Rising USD Could Be a Concern

Since late last year, the dollar has been rising, thanks to the weakened European economy. Although the U.S. is still plagued with excess currency, high unemployment and other issues, and interest rates are still ultra-low, this did not stop the dollar from trending higher. The dollar index has risen steadily from the lowest point of 74 points in December 2009. The recent Greek sovereign debt crisis escalation has contributed to an international capital rush to buy the dollar. Last week, the dollar index ushered in a wave of spirited rallying. After the dollar index successively captured the numbers of 82, 83 and 84 on May 6, the dollar index hit 84.52 points in the Asian session, almost hitting a 12-month high. This is almost a 14 percent rise compare to the 74 points in December of last year.

The impact on RMB

The sudden appreciation of dollars has clearly affected other currencies. The highly anticipated appreciation of the yuan did not come to fruition; instead, it depreciated temporarily. Arbitrage capital, hedge funds, funds of domestic enterprises, trading companies and other forms of capital have been actively involved in the gold rush of yuan-forward transactions in the overseas markets. It greatly suppressed the exchange rate of RMB in non-deliverable forward (NDF) contracts in the NDF market. Subsequently, on May 6, the NDF reached the highest point of 6.6985 since December 22 of last year.

It would be interesting to see if the strength of dollar is just a short-term rebound or if it be evolving into a medium-term affair.

Recently, the majority of people think that the dollar rally would eventually be short-lived. The core reason is that the real economy and financial markets in the U.S. remain problematic. People also believe that the European sovereign debt crisis will be less of an issue because Greece is a relatively small country and the E.U. will come to its aid. Many stress that America’s debt and the size of its deficit are more severe than those of Europe. There is also the view that the sharp appreciation of the dollar does not help the U.S.’ cause because the United States is in the process of implementing “re-industrialization” and “export multiplier schemes.” A strong dollar does not help this situation. Over the past few months, not many people predicted that the dollar index would soar; no one thought the dollar would have a sustained gain.

The precarious state of the euro

The biggest reason for rising dollar is because of its hedging properties. From the exchange rate movement point of view, the largest contribution to the recent rapid rise of the dollar index is attributed to devaluation of its largest counterpart—the euro.

The euro to dollar exchange rate fell to 1.2720 on May 6, the lowest in 14 months. Furthermore, institutions held a generally pessimistic view against the euro in the European market with a revised and lower expectation on the exchange rate. The euro is in a freefall from the early part of this year, and the future looks no better. Investors may soon find the index inching towards the fourth quarter of 2008 low of 1.2330. The German finance minister pointed out that the euro is precariously unstable.

On May 4, a Chinese International Capital Corporation overseas market research department reported that debt restructuring is inevitable for Greece and other countries in similar situations. The prediction is that the euro to dollar exchange rate could hit 1.2 by year’s end. From the current pessimistic trend of a weak euro, George Soros’s claim of euro-dollar parity is not impossible. The president of German Foreign Trade Association has said that the euro will continue to devalue and the exchange rate could reach 1.0 by year’s end.

Chinese private investor Liu Jun Luo published an article titled “The new cycle of the appreciation of the dollar has arrived,” on a website in January 2010, stating that the dollar assets of global capital have begun to return. He pointed out that even if the U.S. job market does not improve, the dollar would still rise because the world is in a structural unemployment cycle. He also pointed out that labor productivity in the U.S. has greatly increased compared to that of Europe and Japan, which will usher in a new cycle of the dollar rising. In March of this year, he predicted that “the most conservative estimate is that the dollar index will rise to 85 this year.” While in mid-long-term, he believes that “within three years, the pound will fall to 1, the euro will fall to 0.8, the yuan to 20 and the yen to 150.” Liu Jun Luo’s argument has stirred up some heated discussion in the country.

This recent episode of a rising dollar index was mainly due to the rapid and sudden deterioration of the debt crisis in Greece and the euro countries, causing global investors to panic and take risk aversion measures. However, the profound changes that are currently underway in the global economy and financial situation will probably provide a more far-reaching cause to a sustained dollar gain. The Greece national strike of public service employees strongly impacts the global financial markets. The Spanish and Portuguese governments, which face similar financial issues, may also need billions of euros in bailout money. If the debt problems of these countries are not properly resolved, it could lead to a domino effect, and the euro economy may gradually sink into the abyss. The Greek government’s sovereign debt has been far more than just the Greek’s or euro area member countries’ debt problem.

In this context, the global investor risk aversion sentiment has been quickly spreading. The rising dollar index and U.S treasury bonds have become a sharp contrast when compared with sluggish stock and commodity markets.

Medium-term strengthening of the dollar

An analysis of the dollar’s index performance since the second half of 2008 and the profound changes in global economy and financial situations, signal a stronger dollar trend in the medium-term. Once a strong dollar has become a reality, investors will have to pay closer attention to the global commodity markets, stock markets, international capital flows in emerging economies as well as the impact of changes in global liquidity.

We should pay close attention to the dollar exchange rate. If the dollar rises sharply, the yuan exchange rate with the euro and other currencies could also rise. This would weaken the competitiveness of Chinese exports. However, this should not be of utmost concern. The more critical problem is that substantial exchange rate changes would impact international capital flows. The current RMB exchange rate with the dollar is relatively stable; U.S. capital still flows into China. However, due to potential RMB passive appreciation, the future of international capital will be heavily influenced by the future of the dollar.