Are Euro Speculators Betting on the Wrong Horse?

In a 1995 report (“The Decade of The Dollar”), I called for a strong and sustained recovery of the US currency over the forthcoming decade. The dollar bottomed at the equivalent of .75 euro in mid-1995, before reversing and rising irregularly to over 1.20 euro in early 2000.

Then, in May 2000, I wrote: The dollar is about to weaken. The main question is: against what?” (See: ““Euro Weakness: It’s The Dollar, Stupid”)The US currency topped later that year at about 1.21 euro and has since retreated irregularly to about .77 euro.

So, I may be confused about the actual length of a decade, but I am not a perennial dollar bear. The only constant in this story is that my bearishness in 2000 met with as much skepticism as my bullishness back in 1995. In the short term, trend is always more convincing than common sense.

At the time of my bearish call of the dollar, I implied that it was hard to make a fundamental case for the Euro but that the dollar had to depreciate against something and that, for lack of alternatives, the European currency would likely be a main beneficiary.

Now, however, this view seems to have been endorsed by a large number of speculators. As a result, the recent slide has driven the dollar-euro parity back to the level where it bottomed out almost ten years ago. (In actual money, the dollar’s 40% drop from its 2000 high is roughly equivalent to the more than 60% gain between its 1995 low and its 2000 high). And this is exactly why I am skeptical of today’s quasi-universal enthusiasm for the European currency. The euro at $.77 seemed like a reasonable contrarian bet. After a 67%, multi-year gain, it seems like a seriously flawed fantasy.

What I believe is that the same forces that have pushed the dollar down against a number of currencies will now start directly affecting real economic activity. As we will see, this is not necessarily favorable for the euro and, as is increasingly frequent, the key to understanding coming developments and their possible consequences lies in China.

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The spectacular rise of the dollar in the late 1990s coincided with an economic boom and stock market bubble in the United States caused by massive inflows of private capital from abroad. This capital was attracted by the investment opportunities then available in America. To the extent that foreigners desired to own even more dollars than they already earned through the widening US trade deficit, the price of the US currency rose.

As all these dollars earned or purchased by foreigners came in to be invested, the US economy was boosted: in the late 1990s, America’s Gross National Product grew at a rate that would have been deemed unsustainable a few years earlier. But that growth came to be accepted as normal, presumably explained by the spectacular productivity gains brought to the American economy by the technological revolutions of the 1990s.

Since 2000 however, as the US trade deficit continued to deteriorate, foreign private investors have become less eager, not only to buy dollars, but also to hold on to the ones they earn by exporting to the United States. Foreign central banks have had to substitute for private investors as the main purchasers of dollars. Since central banks typically are reluctant participants in the foreign exchange market, they will normally buy just enough of a depreciating currency to avoid a precipitous drop. As a result, the dollar has been eroding, but relatively slowly.

The recent behavior of prices for oil, nickel, steel and other materials has taught us that Chinese demand has now become the largest single determinant of the supply-demand equation for globally-traded commodities. They buy, commodities go up: they stop buying, commodities go down.

Today, with the volume of global financial transactions dwarfing that of commercial transactions, the dollar’s fortunes are determined more by market considerations (supply and demand) than by trade competitiveness. In other words, the dollar now behaves like a commodity and whether the Chinese want more or less of it is likely to determine its future.

While still a distant second to the Bank of Japan in terms of total dollar reserves, the Chinese central bank has been rapidly accumulating dollars in an effort to preserve the fixed peg between the Chinese RMB and the US currency. Ironically, China’s overall current account is just about balanced and, in fact, on the verge of falling into deficit. But inflows of foreign capital seeking to invest in the growing Chinese economy have been putting upward pressure on the RMB and have had to be neutralized by such intervention if the RMB-dollar peg was to be preserved.

Now everyone seems to root for a revaluation of the RMB that, it is hoped, would restore balance and order to the international trading and financial system. I don’t think so. In a way, and paradoxically, I would expect economies to become more volatile as currencies become less so.

No one really knows what the ripple effects of a meaningful revaluation of the RMB might be. Global trade flows have changed so much, in recent years, that historical assumptions about bilateral economic links, loops and feedbacks are increasingly outdated.

For example, China is now the main export market for many Asian economies, and certainly the most dynamic one. This explains its balanced current account in spite of a surging surplus with the United States. A significant RMB revaluation would allow other Asian economies to let their currencies appreciate against the dollar, though less than the RMB. On balance, this would boost the purchasing power of their consumers, while allowing their exports to still benefit from increased consumer spending in the Chinese market.

This is likely, not only for low wage countries, but also for Japan and Korea, whose products, I am told, are now considered particularly “cool” by young Chinese spenders. The budding Asian economic bloc would be significantly reinforced, with a possibility that it would eventually become much more independent from fluctuations in the European and American economies. Some observers believe this to already have happened, but we won’t know for sure until America or Europe sink into a recession. Let’s not be in a hurry to find out.

At the same time, it is not at all clear that even a large RMB re-valuation would help the bi-lateral trade balance between the United States and China as much as expected. Of course, there would be some selected market share gains and, indirectly, US exports to the rest of the region would also benefit. But for many of the things that China sells to the United States, there are practically no US domestic manufacturers left, so that those US imports would decline only marginally. Note that for most products assembled in China, the labor content is very low (often 5% or less of total costs), while important costs, such as materials, are often linked to the dollar. 

As for US exports, they are not particularly sensitive to China’s consumer spending (except, perhaps, for jets sold to Chinese airlines). This is especially so since many “US” consumer products sold in China (soft drinks and toiletries, for example) are already manufactured locally by subsidiaries of US companies. American multinationals will benefit, but the American economic activity will do so much less directly or immediately

It is even harder to imagine how a revaluation of the RMB could benefit European trade. Europe’s export gains will be held back by some of the same factors that should limit improvement in the US trade balance, but Europe will also have to deal with the additional burden of a currency that has been revalued against that of the United States, its main trading partner. Our guess is that any benefit that might accrue to Europe from increased exports to China would largely be offset by losses in the US market – as well as in markets where European exports compete directly with American ones. For example, one wonders how many of Airbus’s recent commercial successes against Boeing could have been achieved with the Euro at $1.31.

So, I find it ironic that the Euro has been, to such an extent, the main “beneficiary” of the recent wave of speculation against the dollar.

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Then, there is the question of capital flows. If the Chinese RMB were revalued, the Chinese central bank would not need to intervene as aggressively in support of the US currency, and its purchases of dollars would be cut back accordingly. At the same time, Japan and the other Asian countries for which the Chinese market (rather than the American one) has become the single most important engine of growth, would also feel freer to let their currencies appreciate against the dollar – as long as they did so less than the RMB. They, too, would likely reduce their purchases of dollars significantly.

In other words, a revalued RMB and its ripple effects on other Asian currencies would result in drastically reduced capital flows into the United States. This could only be avoided if private foreign investors returned to the United States on the scale of the bubble years. At the moment, it seems highly unlikely that they will see enough new investment opportunities to do so – especially if the US economy seems to be entering a period of slower growth.

With less investment dollars flowing in from abroad, the US balance on current accounts would have to self-correct. Some of this would accrue through better exports but the rest would have to come from lower domestic consumption, which would cut America’s imports from almost every other country. Asia has a chance to keep growing on the momentum and potential size of its domestic consumption, but Europe is likely to be hurt on balance.

Keeping in mind that the world’s two economic locomotives – the United States and China – are likely to experience current account deficits for a number of years to come, they will jointly act to sop up a significant portion of global liquidity.

The evolving shape of world growth should enhance, rather than reduce, the attraction of Asia for private foreign capital.  As for America, it will likely continue to attract a large chunk of the world’s institutional capital – possibly at the cost of higher interest rates – because most central banks are willing to see it continue to slide, but no one wants it to crash.

In all this, the risk for Europe is to become marginalized in the next several years. With fewer opportunities in Asia than its Asian competitors, weakening export markets in North America, fiscal policy constraints and rigid labor markets at home, and a central bank that is stubbornly Euro-centric, it is unlikely to attract sustained foreign investment on a large scale.

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The puzzle of the evolving global trade and financial system contains too many parts to even attempt to outline a coherent scenario for its evolution. Uncertainties and potential surprises abound – including the possibility that the Chinese RMB will not be significantly revalued any time soon. Nevertheless, experience has taught me that, in times like this, it is better to be a cautious contrarian than a bold trend follower.

 At current levels, Europe’s currency increasingly looks like a sterile bet, at best.

François Sicart

November 27, 2004
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