Three strikes and you’re out

The first strike was the reserve diversification story, which gained credibility on the Swedish Riksbank action in April (see “The return of reserve diversification,” Currency Trader, May 2006).

The second strike is Europe making every effort to get the euro accepted as the new reserve currency. The ECB had good timing, just as the Fed is perceived to be on the verge of pausing its rate-hike cycle. It’s impossible to know with certainty the Fed will pause in June, but by the time the Fed meets, a lot of water will have gone over the dam, including the ECB rate hike earlier in the month and additional comments from top officials.

The ECB seems hell-bent on raising rates no matter what, or at least on giving the impression that it is the top inflation- fighter on the planet. This image contributes to its long-term goal of having the euro supplant the dollar as the world’s reserve currency. Historically, the issuer of a reserve currency is an actual country and the top military power in the world of its day. The European Union does not qualify, but never mind. Maybe the rules are different today.

The third strike against the dollar: The U.S. is picking a fight with Japan it cannot win. It all starts with the refusal to name China as a currency manipulator in the semi-annual Treasury report. Evidently a lot of horse trading was going on in the background. The G7 communiqué was strong or even harsh, in return for the U.S. pulling its punches. (We have yet to hear the response of the congressmen to whom the report is technically addressed.)

During the first week of June, Treasury Secretary Snow gives testimony about the report and answers questions, which ought to be fun. Meanwhile, China allowed the yuan to get past the purportedly psychologically important 8.1 level vs. the dollar, which was perhaps a “reward” to the Treasury for letting it off the hook. A state-sponsored think tank trotted out an economist to offer that an additional five-percent revaluation would be a good thing for the banking sector and domestic economy without causing too much harm. This is a trial balloon wafting over Washington.

While the developments in U.S.-China relations are fascinating, they are not the main event. That honor belongs to the U.S. telling Japan it should not intervene in the dollar-yen rate, or even talk about the dollar-yen in public. The U.S. attitude is that if the market chooses to buy yen as a proxy for the Chinese yuan, the Japanese should grin and bear it. They should not repeat the extraordinary intervention in 2003- 2004, during which time the Bank of Japan (BOJ) was active in the market over 100 times, to the tune of ¥30 trillion.

Japanese Finance Minister Tanigaki protested that the G7 principle is that currency movements should reflect economic fundamentals, and sudden and speculative movements are undesirable. This has been Japan’s hitherto unassailable rationale when it intervened — currency movements are too abrupt and result in levels that do not reflect fundamentals. How can the U.S. sign the G7 agreement and then turn around and deny the right to intervention to another signatory? Tanigaki didn’t say so out loud, but it’s the old “beggar thy neighbor” policy from the days of fixed exchange rates, when one country would over-devalue to grab export markets from its neighbors. Today such a policy is relevant mainly in autos, where Tokyo is eating Detroit’s lunch.

Tanigaki also said the Ministry of Finance “will make cautious judgments on how to manage the composition of the reserves…We don’t believe the reserves should expand unrestrained...but our foreign reserves are massive and we should be very careful about making comments on how we would like to manage our reserves.”

A little later the same day, the ministry came out with modifications, clarifications, and general softening — but how can this be interpreted as anything other than a direct threat? Some say G7 would have to be consulted before Japan could engage in reserve diversification. Well, if the U.S. is not going to abide by a G7 agreement that gives implied authority to Japan to intervene, why should Japan abide by any other part of the G7 agreement?

This contretemps will probably blow over without escalating to the point of crisis — and Japan will win. It can win by actually intervening and somehow getting the U.S. to concede its sovereign right to intervene, or by getting the U.S. to remain silent, which is the same thing. Either way, the U.S. loses face.