Will 2006 kill off the dollar?

As we see the dawn of a new year we also always see loads of predictions and forsigths on how extraordinary good or bad the year will turn out to be. In the field of economics predictions are notoriously difficult to make and even the brightest of us rarely get it right. However, this hardly deters us from trying and this year is no different.

One of the big global economic question of the day seems to be the imbalance between USA's current account deficit and the rest of the world's surpluses. What will happen? Is it sustainable in the long term? Will the crash be soft or hard?

One perspective on this issue is the dollar and how it will do in the coming year as reported by The Economist here; (walled for non-subscribers)   

Despite the expectations (read; predictions) of 2005 the dollar actually rose even as the current account deficit moved to a whopping $800 bn. The primary reason for this was that US fed kept interest rates higher than those in Europe and Japan.

"The Federal Reserve raised short-term interest rates eight times in 2005, to 4.25%. Japan, in contrast, kept the liquidity taps open and interest rates at zero, while the European Central Bank raised rates only once, in December, to 2.25%. Relatively higher American interest rates brought foreign capital pouring into dollar assets and pushed the currency up."

According to the Economist there are consequently four points pertaining to the strength of the dollar in 2006 and whether it will hit for the basement:

1.  Relative interest rates of USA, Europe, and Japan.

Interest rates gaps are litterally impossible to predict in actual terms but the dynamics of the global financial market is speculative and volatile.  If investors expect  the US interest rates to rise more slowly compared to those of Japan and Europe, the dollar will obviously suffer. What can we expect here then? Well I don't think (hope) the ECB will raise interest rates, but as the Japanese economy is creeping out of deflation the Yen is bound to be dearer in the future. What about the US then? Well, the hikes do seem to be over, and as such the gap between rates should decrease.  

However, the most important point here probably is that the relative level of interest rates only have a slight and essentially short term effect on exchange rates.

"Historically, interest-rate differentials have been little more use than anything else at predicting short-term movements in exchange rates." 

2.  Oil exporters' appetite for dollar assets

The article from the Economist also reports that oil-exporting countries' surpluses going into dollar assets not necessarily will be the rule of the day in 2006.

"A recent study by the Bank for International Settlements, for instance, suggested that the currency composition of OPEC members’ deposits has become more sensitive to interest-rate differentials."  

3 China's appetite for US treasury bonds

As China recently chose to change its currency regime and peg the yuan to wider basket of currencies a move away from holding low dollar assets might follow.

"There is also a growing possibility that China will diversify its rapidly increasing foreign-exchange reserves away from dollar-denominated assets and into a broader mix of currencies."

Another very interesting perspective on this as reported over at Brad Setser's blog is that China actually is stuck with a high degree of US treasury bonds, low yielding or not.

"In other words, China is stuck - and perhaps more stuck that it realizes.  It can try to shift from holding low-yielding Treasuries into other dollar-denominated US assets that have a better return.  But even then there are limits: China's dollar weren't fully convertible into an oil company, for example." See also "China is set to remain the dollar's best friend" from FT; (walled for non-subscribers).

4. The current account deficit

According to The Economist, the CA is the biggest issue facing the US economy when it comes to the level of the dollar.

"But the biggest shadow remains America’s huge and rising current-account deficit. Reducing this will, at some point, require a much cheaper dollar."

Like all other predictions the ones above surely won't all come true, but in their light the flow of the greenback will be interesting to follow.