Comment 72: Behind the rise of Euro, why and what next. Pulse of globalization (4) (December 7, 2009)

Recently Euro is appreciating rapidly against U. S. Dollar. The movement of Euro does not reflect the growth potentials of two regions. For example, U. S. economy grew +2.7% in the third quarter of 2009, whereas in Euro region the growth rate was only +0.7%. The consequence of continued rapid rise of Euro is quite obvious even without further analysis. Since Asian exporters other than Japan are insisting to peg their currencies to U. S. Dollar, rising Euro vs. Dollar means falling currencies of other Asian exporters against Euro. If Euro continues to advance, at certain point the gate for Asian exports to flood Euro markets will be opened, throwing a dangerous factor into the current globalization scheme. Let us see why this new factor is dangerous.

In America Wall Street loves runaway trade deficits and routinely labels any attempt to reduce trade deficit as "protectionist", because runaway trade deficits bring in huge profits for Wall Street firms. When America runs trade deficits, U. S. Dollar created by The Federal Reserve flows into the hands of trade surplus countries. Since U. S. Dollar is not legal tender in foreign lands, those out-flowed Dollar must be returned to America to be invested in order to yield some return. When those Dollar is returned to America, they are in the size of millions to billions so they will not be deposited into American commercial banks to earn meager interests but will be thrown directly into money markets through the hands of Wall Street for various borrowers to borrow directly. Even if a portion of the returning Dollar buys U. S. Treasury Securities without going through money markets, a matching amount of domestic capitals in U. S. Treasury Securities will be pushed out of treasury security market and goes into the money market in lieu of foreign owned Dollar. Wall Street then turns over the returning Dollar as fast as it can to create a rapidly expanding credit/debt bubble to derive maximum amount of profits. In the meanwhile American consumers are allowed to tap into the bubble to borrow and spend like no tomorrow. Through this bubble generation process many service sector jobs are created to compensate manufacturing jobs lost due to the trade deficits. By this ingenuous design public anger is placated and this trade deficit driven ad hoc globalization scheme is allowed to continue for more than twenty five years. If the runaway trade deficits are allowed to grow impeded, the end result will be like the situation called "globalization utopia" as depicted in article 7. At that extreme end America will become a total parasitic society living on the forced generosity of Asian exporters, but at the price of losing sovereign power completely. Of course, the sarcastic picture as portrayed in article 7 will never become the reality. As the credit/debt bubble grows, it becomes more and more unstable until its burst from a slight disturbance. The latest credit/debt bubble the aftermath of its burst that we are experiencing presently is not the first one since the onset of this globalization scheme in Reagan era, but the third one that followed the Clinton bubble that followed the Reagan bubble. When a bubble bursts, the economy slumps and the trade deficit will be curbed temporarily. As Government stimulates the economy, the trade deficit returns, spawning another bubble. As pointed out in article 12, the succeeding waves of runaway trade deficit required to sustain the annual growth of American economy at 3% level have become increasingly larger, and so becomes the resulting bubble. Larger the trade deficit, bigger the bubble and more painful when the bubble bursts. If the current globalizattion process is allowed to run its course, the fourth wave of runaway U. S. trade deficit will start as the economy recovers, a bubble even larger than the Bush era one will be inevitable, and when that bubble bursts, American economy will plunge, accompanied by the rest of the world, into a global depression. Thus this ad hoc globalization scheme will come to its natural end, probably by the year 2020. However, the continued strong advance of Euro will upset this scenario. In Euro region, excluding UK, there is no entity comparable to Wall Street that can turn large trade deficits efficiently into credit/debt bubbles. Large trade deficits in Euro region always mean public agony from the loss of manufacturing jobs. Thus politicians are forced to impose sanctions and quotas, kicking off a bitter currency and trade war with Asian exporters with the potential to destroy the globalization scheme itself before the time of its natural end. That is why we need to analyze the future course of Euro. To anticipate the future movement of Euro, we need to understand why Euro is rising in the first place, and that will be the major aim of this article.

There are always people who dismiss the question, why Euro is rising, by attributing the rise of Euro naively to the doing of speculators. Here speculators are large professional speculators like hedge funds and trading desks of large financial institutions. Professional speculators live on leverage, that is, on borrowed money. In this case we are talking about the strategy of borrowing large sums of Dollar and sell those Dollar for Euro. Why do professional speculators want to sell Dollar for Euro against the fundamental economic fact that the growth of Euro region will be weak as mentioned before? Currently short-term interest rate like over night repurchasing rate in the U. S. is around 0.12% vs. about 0.35% in Euro region. There is few high yielding and safe-looking short-term sovereign debt the underlying currency of which is pegged to Euro. It is unlikely that professional speculators are after such meager interest rate spread. Only reason that those professional speculators are selling Dollar for Euro is to make hefty capital gains riding on Euro's strong uptrend. In other words, professional speculators are trend followers but not trend setters. Then the question goes back to square one, what is the cause that set the strong uptrend of Euro in the first place such that professional speculators are induced to join?

The United States of America has been running massive trade deficits for many years. The trade deficit peaked at $800 billion in 2006. Even after the burst of the bubble the trade deficit is still at $400 billion level. The aggregate sum of trade deficits from other countries pales when compared to the trade deficits of America. As a rough approximation we may say that America is supplying all the trade deficits on the globe. On the other side of the ledger there are trade surplus countries. The aggregate sum of trade surpluses of those trade surplus countries should equal the amount of U. S. trade deficits. Since America is financing its trade deficit by creating Dollar from thin air, each trade surplus country receives Dollar equal to its trade surplus. Some trade surplus countries allow their private entities to hold Dollar and trade according to their own instinct to make maximum profits. Those private entities become trend followers just like professional speculators as discussed in the previous paragraph. Thus the fate of Euro and Dollar rest in the hands of governments of trade surplus countries that hold large sums of Dollar. If those governments, in aggregate, opt for the sell of Dollar for Euro, then the uptrend of Euro is set. It should be apparent that we need to analyze those governments' handling of their Dollar hoards to uncover the details about the rising trend of Euro.

Among those governments of trade surplus countries we consider Japanese Government first. After buying about $400 billion from 2003 to 2004 in order to prevent the appreciation of Yen, Japanese Government has not intervened in the currency market since then. The increase of Japanís foreign currency reserve since 2004 has come strictly from interest income and capital gains of its existing foreign currency reserve. At the end of July of 2008 Japan held $977 billion foreign currencies. $638 billion was held in the form of U. S. Treasury Securities. We want to know that among the remaining $339 billion ($977 billion - $638 billion = $339 billion) how much are Euro denominated assets. Euro had plunged 19% vs. Dollar from the end of July to the end of November of 2008. During the same time period Japan's foreign currency reserve had increased by $26 billion. If Japan had held meaningful amount of Euro denominated assets, Japan's foreign currency reserve should have been pulled down by the sharp depreciation of Euro vs. Dollar but not. Therefore we can conclude that Japanese Government did not hold any significant amount of Euro denominated assets among its foreign currency reserve at the end of July of 2008. How about in recent months? From the end of April of this year to the end of October, Euro had rallied by 10% vs. Dollar, whereas Japan's foreign currency reserve had increased by only $17 billion. From those facts we can say that Japanese Government is not part of the parties that have set the rising trend of Euro.

Many crude oil exporters are trade surplus countries. Their governments receive substantial amount of Dollar as they sell crude oil. Some of those governments do not consider The United States of America as their friend and do not want to hold their foreign currency reserve in Dollar so they sell Dollar for Euro. Other governments of crude oil exporters, though are friends of The United States of America, still want to hold a portion of their foreign currency reserves in Euro. Thus those crude oil producing trade surplus countries are a part of setters of the rising trend of Euro. As has been pointed out in article 11, when the price of crude oil price rises, those crude oil exporting countries take in more Dollar, sell more Dollar for Euro, and as the result push up Euro more vs. Dollar. When crude oil price falls, less Dollar for sale from those crude oil producers and Euro falls from its own weight. As emphasized in article 11, it is the gyrations in the crude oil prices that leads the ups and downs of Euro, but not for Euro to lead crude oil price like many naive reports claim. Thus curious gyrations of Euro, synchronized with that of crude oil price, are superposed on a broad rising trend of Euro for many years. In any event, the comparison of the price of Euro with that of crude oil beyond the daily gyration is an important tool to uncover other forces that may be helping to set the uptrend of Euro.

It has been pointed out in article 11 that speculators in general were bearish about crude oil price until May of 2008. Then seeing the relentless rise of crude oil price, speculators gave in, joined the band wagon of skyrocketing oil price, and helped to push crude oil price to its July, 2008 peak around $150 per barrel. The crude oil price turned around at the middle of July of 2008 due to a few factors. One is the passing of Beijin Olympics. Prior to the Olympics, Chinese Government ordered factories near Beijin to stop burning coal in order to keep air clean. That act had boosted China's demand for diesel oil. As the Olympics approached, China had accumulated enough diesel oil to see it through the games, and the demand for diesel oil suddenly waned. In addition to that Olympics factor, the global demand for crude oil turned finally from stagnation to decline under the pressure of skyrocketing crude oil price. With the crude oil price over the peak late coming speculators panicked and started to dump their holding of crude oil futures, further depressing the oil price. There was another important factor that contributed to the decline of crude oil price. During the bubbling years of crude oil price, quite a few oil producing countries got euphoric and started massive infrastructure building. As the consequence the domestic consumption of crude oil of those oil producers had risen sharply. When the crude oil price fell, those extravagant construction projects came to a grinding halt, depressing the domestic demand of crude oil of those oil producing countries and thus reinforced the falling trend of crude oil price. The great financial meltdown of the fall of 2008 and the deepening recession, of course, depressed the global demand for crude oil further. Thus crude oil price continued its steady and sharp fall until February of 2009, losing 80% of its peak value eventually.

Euro followed the crude oil down from its peak set in July of 2008. However, when the financial world melted down in the fall of 2008, a new factor weighed in. Many European entities, following their American counter parts, had borrowed short-term Dollar in the commercial paper market and used those borrowed Dollar to purchase Wall Street issued Dollar denominated poisonous assets. When the commercial paper market froze during the financial firestorm, those European entities, just like their American counter parts, were not able to roll over their short-term Dollar borrowing. On American side The Federal Reserve injected huge amount of emergency Dollar liquidity to save those trapped entities from default. On European side, The European Central Bank injected large amount of Euro liquidity into the market. Those trapped European entities borrowed Euro, sold them for Dollar and rode off the crisis. Thus Euro fell sharply against Dollar, much more than the fall of crude oil price. When the commercial paper market finally unfroze, those European entities borrowed Dollar and bought back Euro, causing Euro to bounce back. Those wide gyrations of Euro around crude oil price trend continued until the end of March of 2009, and then Euro rose along with crude oil price until early June of 2009. Since then the rising trend of crude oil has slowed down substantially, but Euro has kept rising steadily. This implies that a new factor may have entered besides the old trend of tying Euro and crude oil price for quite a few years. Our following analysis, thus, will focus on two fronts. Is there other forces, beside the persistent Dollar selling of crude oil producers, that lie beneath the crude oil generated gyrations of Euro? How to understand the new factor in the rising trend of Euro introduced since early summer of 2009?

China runs the largest trade surplus in the world and has accumulated a foreign currency reserve that topped $2.2 trillion at the end of September of 2009. China's foreign currency reserve far outstrips the second ranked Japan's foreign currency reserve, about $1 trillion at the end of September. It is natural to question what is the role of China in setting the uptrend of Euro. The upheaval of Euro from the mid summer to late fall of 2008 gives us an opportunity to estimate the size of China's Euro holding. From the end of July to the end of November of 2008, Euro lost 20% of its value vs. Dollar. If China held a substantial amount of Euro, 20% loss should have occurred on those Euro denominated assets. On the other hand China was still buying Dollar from the market during August, September, October and November of 2008. The Dollar that China buys comes from three sources, the trade surplus, the foreign direct investment, and the hot money. During the time of financial meltdown, it is reasonable to assume that the direct foreign investment had come to a standstill. The difficult one to estimate is the hot money since those money travels through grey channels. We assume that the hot money was also shocked to the standstill during the financial meltdown just like foreign direct investments. Through the above mentioned four months China ran $133 billion trade surplus so we assume that China bought $133 billion from the currency market in the period of those four months. From the end of July to the end of November of 2008 China's foreign currency reserve increased by $40 billion. Thus the loss of Euro denominated assets should be $93 billion ($133 billion - $40 billion = $93 billion). This means that China's Euro holding at the end of July of 2008 was $465 billion, or about 300 billion Euro. The accumulation of this amount of Euro for many years naturally served as the underlying force, along with relentless Euro buying by crude oil producers, to set the multi-year rising trend of Euro.

President of The People's Bank of China (China's central bank) made public a memo calling for a super currency to replace U. S. Dollar as the international reserve and trade settlement currency in March of 2009. Right after the appearance of the article, in April of this year China boosted its gold reserve by 450 metric tons to a total of 1054 metric tons, as if underscoring China's determination to diversify its foreign currency reserve away from Dollar. This naturally raises the question whether China is stepping up its Euro purchase to the degree of generating the new uptrend of Euro that diverges away from the crude oil price as discussed before. From the end of March to the end of September of 2009, China's foreign currency reserve increased by $319 billion. Earlier we have estimated that China held 300 billion Euro at the end of July of 2008. We have also discussed wide gyrations of Euro around the period from the end of July of 2008 to the end of March of 2009. This kind of wide gyrations indicated that some shrewd Dollar rich parties were accumulating Euro at its bottoms. Let us assume that China was the shrewd party and it had doubled its Euro holding to 600 billion Euro at the end of March of 2009. From the end of March to the end of September of 2009 Euro appreciated $0.15 per Euro. Thus China's 600 billion Euro at the end of March appreciated by $90 billion during the period. This means that China had bought from the open currency market $229 billion ($319 billion - $90 billion = $229 billion) from April until the end of September of 2009. The aggregate trade surplus of China in the period was only $74 billion. Thus from the end of March to the end of September $152 billion ($229 billion - $74 billion = $152 billion) hot money had flooded into China. The amount of hot money may seem to be unreasonably large, but it becomes not surprising from the recent official announcement that in the past one year $70 billion hot money had flowed into tiny Hong Kong. According to U. S. Treasury Department statistics, from the end of March to the end of September China increased its U. S. Treasury Security holding by a meager $31 billion. Among the remaining $198 billion that China bought from the open market, probably a substantial portion was channeled into Euro in consistence with China's desire to diversify away from Dollar holdings. Thus a factor to set a new uptrend of Euro has been introduced.

Many Asian exporters other than China and Japan are also buying Dollar grudgingly to prevent further appreciation of their currency vs. Dollar so that their factories will not lose out to their competitors in China, since China has not allowed its currency to appreciate against Dollar for more than a year now. With this kind of grudging attitude to buy Dollar, we expect them to sell those Dollar bought in the market quickly for Euro and thus further enhance the new Euro uptrend.

Currently Euro is consolidating around the level of $1.5 per Euro and is still below $1.59 per Euro level reached during July of 2008. The future direction of Euro is apparently in the hands of Asian exporters. Based on the condition that The Federal Reserve is flooding the financial market with Dollar liquidity, if Euro tops $1.6 per Euro level and if China persists in not to let its currency to appreciate substantially vs. Dollar, then a currency and trade war between Euro region and Asian exporters becomes very likely. If such a currency and trade war breaks out, the current globalization scheme will be terminated quite a few years before its natural end as discussed before.