The gravity-defying dollar
By Mike Dolan
WASHINGTON (Reuters) - As policymakers put more focus on readjusting, nudging and monitoring the major world exchange rates to balance international trade flows, currency markets appear to behave in ways that confound many of them.
The U.S. trade gap gets wider but the dollar, for 14 months now, keeps rising against the world's most traded currencies.
This seems to fly in the face of conventional wisdom that says financial markets lower the value of a currency to reflect deficits in national trade accounts, helping rebalance trade flows in the process by changing export and import prices.
Yet six weeks into 2006 and after another record U.S. trade deficit of $726 billion (419 billion pounds) in 2005, the dollar is climbing again.
Despite a brief dip in January, the greenback's value against a basket of the world's most traded currencies is back up to where it ended 2005 and looks set to build further on the 13 percent annual gain it made last year.
So is the dollar defying gravity or is something missing?
Treasury Secretary John Snow on Thursday reckoned he knew.
"The fundamentals of this economy are strong and ultimately currencies' exchange rates reflect fundamentals," he said.
What exactly the economic "fundamentals" consist of, however, is never clear.
Currency analysts say data on investment flows still suggest there is enough foreign demand for U.S. assets to offset the trade shortfall and keep the dollar buoyant.
Part of this, as has been the case for years, is that central banks in China, around Asia and elsewhere persist in buying dollars to prevent a falling U.S. currency lifting the dollar price of their exports to the lucrative U.S. market.
On the other hand, traders insist they are simply more focused right now on the Federal Reserve's campaign of raising interest rates, which is boosting incremental returns on short-term dollar deposits.
"We are in a regime where we are worried about the economic cycle, we're risk-loving and are determined by short-term interest rates. The trade data doesn't matter in this regime," said David Bloom, currency strategist at HSBC in London.
But, warned Bloom: "When the deficit matters, it matters big, it matters for a short period and you get huge moves."
That's a worrying thought for policymakers wondering what will happen when the Fed stops tightening monetary policy.
There is a growing body of opinion that the relationship between world trade and national currencies has weakened in a globalized world of complex transnational business.
They caution against putting too much store in currency markets either reflecting or correcting big deficits.
Two recent Fed studies provide grist to that mill.
They both illustrated significant declines over the past decade in so-called exchange rate pass-through -- or the extent to which currency movements affect import and export prices -- across the Group of Seven most developed economies.
The upshot, they said, was that exchange rate shifts had a more muted impact on correcting trade balances.
One reason put forward for the growing impotence of currency rates in synching trade accounts is that national trade statistics disguise the real nature of trade flows.
A study by international consultants McKinsey last year showed that one third of the U.S. current account deficit results from trade with U.S.-owned subsidiaries abroad.
"The intricate web of global trade demonstrates why traditional interpretations of the current-account deficit are outdated," the report said.
This view has also gained credence in financial markets.
Joseph Quinlan, chief strategist at Banc of America Capital Management, says intra-company trade -- which exceeds 60 percent of bilateral U.S.-Germany and U.S.-Japan trade -- is highly insensitive to currency movements.
Shipping components from one plant to another is driven not by the relative value of exchange rates, Quinlan argues, but by the power of final demand for the finished product.
But there are many critics of this view, who say it is overly concerned with the old G7-based industrialized world and not the new global economic landscape including emerging economic giants such as China, India, Brazil and Russia.
Using the Fed's broad index of dollar strength, weighted against the currencies of America's biggest trading partners, the dollar has risen little more than 2 percent since the end of 2004. Heavy intervention by the Asian central banks has been the big factor preventing an outright decline.
The weightings in this index show what currencies are really important when the actual shares of U.S. overseas trade are taken into account. They show that China, Hong Kong and Taiwan together, for example, account for more bilateral U.S. trade than the entire 12 countries using the euro.
"The idea that currencies are less important to trade accounts now doesn't stand up to serious analysis," said Jim O'Neill, Chief Global economist at Goldman Sachs.
"The big U.S. trade deterioration is against the emerging economies. The dollar is under serious pressure against those currencies and intervention is holding it up," he said. "If you had a trade-weighted dollar fall of 10 to 20 percent today, you will still today see significant impact on the deficit."