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Monday, November 26, 2007 1:16 AM


Currency Twilight Zone


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Questions about reserve currency status are being raised in Bet your bottom dollar tensions will follow.

Europe has finally had enough of America's "benign neglect" dollar policy. As a large economic area, with a floating exchange rate, the eurozone suffers most. Over the past seven years, the single currency has risen by a shocking 82 per cent against the greenback. That's hammered eurozone exports - provoking serious trade disputes between the EU and US, the world's two biggest trading blocks. No wonder French President Nicolas Sarkozy describes America's drooping dollar as "a precursor to economic war".

European leaders last week said the US currency's value now threatens the survival of Airbus - whose cost-base is in euros, but which sells planes in dollars.

But America's currency-related tensions with Europe are as nothing compared to the brewing crisis with China, Russia and the oil-rich Gulf states. As is well known, these countries - and emerging markets in general - used to run big trade deficits. Strong exports and expensive oil means they now boast big surpluses. As a result, their foreign exchange reserves have ballooned, with China controlling $1,400bn, Russia $450bn and the Arab world much more than it admits - the vast majority in dollars.

The greenback's fall, of course, is costing these countries serious money. Until sub-prime, they didn't talk about quitting the dollar - the world's "reserve currency".

But the decline has now gone so far, and the US looks so wounded, that tomorrow's economic superpowers are now "dollar divesting" - despite the fact that doing so will further weaken the currency, undermining their reserve values even more.

Reserve currency status brings America huge power. It puts the dollar constantly in demand, meaning the US can secure cheaper debts and run bigger deficits at everyone else's expense. It means weaker nations "peg" to the dollar, greatly extending America's sphere of influence.

Incredibly, this long-standing system is now unravelling. Rather than keeping their reserves in falling dollars, the new economic titans are stuffing them into "sovereign wealth funds" - which they're using to buy-up debt-distressed Western firms, African oil fields and any other canny investment they can find.

The importance of "dollar divestment" cannot be overstated. At the very least it means the greenback has much further to fall - plunging the US into recession. But it begs a bigger, more alarming, question. How will Washington react to the end of the US hegemony?
Sword of Damocles

Will Europe intervene in the currency markets? That is the question I am asking as Airbus eyes radical moves as euro nears $1.50.
Plane maker Airbus plans to introduce radical measures to prevent the surge in the euro from throttling the company. According to a report in German newspaper Der Spiegel, Airbus chief executive Tom Enders had admitted that the maker of the A380 superjumbo may face "massive losses" as the euro heads toward $1.50.

Mr Enders was also quoted as saying that the euro's strength will put future investments to "the test".

Jean Claude-Juncker, chair of the Eurogroup of finance ministers, said this week that the dramatic rise in the currency since August had begun to inflict damage on vulnerable parts of the 13-nation bloc.

"We deplore the sudden changes in the exchange rates. We will be keeping a very watchful eye on the exchange rate markets,' he told the European Parliament. Mr Juncker is leading an EU troika to Beijing next week to pressure the Chinese authorities into speeding up the glacial pace of yuan revaluation.

Louis Gallois, head of EADS, said: "My main concern for the future is the weakness of the US dollar. "It is a sword of Damocles hanging over our heads and it is a fantastic handicap against our only competitor in commercial aircraft," he said, alluding to Boeing.

"It's becoming unbearable. The euro zone doesn't really have anyone in charge of exchange rates, and I think this is a huge omission when we face other monetary regions which are managed. We have to react to this slide in the dollar...We must find additional savings of roughly €1bn by 2010, 2011," he said.
Exchange Rate Twilight Zone

I have to laugh at this comment "The euro zone doesn't really have anyone in charge of exchange rates."

Is every country supposed to have a currency czar dictating the value of its currency? Exactly how is this supposed to work? The following example should clarify the picture.

Twilight Zone Picture
  • Japan sells Yen to buy dollars
  • China sells Renminbi to buy dollars
  • Oil producers sell dollars to buy Euros
  • Europe sells Euros to buy dollars
  • Europe sells Euros to buy Yen
  • Europe sells Euros to buy Renminbi
Notice the first three are happening already. As a result, dollar reserves in both Japan and China have been massively rising.

Intervention action by Europe to strengthen the dollar would lead to an accumulation of dollars problem in Europe compounding the problem of accumulation of dollar reserves by China and Japan. A further complication is the oil producers are dumping dollars in mass to exchange for Euros.

Obviously the top three points are a mess in and of themselves. Intervention by the EU would make matters worse and I have left out potential reactions by Japan, China and the UK as well, should the ECB attempt intervention.

Exchange Controls Are Not The Answer

The above should make it very clear that exchange controls are not the answer. However, that is not stopping the question: Will Europe impose exchange controls to head off disaster?
The die is now cast. As the euro brushes $1.50 against the dollar, it is already too late to stop the eurozone hurtling into a full-fledged economic and political crisis. We now have to start asking whether the EU itself will survive in its current form.

As Airbus chief Thomas Enders warned in a speech to the Hamburg workers last night, Europe's champion plane-maker - the symbol of European unification, in the words or ex-French president Jacques Chirac -- is now facing a "life-threatening" crisis.

Mr Enders said the company's business model is "no longer viable", and "massive losses" are on the horizon. So much for all those currency hedges that analysts like to cite. Have they ever tried to buy a currency hedge? They would discover how expensive these instruments are. Hedges cannot protect a company with $220bn in delivery contracts priced in dollars, when the euro/sterling cost-base is leaping into the stratosphere.

One thing is sure, President Nicolas Sarkozy will not let Airbus go bankrupt, nor see decimation of the French industrial core, without an almighty fight against those countries deemed to be engaging in a beggar-thy-neighbour strategy of currency devaluation - benign neglect in Washington, less benign in Beijing.

He will have allies soon enough, once the housing bubbles collapse in Spain and across the Med. Mr Zapatero will not be in power for long in Madrid. Mr Prodi is on borrowed time in Rome. A new political order will soon take hold in much of Europe, bringing in a new wave of prickly national populists.

So, how will they fight? Will Mr Sarkozy and his allies resort to 1970s-style exchange controls to stem the rise of the euro?

Any decision would be taken by EU finance ministers under qualified majority voting. Britain would have no veto, even though the effects of such a move on the City of London would be catastrophic - and trigger the certain withdrawal of Britain from the EU (and good riddance, some might say in Paris).
My Comment: Talk of the EU breaking up is misguided even as the problems facing the EU are dramatically understated.
Portfolio inflows into the eurozone reached a record EUR46.2bn in September. China, Asian wealth funds, Petrodollar sheikdoms, and now even Nigeria, have all joined a stampede into euros, utterly disregarding the underlying reality that Europe is in no better shape the United States itself. It is in worse shape, though this is disguised by the cycle. It is much worse in terms of economic dynamism and demographics.

EU industrial orders fell 1.6pc in September. Spanish, French, South Italian, and Irish house prices are already all falling.

The European Covered Bond Council suspended trading in covered bonds this week because the spike in spreads had become disorderly, and three-month Euribor rates have gone through the roof again, and that is the rate that sets Spanish and Irish mortgages. Bond issuance in Europe is frozen.

France is in the grip of a national strike costing EUR2bn a day. The railways are paralyzed. The country's 5.2m public workers are staging walk-outs.

Is this a currency bloc that should be now be deemed the ultimate safe-haven, the repository of trust in a dangerous economic world?
My comment: On that I agree. The Euro is horribly overvalued vs. the US dollar. However, attempts at currency controls always fail unless they are in alignment with the current trend. Thus, should the EU attempt currency intervention, the result could easily see Europe swamped by counter action from the oil producing states who want to diversify out of dollars without crashing it.
Exchange controls are the nuclear option, but .... French President Nicolas Sarkozy certainly seems inclined to go this route. ....

The ECB may or may not intervene in the currency markets to cap the euro. But this is a red herring. Europe's retort - if and when it comes - will be far more political, and far more dramatic. We are at one of History's "inflexion points".

One recalls the months leading up to the collapse of the Gold Standard in 1931. That was triggered first by Credit Anstalt in Austria and then by a British naval mutiny in Scotland.

Any bets on what will trigger the collapse of Bretton Woods II? I wager that it will be a decision by the Gulf states to break their dollar pegs, leading to a temporary surge of euro purchases. That will tip Mr Sarkozy over the edge.

Just idle speculation.
While it may be idle speculation as to what the exact trigger is that causes the collapse of Bretton Woods II and with it US dollar hegemony, in due time the US will lose reserve currency status. The sooner it happens the better it will be for everyone.

In the meantime it is clear the US, EU, China, and Japan are all engaged in economic warfare. Mistakes will be costly and the EU would be making a big mistake to retaliate with currency intervention. All such actions would accomplish would be to increase dollar reserves in the EU that it would not know what to do with. Simply put, currency intervention cannot be the solution, given that currency intervention is one of the problems.

The eventual way out is easy to see. What needs to happen is for countries to refuse to finance US debt in dollars. But remember this is the twilight zone. Taking that action would cause non-dollar currencies to rise. Virtually no country wants its currency to rise for fear of losing exports to the now failing model of US consumers buying stuff they do not need and cannot afford. So the band plays on, just as it did on the sinking Titanic.

Life would be much simpler under a gold standard than it is in the currency twilight zone.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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