One of the old, and often reliable, market adages is that when reaction to an event is different from what is expected, this is often an indicator of a major trend movement in the opposite direction. As a student of the foreign exchange market, I have been wondering whether recent movements of the dollar among the G3 currencies (the yen, the euro and the US dollar) is such an event.
For a long time now, the dollar has been regarded as a “safe haven” currency to which speculators/investors migrate in times of uncertainty. The last time this phenomenon was witnessed was in late 2008 when, after the collapse of Lehman Brothers and the crisis in financial markets, the dollar strengthened sharply in global markets. But the recent experience is quite different (see graph). Remember that this period included the overthrow of two long-established rulers in West Asia (Tunisia and Egypt), and the rebellion in Libya which is continuing at the time of writing. There have been strong protests in Algeria and Yemen and, to some extent, in Iran. The Organisation of the Petroleum Exporting Countries has promised to increase output to compensate for Libya, but any extension of the troubles to Saudi Arabia will put the oil market on fire. And, as The Economist reminded in its issue of February 26, much of Saudi Arabia’s oil reserves are in its eastern, Shia-dominated provinces in a Sunni-ruled country. Incidentally, this issue also underlies the unrest in Bahrain.
Indeed, the entire situation in that part of the world, which produces something like 40 per cent of global oil supplies, is in ferment. As a result, crude oil has jumped from a few dollars below $100 per barrel to $120 at the time of writing. Developments in our immediate neighbourhood, nuclear-armed Pakistan, are equally worrying: the murder of a relatively liberal chief minister of Punjab for his call for blasphemy law review has been followed by the murder of a Cabinet minister, for similar reasons. The murderers are heroes even to the middle class and the lawyers, whose protests led to the ouster of former Pakistan president Pervez Musharraf. Clearly, the “democratic” government of Pakistan is unable to halt the spread of Islamic fundamentalism, which is gaining ever more support. At the moment, there is no indication of what kind of governments will assume power in Tunisia and Egypt, but there are reports of sectarian clashes in Cairo.
To say the least, these developments are a surprise. This is because only a few months ago, analysts were questioning the very future of the currency, given the fundamental differences on inflation, external balance and growth between the Southern Cone countries and the other group led by Germany. In the New Year, yesterday’s discredited currency suddenly seems to have acquired the status of a new safe haven. On some fundamentals, of course, the eurozone is stronger. Its external account is in far better balance than the US’, and there is political will to cut the fiscal deficit — in the US, the Republican-Democrat divide is going to make it far more difficult to restore public finances. Also, latest central bank statements suggest the European Central Bank is likely to raise interest rates sooner than the Fed.
Surely, the country that should be most worried about the fall of the dollar is China — its exposure to dollar-denominated assets is huge.
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One also wonders whether the recent change in the status of the euro, if it lasts, would gradually reduce the predominance of the dollar as the world’s reserve currency, and the “exorbitant privilege” this confers on the US. Barry Eichengreen, an economist at the University of California, Berkeley, has recently come out with a book with the same title, which discusses the rise and fall of the dollar and the future of the international monetary system. In a separate article in The Wall Street Journal (March 2) Eichengreen discusses “why the dollar’s reign is near an end”. This should not be much of a surprise. Sterling’s reign lasted a little over the nineteenth century, and the dollar’s unrivalled status goes back to 1945. And economic cycles seem to be running ever faster.