Dollar Worries Persist Despite Today's Gains

The dollar is posting broad based gains today, with the yen as the notable exception. Despite the upticks, which are carrying the greenback to the upper end of its recent consolidative ranges, there continues to be much talk about the dollar's future as the numeraire--the key currency in the world economy, especially ahead of the G8 meeting later this week.

Today, three Shanghai companies have agreed to settle trade contracts in yuan for the first time. The deals with customers in Hong Kong and Indonesia are worth an estimated $2 millon. The People's Bank of China has arranged a total of CNY650 billion (~$95 billion) to Argentina, Belarus, Hong Kong, Indonesia, Malaysia and South Korea, via currency swaps.

The Bank of China, which is one of the two Chinese banks that press reports indicate are offering yuan settlement services. The President of the Bank of China was quoted on the news wires: "More and more companies will choose yuan to settle international trade as China's economy gets stronger and its financial market plays a more important role in the world."

This may sound reasonable, but it simply does not stand up to the historic tests. By that reasoning, for example, sterling and the yen should be larger invoicing currencies than they are. Almost half of Japan's exports are invoiced in dollars--and of course very little, if any, of these exports are commodities that are denominated in dollars, like energy or foodstuffs. A little more than a quarter of UK exports are invoiced in dollars. Some Japanese auto parts makers reportedly insist on invoicing in euros, forcing UK companies to bear the burden of the decision to stay out of the EMU.

There may be some token moves, but the size of the bilateral yuan swap lines (relative to Chinese trade), the competitive pressures to use a similar vehicle currency (some times called "herding" in the literature), and the fact that the yuan remains nonconvertible and illiquid warns against exaggerating the significance of the yuan-settlement.

It is ironic that the concerns about the dollar's future seem to have intensified in a bull market for the dollar, not a bear market. Since 1 July 2008, the euro has fallen 12%, sterling 19%, Brazilian reai has fallen 18%, Indian rupee -10.5%, Russian ruble -25.6%.

Nor has the concern about the dollar's future taken place amid a decline in its share of world reserves. The IMF's authoritative COFER report last week indicated that the dollar's share of global reserves (where the allocation is reported) rose to 65%, to stand at its highest since 2007.

China's Deputy Foreign Minister He Yafei was quoted over the weekend saying that the dollar will maintain its role for "many years to come". How then to reconcile these developments. Some Chinese contacts suggest that experiment to increase the yuan as an invoicing currency stems not so much from an outlook for the dollar, but more as a response to the disruption in trade in the second half of last year as trade financing dried up. As credit of all kinds evaporated as the global crisis became extreme and the limited access to trade finance disrupted trade flows.

However, the real challenge to trade is not coming any more from trade finance, according to a number of reports. Instead the main challenges are coming from the extensive global supply chains, which means that a decline in demand can have ripple effects through numerous countries. Demand itself remains weak as consumers have been squeezed by rising unemployment and wealth effects. In addition, various forms of protectionism appear to be on the rise.