CHINA MOVES KEY TO DOLLAR´S FATE / THE FINANCIAL TIMES ( RECOMMENDED READING )

China moves key to dollar’s fate

By Henny Sender

Published: March 19 2010 19:09

In July of 1997, when the Bank of Thailand was forced to devalue the baht, few analysts anticipated that the move would lead to contagion affecting other countries in south-east Asia and that it would eventually spread to Korea and Taiwan.

Within six weeks of the baht’s devaluation, the Indonesian rupiah was in freefall, going from 2,300 to the dollar to well over 10,000. The computer systems of some Japanese banks crashed as they were not programmed to handle a move from four digits to five.

For years, Bank Indonesia had let its currency lose value very gradually and predictably against the dollar. Precisely because the central bank’s exchange rate policy was so predictable, Indonesian companies happily borrowed dollars rather than their own currency since dollar interest rates were much lower.

Foreign lenders who provided those dollars then hedged the risk by buying credit insurance. But because there was not a liquid market for insurance on Indonesian companies, lenders bought credit derivatives on Indonesia itself. This was an imperfect hedge made more imperfect by the fact that the sellers were Indonesian banks, whose own creditworthiness also suffered when the rupiah began to drop.

Such was the transmission mechanism by which the contagion originating in Thailand spread to its neighbours. Fast forward a few years to the current economic situation, and the question is whether the US dollar will suffer a similar fate to the rupiah.

The week of March 8, the US dollar had its worst week since January, suggesting to economists at JPMorgan that the end of the dollar rally may well have arrived. That dollar move followed news that the US had its largest monthly deficit in history — a shortfall of $221bn — in February.

A month ago Credit Suisse produced a provocative research report pointing out that the country whose debt profile most resembles that of Greece is – hold your breath — the US.

So far, to be sure, the dollar has held up better than expected because it is still a safe haven in a storm. It is also the beneficiary of jitters over pressure on the euro, the sovereign debt of the weaker members of the European currency union, global recession and (conflicting) concerns over both overheating and possible slowing growth in China. In fact, US dollar strength has been far more pronounced against the euro and sterling than against other currencies, as analyst Chris Wood notes, in his recent “Greed & Fear” report for Credit Lyonnais Securities Asia.

But as the storm passes, the weaknesses become ever more evident. To be sure, those weaknesses are less obvious against other developed world currencies than they are against some emerging market currencies. And there are plenty of dollar champions who predict the dollar will be supported by relatively strong economic growth and a Fed that may soon raise rates.

Until now, one reason the dollar has held up well is that so many countries tie their currency to the dollar, most notably China. In April, the US Treasury will have to tell Congress whether China has been manipulating its currency against the backdrop of an increasingly strident debate between the two countries.

China may also slow its purchases of US Treasuries. Indeed, Japan has overtaken China as the largest buyer of US Treasuries in recent months. So far, though, China’s appetite for dollar-denominated assets appears undiminished.

Most officials take the view that China would be cutting its own throat if it were to sell Treasuries, or even reduce its purchases significantly. But countries, like individual investors, are not always rational. Indeed, Chinese Premier Wen Jiabao’s recent assertion that the renminbi is not undervalued “indicates an increasing political assertiveness on the part of China to defend its turf in public”, says Mr Wood.

If China decided after all that it would be damaging its own coffers less than the US, the dollar could be in for a period of much greater weakness.

Copyright The Financial Times Limited 2010.