to cheap money has already helped restore the profitability of many investment banks.

In turn, this has fed risk appetite which is evident in the rally in stocks since the spring, increased demand for "risky" currencies and a recovery in commodities prices. Brent oil has rallied by 128 percent from its 2009 low. The ability of oil to rally despite the existence of oil supplies well above the seasonal average suggests there is already speculative element in this market which could be in danger of driving prices above their fair value.

This week’s meetings of the Federal Reserve, the Bank of England and the European Central Bank have focussed attention not so much on rates, but on the extraordinary policy decisions taken by these central banks in the wake of the financial crisis and whether conditions are ripening in favour of a gradual withdrawal of some of these policies.

The Fed last week ended its $300 billion treasury bond purchasing plan, though it will carry on buying mortgage backed securities. The Bank of Japan last week announced that it will stop buying corporate bonds at year end. The Reserve Bank of India also removed emergency support measures last week.

This week there is speculation that the ECB could announce that it will hold no more 12-month cash tenders next year. By contrast the Bank of England is expected to increase quantitative easing at the November 5, Monetary Policy Committee meeting. Supporters of quantitative easing continue to stress that the lack of clear inflation pressures suggests there is room for these plans to be extended.

However, the lack of response in either money supply or inflation indices could equally be illustrating that these plans are not having a significant impact on the real economy and are therefore no longer appropriate. The paring back of these plans are likely to have an impact on the ability of some banks to turn an easy profit and thus should rein in risk appetite and limit speculative and "bubble" forming activity.

Unfortunately, a bubble can only be truly confirmed after it has burst; a characteristic with clear destabilising consequences. If bubbles are natural phenomena within financial markets, the need for tighter regulation and ongoing reviews of processes that oversee the financial system are absolutely necessary.

This conclusion, while in complete contrast to the implications of the efficient markets theory, ties in very well with the political desire to reform the banking regulatory framework in order to protect the tax payer from future hefty bank bail-out costs. The banking landscape, while already vastly different from just two years ago could continue its transformation for years.

researchEMEA@forrex.com

-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

The U.S. dollar may have found support this week but the USD index remains at a 14-month low.

The impact of the financial crisis in drawing buyers to the "safe-haven" dollar has in effect been almost cancelled out by the healing in risk appetite. The dollar looks to have re-embarked on the downtrend that had been in place for more than two years prior to the start of the financial crisis, only now the U.S. fundamentals have arguably deteriorated further.  

Slow growth and a hefty budget deficit are likely to hamper the attraction of the dollar for some time.  That said, there is a huge invested political interest in ensuring that any further declines in the dollar remain orderly.

The weakness of the dollar has already prompted some Asian countries such as South Korea and Taiwan to intervene in order to prevent the appreciation of their currencies impacting competiveness.  This action can be viewed as a protest against the renminbi-dollar peg and a guard against losing competitiveness to China.

As the euro rises against the dollar, it is also rising against the renminbi and -- spurred on by the actions of other Asian central banks -- the chances are that it will continue to appreciate against a host of other Asian currencies.

Since the start of last year, the euro has risen by 37 percent against the South Korean won.  In recent comments, French Finance Minister Christine Lagarde stressed that she did not want to see the euro bearing the brunt of the downward adjustment of the dollar. 

The U.S. is still the Eurozone’s second largest trading partner after the UK suggesting that a move above EUR/USD1.500 cannot be welcome, but the pegging of the renminbi versus the dollar makes the downward adjustment of the dollar a far more painful experience for the Eurozone.

This is not the only objection to the renminbi-dollar peg.  The traditional objections relate to the huge US and Chinese imbalances which are evident in the ability of China to build-up huge foreign currency reserves largely denominated in dollars. 

Domestic policies which could lessen savings and promote domestic consumption are the usual prescriptions offered to China.  Higher government spending on social systems such as education and healthcare could offer part of a solution as this should limit the amount of savings viewed as necessary and boost consumption. 

Clearly a weaker exchange rate could be a significant part of the solution since this should limit export growth and promote demand for overseas goods.

Clearly China can not rush a move to a flexible exchange rate regime.  The Chinese authorities understandably fear that a quick move could prompt capital flight and undermine its banking system.  A fully convertible, flexible exchange rate must be a long term goal rather that a quick fix solution but China can expect to feel increased pressure to adjust its currency peg versus the dollar.

The renminbi and the dollar are of course linked in more ways than one.  China’s exchange rate regime can be blamed for exacerbating global imbalances which have undermined the value of the dollar.  It is ironic then that China, along with other creditor nations, now has an interest in supporting the value of the dollar in order to avoid a sharp depreciation in the value of its assets.  

Theoretically, the sudden, sharp rise in the U.S. budget deficit towards 11 percent of GDP this year, Obama’s difficulties in making progress with healthcare reform and projections for below trend U.S. economic growth at least through 2010 should be sending bond investors to run for the hills. 

The maintenance of good demand from overseas central banks for U.S. Treasury paper this year suggests that creditor central banks are continuing to play their part to ensure that the decline of the dollar remain orderly.  A move to EUR/USD1.55 may be further away than it seems.

-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

If there is one foreign exchange story that will run and run it is the one about the U.S. dollar (USD) and its future as the world’s dominant reserve currency.  The discussions on this topic have at least brought some agreement, namely that there is no clear alternative and therefore there can be no quick fix change.  That said, much uncertainty remains as to what can, if anything, eventually replace the dollar.

The basis for questioning the USD’s position as global reserve currency stems from its declining value and its "poor" fundamentals.  The dollar index is currently trading close to where it was 14 mpnths ago, ahead of the financial crisis.  At that point the USD had been on a downtrend for over two years. The widening in the U.S.’s budget deficit this year has worsened the fundamental backdrop and drawn attention to its "twin deficits".  This has made creditor nations nervous. 

So, how bad are these fundamentals?

The U.S. current account deficit this year has actually improved.  However, once the U.S. recovery gets underway, many expect to see the current account widen again.  Textbooks suggest that a current account deficit should lead to a downward adjustment in the currency which will help address the imbalance.  This is not always the case.  Australia presently has a current account deficit of around 4.5 percent of GDP and the effective Australian exchange rate has rallied by 27 percent since January 1, 2009. 

Current account imbalances, while always a potential currency negative, only weigh if international savers become less keen to fund it.  Investment decisions will be determined by other factors such as relative growth and interest rates, political stability and fiscal coherence.   A huge USD negative this year has been the widening in the budget deficit to potentially 11 percent of GDP from 4.7 percent in 2008.   This implies huge bond issuance. 

To date, Treasury auctions have been well subscribed.  While supply has not caused the USD any clear problems, budget deficits of this size inevitably imply fiscal spending cuts which could weigh on growth for years.  This suggests limited growth in addition to low short-term interest rates which is a poor currency dynamic.

While a strong budget position is highly desirable for a reserve currency it is not the only factor.  Clearly a reserve currency needs to be fully convertible.  This requirement counts out the Chinese yuan (CNY).  The ability to cope with huge liquidity demands excludes currencies such as the Norwegian krone, Australia dollar and the New Zealand dollar.  The euro (EUR) fails the criteria insofar as there is no single sovereignty.  

Some argue that differing fiscal policies in the Economic and Monetary Union (EMU) have the potential to lead to friction, while others stress the geopolitical line that the absence of a single policy on defence would for some countries mean that the EUR would be an inadequate USD replacement.  This does not mean that the EUR will not take a greater role in the coming years.  There are signs that central banks have slightly increased their holdings of EUR along with the Japanese yen (JPY) this year and this trend may continue.

Looking forward, assuming U.S. fundamentals remain poor it is feasible that talk of a basket of reserve currencies will eventually become more relevant with the EUR and the JPY potentially playing a greater role and even the CNY playing a part in the next decade or so.  However, any adjustment in central bank currency reserves will be slow and is unlikely to lead to any tangible downward pressure on the USD particularly since creditor nations have an interest in protecting the value of their holdings.  As a result, any additional USD declines are likely to remain orderly.

researchEMEA@forex.com