More than G7, G20 now may be needed for dollar propping


In Foreign Exchange Casino, Don't Bet Against Central Banks

By Jamie McGeever
Wednesday, July 23, 2008

LONDON -- The global foreign exchanges may now be a $3.2 trillion-a-day behemoth but one maxim still holds true: Ignore concerted central bank intervention at your peril.

While it may not be imminent, traders are probably on their highest alert for an international move to support a currency since U.S., euro zone, and Japanese monetary authorities rallied to the euro's defense in September 2000.

As the dollar plumbed a record low of $1.6038 per euro last week and threatened a new round of food and fuel price rises, calls grew for action to shore up the greenback and Federal Reserve Chairman Ben Bernanke pointedly left the door open to such a move if needed.

And even though the physical amount of foreign currency reserves Group of Seven central banks have at their disposal is tiny relative to FX market volumes, analysts insist coordinated intervention remains a potent weapon in policymakers' arsenal.

"If the currency market is a casino, the central banks are the house," said Neil MacKinnon, chief economist at ECU Group, a London-based hedge fund.

"Although they don't have the firepower to match the daily trading volumes, all it takes is for them to intervene. It doesn't really matter what the size is," MacKinnon said.

As every gambler knows, you don't often bet against the house and come up trumps. The message of the most influential central bankers saying "enough is enough" is a powerful one, especially if timed right and supported by the broad tilt of relative monetary policies.

The history of concerted FX intervention with the U.S. Treasury on board supports that, especially given that the amount of hard cash spent in these forays is typically modest.

The September 22, 2000, intervention to buy euros was critically reinforced by the European Central Bank and euro-zone national central banks over the next couple of months.

Even though the fledgling currency fell back briefly to a record low of $0.8252 on October 26 that year -- a decline of some 30 percent from its $1.1747 debut in January 1999 -- it then embarked on a steady upswing over the following eight years, culminating in last week's record high.

Between April 1994 and August 1995, U.S. authorities regularly intervened with Japanese and European central banks to buy the dollar, which had sunk to a record low of 1.3455 German marks in March 1995 and a post World War Two low against Japan's yen of 79.70 yen a month later.

By August 1998 the dollar was trading above 145 yen and then hit record highs against the mark's replacement, the euro, by October 2000.

Dollar weakness is again the problem. It fell to a record low against the euro last week beyond $1.60 as concern over embattled U.S. mortgage giants Fannie Mae and Freddie Mac deepened already entrenched worries about the broader U.S. financial system and economy.

The last thing global policymakers want is for dollar weakness to morph into a run on the currency, a development that would only intensify fears about the value of U.S. assets and aggravate the fuel and food price inflation that is preventing central banks from cutting interest rates to ease the crisis.

... BRICS on board?

So how might coordinated intervention look this time around if it is carried out?

There has been massive change in the total value and currency composition of global FX reserves since 2000.

Data from the International Monetary Fund and Bank for International Settlements shows how the clout in foreign exchange markets has shifted toward the developing world.

In late 2000 when central banks intervened to prop up the euro, global FX market turnover averaged just over $1 trillion a day, BIS data indicate. Global FX reserves stood at $1.87 trillion, of which 41 percent was held by developed nations and 59 percent was in the hands of developing countries.

Back then, 72 percent of the $1.46 trillion of FX reserves, at least those where currency denomination was known, was in dollars and 17 percent in euros.

Since then, however, FX market volumes have more than tripled to some $3.2 trillion a day and global reserves have ballooned to $6.87 trillion -- almost 80 percent of which are held by developing countries.

Slightly less than two thirds of the $4.32 trillion reserves where currency composition is known is in dollars. A little more than a quarter is now in euros.

So, if the world's central banks are to intervene buying dollars any time soon, they have more than a third of their stash as ammunition. The fact that U.S. FX reserves are a relatively puny $76 billion may be irrelevant.

"You need exponential power and exponential power doesn't come from G7 -- it comes from G20," said David Bloom, head of global strategy at HSBC.

Having non-G7 central banks on board -- like those of the BRIC nations Brazil, Russia, India, and China, as well as oil-producing Gulf countries -- would help achieve maximum impact, Bloom says.

China's $1.81 trillion foreign exchange reserves are now a quarter of the world's total -- easily the largest in the world -- and more than 10 times the $160 billion of eight years ago.

"The most important thing is everyone would have to be involved and buy on behalf of their own account. The huge growth in reserves means you need people with power, and the flow behind it. The G7 can't do the flow," Bloom said.

BIS figures show interbank trading accounts for around 43 percent of total market turnover versus 64 percent a decade ago. This suggests institutions through which any intervention would likely be carried out have less ability to move the market.

So now more than ever, intervention would be aimed at sending a signal more than anything else.

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