The US dollar, the Norwegian krone and the ‘ugly contest’

All eyes have been on the Fed in the past 24 hours – and all currency gyrations, particularly the dollar’s sharp depreciation – have been attributed to the Fed’s move to spend $300bn on buying long-term Treasuries, among other measures. As some currency analysts observed on Thursday, however, the dollar’s steep decline suggests there may have been some over-reaction to the Fed’s move.

But there are other factors at work behind the dollar’s downward trajectory – not least, growing disenchantment in some parts of the world with US economic policies (or lack thereof), and rumbles about dumping the dollar as the world’s reserve currency and adopting a shared basket of currencies.

In an article about a gathering of top Asian think tanks on Thursday in Tokyo, Reuters reported:

The role of the US dollar as the key global currency will decline after the financial crisis, and its value may also weaken due to America’s current account deficit, officials at some of Asia’s top think tanks said. But Asia, which is heavily invested in US assets, hopes any decline in the dollar will be gradual to avoid further shocks to financial systems, the officials said on Thursday.

Summing up Asian countries’ growing fears, Chalongphob Sussangkarn, a former Thai finance minister and now president of Thailand Development Research Institute, said:

The US deficit is so huge. This is why all countries, particularly East Asia, are concerned because we hold a lot of these assets. What happens if the US dollar falls 40 percent? Many central bankers will be losing huge amounts of money.”

Such fears, now spreading among governments about their relatively large holdings of dollar reserves, have been fuelling sentiment against the dollar among a United Nations panel of experts, which is preparing to recomment that member countries move away from using the dollar as the world’s reserve currency and instead, adopt a shared basket of currencies.

As Reuters reported on Wednesday, panel member and currency expert Avinash Persaud, said the proposal was to create something like the old Ecu, or European currency unit, that was a hard-traded, weighted basket:

Persaud, chairman of consultants Intelligence Capital and a former currency chief at JPMorgan, said the recommendation would be one of a number delivered to the UN on March 25 by the UN Commission of Experts on International Financial Reform. “It is a good moment to move to a shared reserve currency,” he said

Yes, the UN often appears bureaucratic and ineffectual – but it sometimes does make an impact, and the panel’s recommendation will almost certainly add to growing international debate about the dollar’s role.
The accelerating sentiment against the dollar, fuelled by reports such as the one on the UN panel, was “as large a reason for the overnight sell-off in the dollar, as was the Fed’s announcement to buy US Treasuries as part of their quantitative easing policy”, noted Richard Grace, CBA’s chief currency strategist in a Thursday note.

While Grace suggests it’s “worth waiting until next week” to see the full intention of the UN’s recommendation to diversify out of dollar, he voices three key reservations about such a move:

(1) The UN does not carry as much weight as the G7. If it were a G7 announcement (or even an IMF announcement) then the announcement effect (and the full ramifications) on the USD would be extremely significant (and USD negative). We do not expect such an announcement from the G7 anytime soon.

(2) Most major currency reserve managers already diversify (out of USD) anyway. There is nothing new here. Currency reserve managers will diversify according to liquidity, expected return, and to cover a mix of underlying assets (be it imports or underlying securities). Central bank data from the IMF illustrates that, while there is plenty of room for diversification, a significant amount of reserves are already diversified in non-USD currencies (chart 4).

(3) Most trade contracts and commodity prices are priced in USD. If the UN statement is designed to re-price commodities and trade contracts in an alternative to the USD, and toward a basket of currencies such as Special Drawing Rights (SDR’s), then it is a significant announcement by the UN, and clearly USD negative. But it is worth waiting until next week to see if this is the intention of the UN, and if it has endorsement from the US Treasury. The logistics of such a move are huge and will take some time to implement, but an immediate depreciation of the USD under the above circumstances would certainly occur.

Afterall, notes Grace, the two major foundations which keep the dollar stable as the world’s major reserve currency are first, that the US is the largest economy in the world; and second, that it has the deepest and most sophisticated bond markets in the world (so there is somewhere to park capital reserves). “It takes time for alternative markets to grow and adjust to additional demand”, he noted.

Even so, it’s clear, as the FT reported recently, that countries such as China, which hold massive dollar reserves, are concerned, and that there is some interest in at least radically reducing dollar holdings if not shift out of the dollar as the reserve currency. And as we saw last week, moves by Switzerland to intervene in its currency – and fresh speculation that Japan may go the same route (see Related Links, below) has triggered much discussion within governments about forex holdings and safe-haven currencies.

On top of that is the point made by Morgan Stanley’s Stephen Jen this week, that plans to massively boost the IMF’s funds in order to channel aid to Eastern Europe could ultimately see the euro gaining substantial ground. Still, as Hong Kong-based research and investment house Gavekal remarks in a note on Thursday:

There are numerous reasons to dislike the euro … some valid concerns about sterling and the yen, and, with the Fed clearly indicating its “no holds barred” approach to printing money to spur economic activity, dollar-aversion is no surprise either…

Still, we continue to believe that, warm and fuzzy IMF statements aside, the issues Europe is confronting are very serious and will necessitate a political will and flexibility which we have yet to see on the Old Continent. Thus, of all the three-legged blind mules out there, the euro remains, in our view, the most structurally challenged.

Perhaps, as the FT’s currency correspondent Peter Garnham suggests on Thursday, Norway’s krone may emerge as the big, new safe-haven currency.

The bottom line, as Gavekal concludes, remains that picking a currency has truly become an “ugly contest”. Meanwhile, it says, “away from the spotlight, some currencies either offer tremendous value because they have been oversold concerns about debt exposure (SEK, KRW, IDR…), or because they have sound-enough fundamentals which, in these panicked times, the markets are ignoring (CA$, BRL, MYR…).”

Related links:
UN panel says world should ditch dollar - Reuters
Norwegian krone: the new safe haven currency? – FT
Game-changer for the euro, and a coming CHF bloc – FT Alphaville
Getting the IMF to take the heat – FT Alphaville
Ministers agree on need to boost IMF funds – FT
The Swiss franc factor
- FT Alphaville
Swiss franc intervention – Short View
Swiss stoke fears of currency wars - FT
On your marks, get set, devalue
– FT Alphaville
China’s dollar dilemma – FT

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