Central Banks Prop Up Dollar
By all accounts, the decline of the US Dollar has been measured, and without incident. This,
despite the fact that most investors reckon the Dollar is doomed, both from a long-term and
a short-term perspective. What, then, is preventing an all-out collapse?
Personally, I think the best answer is that Central Banks (and their sponsoring governments)
don’t want the Dollar to collapse. In other words, a schism is forming between private
investors and public government, whereby investors (on a net basis) are rooting against the
Dollar, while Central Banks are rooting for it. That’s not to say that there is a global
conspiracy involving Central Banks, designed to prop up the Dollar. Rather, it is that
Central Banks are simply trying to protect their short-term financial interests, and long-
term economic interests. By this, I mean simply that foreign Central Banks have everything
to gain from a strong Dollar, and seemingly everything to lose from its collapse.
From an economic standpoint, foreign Central Banks also benefit from a strong Dollar,
especially those whose economies are powered by exports. “A stronger local currency relative
to the dollar attracts foreign investment and tempers domestic price pressures by keeping
import prices in check, but also cuts into the competitiveness of the country’s export
sector.” Given that inflation is currently a moot issue whereas economic growth remains
tenuous, Central Banks have made it clear that they currently favor weak currencies. “If
(their currencies have) too much strength and the U.S. recovery falters, it’s bad for
emerging market growth,” and could even lead to a so-called “double-dip recession.”
In order to alleviate this possibility, many Central Banks have intervened directly in forex
markets and depressed their currencies through the purchase of Dollars. During only one
trading session earlier this month, “Asian central banks said to be intervening in currency
markets overnight by buying dollars included South Korea, Hong Kong, Taiwan, Thailand, the
Philippines and possibly, Indonesia, according to analysts.”
Meanwhile, Central Banks in industrialized countries are using increasingly strong rhetoric
to try to talk down their currencies. The Banks of Canada and England have achieved modest
success in the last few weeks in convincing investors that overvalued currencies would be
met with decisive action. The Royal Bank of Switzerland has intervened several times, while
the European Central Bank has expressed concerns about “volatility” (code for the rapid
appreciation in the Euro) in forex markets. It’s still not clear where the Bank of Japan
stands. The newly appointed Finance Minister has already flip-flopped several times,
settling finally on a course of action that would prevent the Yen from rising too high and
threatening the nascent recovery.
Consider also foreign Central Banks’ collective holdings of US Treasury securities, which
increased by nearly $800 Billion over the last year, a large portion of which was accounted
for by the Banks of China and Japan. According to the most recent Federal Reserve data, they
are collectively adding to their stockpile at a pace of $10 Billion per week. As the WSJ
explains, “The inflows highlight the challenges facing nations with large dollar holdings,
particularly developing countries. A weaker dollar is, in theory, bad for their investments
as it eats into returns when translated back into local currencies
In other words, continued foreign Central Bank investment in US Treasury securities is perhaps rooted less in investment strategy, then in the simple desire to prevent their current holdings from depreciating. At the same time, those banks that intervene directly in forex markets often have little choice other than to hold their forex reserves in US Treasuries. You can see from this that the idea of an alternative reserve currency would actually run counter to the interests of many of these Central Banks. With the exception of a few (i.e. Iran, and to a lesser extent, China) that would like to see the Dollar fail for political reasons, the vast majority of banks have a vested interest in the Dollar remaining where it is. Otherwise, they would witness the value of their Dollar-denominated assets collapse, as well as a collapse in exports to the US. It looks like, then, there will be a showdown at some point between the Central Banks and investors. If you accept the notion of efficient markets, then it should be obvious who will win in the long-term. On the other hand, you can’t underestimate the determination of some of these banks.
In other words, continued foreign Central Bank investment in US Treasury securities is perhaps rooted less in investment strategy, then in the simple desire to prevent their current holdings from depreciating. At the same time, those banks that intervene directly in forex markets often have little choice other than to hold their forex reserves in US Treasuries. You can see from this that the idea of an alternative reserve currency would actually run counter to the interests of many of these Central Banks. With the exception of a few (i.e. Iran, and to a lesser extent, China) that would like to see the Dollar fail for political reasons, the vast majority of banks have a vested interest in the Dollar remaining where it is. Otherwise, they would witness the value of their Dollar-denominated assets collapse, as well as a collapse in exports to the US. It looks like, then, there will be a showdown at some point between the Central Banks and investors. If you accept the notion of efficient markets, then it should be obvious who will win in the long-term. On the other hand, you can’t underestimate the determination of some of these banks.
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