By
Scott B. MacDonald
NEW
YORK (KWR) -- Foreign exchange markets had an interesting
2003 and it appears that 2004 will perhaps be even more
challenging. The combination of U.S. economic policies
and improving European and Japanese economic performance
add up to an ongoing downward track for the U.S. Dollar.
We expect a soft landing, but clearly recognize there
is a risk of a hard landing, especially if protectionist
sentiment is not controlled. China remains a potentially
disruptive X-factor. The Bush administration’s
backing down on steel tariffs was an important step in
avoiding a costly trade war with Europe and Japan and
helps to maintain a gentle downward trajectory – at
least for the short term. Trade tensions, however, continue
as reflected by the Bush administration’s tariffs
on Chinese textiles and its search for other measures
to protect the domestic steel industry.
For the Yen/Dollar, we look to 105-108 over the next 6-8 weeks. The primary
pressures on appreciating the Yen are a weak dollar policy on the part of
the Bush administration, no increases in U.S. interest rates in the near-term,
and improved sentiment about the Japanese economy. In the recent Tankan report,
Japanese business sentiment was at its highest level in six years, indicating
a sustained improvement in headline sentiment. At the same time, the Bank
of Japan is likely to maintain a rearguard action opposed to the Yen rising
too quickly. In 2003, the Bank of Japan sold a record Y17.8 trillion ($165.2
billion) in an effort to slow the Yen's appreciation. A few billion more
Yen is likely to be deployed in the weeks ahead if it appears that the dollar
is set to fall further. If these trends continue, there is talk that the
Yen could strengthen to 100 by year-end 2004.
The dollar/Euro relationship has also been one of dollar depreciation. While
the Euro was initially a weak currency with a questionable future, it has
steadily gained in strength as the dollar declined. Thus far, the dollar
has declined 17% in 2003 against the Euro (now trading around $1.23). We
think the dollar could weaken to $1.30 per Euro by mid-2004, perhaps sooner.
There is even some speculation that the dollar could weaken to $1.40 by year-end
2004 if present trends continue.
While a weaker dollar (pushed along by a soft landing policy) is helpful
in bringing the U.S. current account down to more prudent levels, current
trends in international currency markets carry a number of risks. First and
foremost, the combination of a weaker dollar and no increase in interest
rates is likely to make investing in United States financial instruments
less attractive (which reinforces our earlier view of a growing chance that
the Fed will act before the summer). The U.S. needs foreign investment flows
to help pay the current account imbalance.
Secondly and equally important, a rapid strengthening of the Euro and Yen
will not be a help to the economic recovery of either Europe or Japan. In
both cases, economic growth is sitting heavily on the slender pillar of exports.
The Euro is more vulnerable than the Yen because the Bank of Japan is much
more willing to intervene. Hiroshi Watanabe, head of the Ministry of Finance's
international department, stated late last week that the government is "looking
to stablize the currency in the range of 108 to 110 to the dollar." All
things considered, we look to a weaker dollar and strong Euro and Yen in
the weeks ahead.
A more medium-term concern is China. Asia’s largest country has emerged
as the workshop for the world, pegging its currency, the Remnimbi, to the
Dollar, the currency of its major trade partner. China is clearly in a sprint
to make the transformation from a backward agricultural economy into a modern
industrial power, a process that began in earnest in 1978 and is still continuing.
While Beijing is seeking to pull China up the economic ladder, part of the
cost is being carried by the United States, where consumers eagerly buy cheap
Chinese-made products, pumped into retail distribution outlets, such as WalMart.
Where U.S. consumers benefit, U.S. workers in the manufacturing sector suffer – some
2.6 million jobs have been lost in the United States over the last three
years. This loss has been largely attributed to China’s low costs and,
increasingly, an undervalued currency. It has been said more than once among
U.S. labor unions: “Not everyone wants to work at WalMart.” In
response, Washington has put China under pressure to appreciate the Remnimbi
by imposing tariffs on textiles and trade issues are always a topic of conversation
during high-ranking government-to-government talks.
What complicates matters for foreign exchange markets is that China is also
a major holder of U.S. treasury bonds and government agency paper (i.e. Fannie
Mae and Freddie Mac). If the U.S. pushes too hard, China could feel compelled
to dump these securities into the market – not a net positive considering
the Bush administration’s reliance on deficit financing. In addition,
a rapid appreciation of the Remnimbi could brake China’s strong economic
growth (7.5% in 2003). This would ripple through commodity markets (not good
news for countries like Canada, Australia and South Africa), slow economic
expansion through the rest of Asia and Latin America (Brazil, Chile and Peru
are big suppliers of commodities to China), and ultimately clip U.S. exports
to China (which is already one of the world’s most significant consumer
markets). What all of this means is that the Bush administration must carefully
balance how hard its pushes for China to appreciate the Remnimbi as it reaches
out to the manufacturing heartland of America for the 2004 election and its
own medium and long-term national interests. Pushing China into a recession
could precipitate a global economic slowdown and make it more difficult for
U.S. companies to take part in the world’s most rapidly growing consumer
market.
One of the ironic twists in the globalization process is that the U.S. is
still the global economic locomotive, but China increasingly is emerging
as an interrelated partner, badly needed to pick up the slack left by the
slower moving European and Japanese economies. In foreign currency terms
this means that China’s undervalued currency at some point must adjust.
The trick is going to be exactly the same issue facing the Dollar’s
devaluation – how to find a soft landing. If China is forced to appreciate
too quickly, there is a hard landing scenario that is no one’s interest.
We do not see China appreciating the Remnimbi in 2004, but interest rates
could go up, leaving 2005 as the year of foreign currency adjustment.
The dominant theme in foreign currency markets in 2004 will most likely be
the ongoing depreciation of the Dollar, the appreciation of the Euro and
Yen, and ongoing pressure on China to allow the Remnimbi to appreciate, to
help reduce Sino-American trade tensions. The key variables will U.S. weak
Dollar policy, complemented by further appreciations in the Euro and Yen,
while the Remnimbi is likely to remain in a status quo though Chinese interest
rates could go up. If political pressures mount, which they could, the soft
landing for the Dollar could shift to a hard landing.
