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March 11, 2005

Jumping Into the Abyss

In an article worth reading, Caroline Baum, a Bloomberg columnist, imagines that “Asian central banks are poised on the edge of a cliff.”

A vivid metaphor, indeed. In other words, given recent signals from Japanese and Korean officials, it would appear that the US dollar hovers on the brink of an extreme revaluation.

Unsurprisingly, given the great set-up in the article’s first sentence, Ms. Baum then asks the question: “Who will be the first to jump?” Any answer to this question presupposes that someone will jump.

Ms. Baum goes even further, explicitly encouraging a first mover. “It would be much smarter for these banks to quietly sell dollars, if that's what they want to do, without calling attention to it.”

But will any of the central banks jump into the abyss?

If media reports are to be believed - please be skeptical - many think so. On an unusually warm weekday at the end of last year, certain currency traders expected a devaluation of the renminbi over the weekend – drinks were had all around on the Saturday, but no one had yet profited from that bet. Nor months later, as of today.

To be sure, the idea of RMB devaluation has been batted around like a badminton birdie since the late 90s. More conflicting signals from the Chinese government – if signals they be, instead of expressions of indecision – confuse the issue.

I have steadily maintained that a major revaluation runs contrary to China’s national interest. [Here and here.] This, despite indications that China must do so or suffer the economic consequences, as summarized by James Dorn, here.

At the end of 2004, Chinese foreign reserves reached US$610bn, an enormous sum by any earthly measure. But Chinese officials, historically, tend to use even grander measures to gauge China. Zhou Xiaochuan, governor of the People’s Bank of China has stated that "China's foreign reserves are indeed somewhat high, but not by any big magnitude.”

A major policy change is, of course, possible. After all, China raised interest rates after many years of speculation and chatter. But only after foreign governments shut up and stopped complaining about it. Indeed, when the day comes for the peg to be removed, it will happen only after foreign governments stop complaining about it - and when Chinese officials under difficult circumstances have no choice but to do so. And when they do so, that action will be explosive and change China as greatly as removal of Taiwan's NT dollar to US dollar peg changed Taiwanese economic life.

Note, however, that the Chinese central bank has diversified over the past few years away from the US dollar to Euros. Is this the “quiet selling” that Ms. Baum suggests for the Japanese and Koreans?

Imagine what might happen when – if – the Asian central banks jump, having first hollered. (Of course, the hollering is aimed at the ears of their dear friend, the government of the United States of America, for help in an hour of need.)

Imagine when - if - the current administration fails to put a good word in for their allies in the region and, by not informing the markets that the value of the dollar is sacrosanct, fails to pre-empt the radical dollar movement everyone but the administration fears. Suddenly, it is sold in great quantity. It tanks. US Treasuries held by those foreign governments concomitantly suffer enormous loss in value.

The first mover may gain somewhat – but everyone loses in the end. A jump into the abyss.

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Posted by: Luca at March 12, 2005 3:10 PM

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