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Alan Ruskin: Moral hazard encourages weak dollar

Section: Daily Dispatches

By Alan Ruskin
Financial Times, London
Monday, October 8, 2007

The slide in the actively traded dollar index to its record low makes a final mockery of the US Treasury's mantra that "a strong dollar is in the US interest."

Henceforth, the foreign exchange market will view these comments with derision while urging policymakers to act. The non-interventionist European Central Bank and US Federal Reserve would much prefer to do nothing for now in the hope that the dollar move does not turn into a rout.

The worst scenario for central banks is to have to intervene but then look ineffectual. The risk of this is not negligible. How many days would it take the Federal Reserve's $67 billion of reserves (including $42 billion in foreign currency) to be gobbled up by a market that churns $3,000 billion a day?

Yes, there are swap lines to borrow from other central banks, but the reserve policy of the US speaks either to a commitment not to intervene or to a complete lack of preparation.

There may also be a belief that foreign central banks will bail the US out. The latter reflects latent attitudes reminiscent of the 1970s, when John Connolly notoriously remarked: "The dollar is our currency but your problem."

Central banks have spoken voluminously about moral hazard but one of the greatest moral hazard problems lies in their midst. The US has been tolerant of dollar weakness, and neglected building reserves, precisely because it knows that its trading partners could suffer more than the US from a dollar collapse and would do something about it.

So far, this implicit US assumption that the dollar is "too big to fail" has been correct. The latest IMF data show global reserves in the 12 months through the second quarter up $1,100 billion, indicative of global policy makers indirectly bailing out the dollar on an ever-expanding scale.

Most of this intervention has come from emerging market countries trying to suppress their own currencies. This emerging market foreign exchange intransigence has shifted much of the adjustment burden of the weaker dollar to the more flexible "major" currencies.

The speed of any further dollar decline versus "the majors," and how destabilising this becomes for other asset classes, will ultimately dictate whether central banks enact the ultimate bailout and buy dollars with the active support of the US.

This side of $1.45 to the euro, central banks will probably feel safe, but at the pace of dollar decline we have seen recently, these levels could easily be reached by the G7-IMF meetings later this month. If so, the G7 will be forced to add reinforcements to its standard statement: "Excess volatility and disorderly movements in exchange rates are undesirable for economic growth. We continue to monitor exchange markets closely, and cooperate as appropriate."

As pressure concentrates on European and commodity currencies, it is inevitable that the G7 refocuses attention on the need for currency flexibility elsewhere, notably among surplus countries in the emerging world.

Unfortunately, this adds to the G7 intervention dilemma, since any G7 intervention on their own currencies will contradict their demands for currency flexibility in the emerging world. This will further delay intervention but not stop co-ordinated action should the euro threaten $1.50 or beyond.

Another policy option that avoids the contradictions of intervention is interest rate cuts by the likes of the ECB, Bank of England, and Bank of Canada. Rate cuts will be less dependent on the level the currency hits than the economic backdrop to the currency price action.

As a general rule, the right option will probably be for central banks to show they are attentive but to continue to sit tight for as long as the currency spillover to the real economy and asset markets remains dormant.

This is not least because the more that central bank interventions or rate cuts are directed at a specific dollar value, the more they exacerbate the policy moral hazard that has progressively encouraged easy money and the dollar's debasement.


The writer is chief international strategist at RBS Greenwich Capital.

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