Wednesday, November 28, 2007

Old Maid Continues as Europe's Great Men go to China

by Claus Vistesen

cross posted from Alpha Sources

Not too long ago as I was finding my self in my creative corner as I quoted the Stereophonics song Pass the Buck as a metaphor for what was going on at the moment in global financial markets. At the time I was also scouring my mind and, as it were, the internet for a the name of shedding card game where it set piece is to relinquish yourself from all the cards and then to avoid remaining with the 'old maid.' You see, it appears that the old maid is a fitting metaphor for what at the moment seems to be a global game being played about not ending up being stuck with the Dollar. Yet, as practitioners of the dismal science no doubt will be at pains to point out we need both pairs of those scissors. As such and while everybody can agree, at least based on economic logic alone, that the Dollar must fall which indeed is has been it is a little bit more tricky when it comes to the flip side. In this way, we need to understand that when you sell USD (or USD denominated assets) you buy something else which in this case could be foreign denominated assets or domestic assets where the latter would signify that you own currency appreciates. Of course this is all things equal and all and especially the general growth in the monetary supply must be taking into account but still I think it is fair to say the fall in demand for USD denominated assets has to be matched by a corresponding increase in demand for assets denominated in other currencies from other regions of the world. This would then bring us back to those scissors of Marshall's since where is indeed the supply and where is the yield?
Ultimately, I have a strong belief that economic fundamentals will solve such global games of old maid and I even have a pretty good reason as to what kind of fundamentals to look out for. However so far, the game is played and apart from the USD starring it could also seem as if a derivative of the old maid would be who in fact must step up to take the role for the USD as the structure of Bretton Woods II is ground down. Here of course, it will soon (i.e. after my exams) be time to re-visit old arguments but for now I will merely note that I always saw the current structure as very strong and fragile at the same time. It was/is very strong quite simply because de-coupling/re-balancing in the traditional sense where Europe and Japan ascends to take over the throne of the US would be virtually impossible. The fragile nature then comes in as an immediate consequence of this since if Europe and Japan cannot step up to the task who can and indeed will? As I say, fundamentals will tend to drive this and no-doubt the process of global re-coupling whereby the likes of India, Brazil, and Turkey takes over the clout of the US will materialize itself but a lot of glasses might end being shattered in the process. Ok, enough about that for now. Also, it clearly seems that my view of the fundamentals has not quite sunk in just yet epitomized by the very sharp decline of the USD against the Euro and the Yen. Of course this is only natural as an interim but the current process of shift in capital flows is beginning to bite. As such and turning back to my headline above the game continues as Europe sends an envoy to China in order to persuade Chinese authorities to do something about the Yuan/remninbi ...
Europe's finance chiefs arrived in Beijing today with the warning that China must let its currency strengthen against the euro or risk sparking a trade war. European Central Bank President Jean-Claude Trichet, Luxembourg Prime Minister Jean-Claude Juncker and European Union Monetary Affairs Commissioner Joaquin Almunia will argue that an undervalued yuan is ``triggering protectionist tendencies,'' according to a briefing document obtained by Bloomberg News.
The yuan rose to its strongest since a peg to the dollar was scrapped in July 2005 as Juncker told reporters in Beijing that the exchange rate will be the main topic of the two-day talks. European policy makers are pressing for the yuan to gain more versus the euro to curb a trade deficit with the world's fastest-growing major economy that's swelling by $20 million an hour.
Of course, the strong Euro relative to the Yuan is not exactly news straight in off the wire but in the light of the USD's recent slide it has clearly began to pinch. Especially the following kind of 're-balancing' is something which the Eurozone won't be able to muster for long ...
While the yuan has risen 5.7 percent against the dollar this year, it has dropped by about the same margin versus the euro. That leaves the Chinese currency undervalued in the eyes of European policy makers who blame it for inflating their trade deficit with China by $20 million an hour and helping to push the euro to an all-time high against the dollar.
On the other hand you can ask yourself what good all this will make. Quite obviously, and in light of Paulson's formidable strides, it may take many a trip from Frankfurt and Brussels to make China budge if at all. Meanwhile, the process continues as Brad Setser demonstrates in his recent post. Go see for the graphical version but the picture is pretty clear in words alone ...
I didn't’t use the term “sudden stop” in my post on the September TIC data release lightly. The attached graph -- which comes straight from the TIC data -- shows an extremely sharp fall in net purchases of US long-term financial assets over the last three months.
As a counterpart to this Setser cites a recent analysis from Danske Bank's Teis Knuthsen which shows that inflows with respect to the FDI and portfolio accounts into the Eurozone continue to increase on a rolling month basis. Also in annual terms the net inflow of portfolio investments reached an all time high. This is clearly the text book case for re-balancing/de-coupling in the traditional sense but do remember as an aside that the Eurozone is still running an overall external surplus on the trade balance which suggest an overall process of re-funnelling. In this respect, please do not miss the following seemingly trivial but very important data point as reported by Eurostat.
EU27 trade with most of its major partners grew, with the exception of exports to the USA (-2% in January-August 2007 compared with January-August 2006), and imports from Norway (-9%) and Russia (-5%). The largest increases were for exports to Russia (+29%), India (+22%), Brazil (+17%) and China (+15%), and for imports from China (+22%), Brazil and India (both +17%) and Turkey (+14%).
Now, this would be tantamount to re-coupling. More generally and while nobody can deny the facts as they are presented the very nature of the current shift is likely to present notable and difficult issues in the interim not least for the Eurozone and certain key members as well as of course those most strained economies in Eastern Europe. Ok, I will sign off for now. Of notable things that I missed out on in terms of commentary include Federal Reserve Vice Chairman Donald Kohn's statement today which has largely been interpreted that the Fed is going to cut once more this year. As always, I remain rather contrarian and believe it to be a holding operation but given the sharp rally in equities today I seem to be pretty alone on this position. Moreover, the tradeoff in the Eurozone facing the ECB is becoming crystal clear if it ever was anything else as inflation seems certain to pick up.
As a more general note I am entering exam periods now which means that I may be a bit more erratic than usual but I will try to keep up. Tomorrow (Thursday) is applied econometrics; wish me luck.

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