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Where are the US dollar and the Yuan heading?

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currency_3(Sept. 11, 2009 - Thaler's Corner) This has become the several trillion-dollar question since the greenback seems to have fallen through major supports against the yen and euro, without mentioning the Australian dollar.

Without returning to last year’s lows (1.60 vs the € and 87.25 vs the yen), the dollar’s depreciation in recent months is beginning to alarm many investors for whom the movement recalls some unpleasant memories.

But we are less worried about the dollar’s climb than we are the euro’s and yen’s relentless and unwarranted rise, in view of the difficult economic state of their respective economies, while the yuan continues to be contained by Chinese authorities.


This provides an enormous competitive advantage to Chinese goods against those from Europe and Japan. Moreover, I still can’t figure out why we do not have the possibility, like in the United States, to impose tariff sanctions against a country that we can prove is manipulating its currency – especially, since, unless I am sadly mistaken, we do not have to contend with the same capital dependency as the US.

In order to dig a little deeper and open up the debate on this subject, we have compared the trade deficit of the US with those of the three above-mentioned zones along with their currencies, since the explosive growth of Chinese trade surpluses in 2002 and the advent of the single-European currency in 1999.

You will see that the conclusions are far from obvious.

I purposely ignored the deficit vis-à-vis OPEP countries, which essentially depends on oil prices, so as to remain focused on the problem of international competitiveness and purchasing power parities.

In the first paragraph, below, you can see the bilateral deficits vis-à-vis the US.

As you can see, they are, in fact, fairly stable with Europe and Japan for the period 2002-2008, with a sharp inflexion during the collapse of US demand in Q3 2008.

In contrast, imports from China have been continuously rising strongly since 2002, and, following their sharp contraction in the wake of the Lehman bankruptcy, they are apparently on the verge of returning to their previous levels!

This is especially so if we consider the seasonal nature of the bilateral deficit, culminating in October of each year, undoubtedly due to the importation of toys by the major American department stores in preparation for the holiday season.

And despite our constant harping on the American consumer’s de-leveraging, buying gifts for children is one sector in which households are highly unlikely to make major spending cutbacks.

As such, we fear that the US trade balance figures for the next three months will be worse than those of July.

So where does that leave the euro and the yen between now and year-end, given that the dollar has only adjusted these two currencies and not against the yuan?

Bilateral US deficits vs China, Eurozone and Japan

And the champion is…


An examination of the following graph of these three currencies (euro in reverse representation) against the dollar surprisingly leads us to a slightly different conclusion.

If we assume a base of 100 against the dollar at the beginning of 1999, the euro, yen and yuan, we find ourselves today finishing in the same very narrow range.

This is logical in the case of the euro against the yen, which was worth 132.51 yen on 1 January 1999 and 132.56 today at 3pm today!

We can see, however, the euro’s much higher volatility, a logical consequence of the ECB’s non-interventionist policy and the absence of a real Mr Euro (Mr T notwithstanding) capable of warning markets in case of “exaggerated” movements.

But the most surprising aspect is that the yuan underwent no more nor less the same re-evaluation against the dollar during the period 1999-2009, under very different circumstances!

Stuck at around 8.27-8.30 yuan per dollar between 1995 and 2005, the Chinese began a gradual but controlled 5.65% annual rise against the dollar until July 2008.

Since then, the renminbi has remained blocked at around 6.80 for the past 14 months.

These various “administered” movements in the past ten years has left the Chinese currency nearly unchanged against the Japanese and European currencies while the balance of trade has shifted heavily in favour of the Middle Kingdom.

For the entirety of Europe, the balance of trade has moved from about zero to a record $17.75bn monthly deficit in 2008, which contracted to $7bn this year given the shrinkage of world trade.

As for Japan, the country went from a deficit of $1.8bn in January 1999 to a record $10.7bn deficit last year, with a dip to $8.2bn in July 2009, for the same reasons as above.

I realise that for nations of rentiers, like Japan and soon Europe, a strong currency is not only a matter of national pride but also a political imperative, but the fact remains that China’s policy in the face of the declining dollar will in time lead to unbearable tensions.

This is especially true when we consider the importance of foreign trade for both economies.

Japanese GDP for Q2 2008, revised this morning, came in below expectations (+1%) at +0.6%. It includes a +1.6% contribution from foreign trade. Just imagine if the dollar continues to depreciate and the yuan with it.

The result would no longer be just deflation in Japan: we’d have to come up with another name.

And in Europe, are we really dieing to have the world’s strongest currency?

Are the Swiss any worse for periodically intervening to prop up the euro vs the SF to prevent the Helvetic confederation from falling into a deflationist trap?

Oops, I forgot: Mr Stark has already assured us that there is no deflationary risk on the eurozone.

One thing is for sure, unless I am being naive:

I cannot go along with the theory, as much as I would like to be optimistic, that the new phase of Chinese growth (and in its wake, world growth) will be fuelled by a financial revolution, leading to the phase of higher capital productivity (following the agriculture, industry and services phases).

It is true that the theory is logical and has a certain intrinsic beauty. A number of things point in this direction, like this morning’s statement by Fang Xinghai, director-general of the Shanghai government’s Financial Services Office:

“I think some time early next year we will have one or two foreign companies listed on the Shanghai Stock Exchange”

But how can they bring about such a revolution while the national currency remains “directed”?

And that’s leaving aside recent announcements by public enterprises threatening to break their financial derivatives contracts with their Western bank counterparties.

Not to mention the conflicting messages as to what officials really want, like the declaration this morning by Zhang Xiaoqiang, vice-director of the National Development and Reform Commission;

"It's irrational that we have too much capital going into stock and property markets," he said. "We need to adjust this."

The major problem is that, for the time being, mercantilism in Chinese culture is of unparalleled importance, and the country will remain for a long time the world’s deflation exporter, and it will take light years for the country to change its development model.

This is in no way a “value judgement”, but simply a factual recognition of the long economic cycle in which the country finds itself.

With a CPI out this morning at -1.2% y-o-y, Producer PI at -7.9% and a Purchasing PI at -11.4%, imagine the impact of a unilateral 20% upward revaluation of the yuan (and not just against the dollar!) -- the minimum needed to readjust currency parities!

Dollar against the euro, yen and yuan since 1999

Strange, isn’t it?



We remain favourable to fixed interest rate instruments, now with a bias more favourable to the 5-10 year range than to our 2-year champion.

We say the same thing for stock markets. We have considered it prudent to avoid participating in the recent rally, since the risk/profitability ratio does not look all that sexy.

But we prefer waiting until we get to the 2850-2900 range, before suggesting real delta negative hedging strategies.

Erwan Mahé

Asset allocation and option strategy

22, rue des Capucines
75002 Paris

TEL : + 33 1 53 05 57 20

FAX : +33 1 53 29 35 28


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