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Andrew Allentuck

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Towards a more diverse currency standard

Andrew Allentuck

 

Concerns over credit quality in the U.S. are echoing in the Far East where the Australian dollar, the Indian rupee, the Indonesian rupiah and the Philippine peso tumbled in exchange value against the U.S. dollar at the end of July. The cause - rippling effects of the continuing meltdown of subprime U.S. residential mortgages.

The decline of currencies of nations remote from American suburban bungalows anticipates a growing possibility that global interest rates will rise and cause investment to decline. Around the world, investors are demanding to be paid more for the risks they take. Lending standards are being raised along with the cost of loans. There is a likelihood that there will be less direct investment in emerging markets. Less investment translates to reduced demand for those foreign currencies. Asia is vulnerable for it has become the factory for consumer goods in much of the rest of the world.

“There has been instability in credit markets that is causing lenders to raise the compensation required to carry the risk of loans,” said Chris Kresic, Senior Vice President for Investments at Mackkenzie Financial Corporation in Toronto. “The market balked and said that with leveraged buyouts cascading onto market, investors have said enough - they want more money for the risk.”

When money is rationed, it tends to go to the most familiar and most secure borrowers. There is a flight to quality and in the choice between buying G-7 debt in sterling or euros or emerging markets debt in domestic currencies, the decision is always to the senior credits in periods of uncertainty, Mr. Kresic said. Thus weaker Far Eastern nations, which include Bangladesh and Viet Nam, are bound to suffer, he explained.

The trend is likely to continue in the short term. Pressures to restrict global credit are underway. Central banks around the world are in a tightening cycle, noted Nick Chamie, head of emerging markets research for RBC Capital Markets in Toronto. He pointed out that at the end of July, regional currencies in Asia fell while the Japanese yen rose as traders bought into the Japanese currency to pay back low interest yen loans. The yen reached a six week high tracking gains on U.S. bonds after investors sold stocks and took refuge in U.S. Treasury bonds.

For the longer term, Asian currencies may do quite well, Mr. Chamie added. “The underlying fundamentals remain in place. Large amounts of foreign direct investment and portfolio inflows and strong economic growth have not been derailed.”

There is a technical point that has to be made in any discussion of currency exchange rates. The global standard of exchange remains the U.S. dollar. Even if there is weakness in a foreign currency, if the U.S. dollar is as weak or weaker, the exchange ratio may stay the same.

“There is an symbiotic relationship between Asian exporters and the U.S. consumer,” Mr. Chamie added. “Asian exporters and central banks would be shooting themselves in the foot if they ceased to hold U.S. dollars. And since the trade is in U.S. dollars, the value the dollar does not matter very much.”

Further declines of the U.S. dollar seem inevitable. Trade deficits, tax deficits, and the cost of the war in Iraq imply that the U.S. dollar may decline a further 20 per cent against the euro and other major currencies. That decline would cut the spending power of U.S. consumers and reduce exports by the Asian tiger economies that supply Wal-Mart and much of the rest of the U.S. economy.

In spite of the continuing use of the U.S. dollar as the basic standard of world trade, there are signs that the world economy will be realigning to a more diverse currency standard. Indeed, it is inevitable. The U.S. dollar recently hit a record low against the euro at $1.3845.

As a result of the weakness and relative overvaluation of the U.S. dollar, Asian currencies remain undervalued. A good meal in a restaurant in Thailand can be had for $3.25, which barely buys a Big Mac in New York. Using the cost of a Big Mac in various Far Eastern nations, the Chinese yuan is nearly 55 per cent undervalued against the greenback, the Hong Kong dollar by 52 per cent, the Indonesian Rupiah by 46 per cent, the Malaysian ringitt by 51 per cent, the Philippine peso by 42 per cent, the Singapore dollar by 26 per cent and the Taiwan dollar by 29 per cent. The Big Mac measurement of purchasing power parity was published by British newsweekly, The Economist, in February this year.

Over the long term, currencies should adjust to bring their purchasing powers into alignment, though process can take many years. Until then, trade and capital flows will have varying effects on currencies.

The results vary by nation. “Emerging markets economies have improved their balance sheets dramatically and their currencies are therefore better able to withstand the volatility of capital markets,” Mr. Kresic explained. Far Eastern emerging markets currencies will be under pressure. Yet today they have a far greater ability to withstand that pressure. The less liquid currencies will suffer and currencies like India's rupee and the Malaysian ringitt, which rose strongly in the last 12 months, would be most likely to fall. The Japanese yen, which has not appreciated greatly in the last two years, is likely to hold its value, he said.

Andrew Allentuck writes about investments for The Globe and Mail, and reviews books on finance for globefund.com and globeinvestor.com. He is also the author of several books.

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