The US dollar has defied all forecasts. The dollar index is trading at a 7 month high, and this at a time when its current account deficit is approaching 7 % of GDP. The Japanese yen, the Euro and the Indian rupee are trading at 19 month lows. If there are any fundamentals that are driving the dollar to these multi-year highs, I don’t know of them. Let’s consider interest rates. European interest rates have begun to rise again, after having declined since Oct. 2000. Japanese interest rates are scheduled to increase from their near zero levels of the last four years. Let’s consider stock markets. This calendar year, European stocks have risen about 20 %, Japanese stocks about 30 percent. US stocks – despite the year end rally, they are barely in positive territory. Let’s consider growth rates. US growth is slowing down marginally, whereas both Japan and Germany are no longer the sick men of the world. Indian growth rate has exceeded 8 % for the first time in a year not following a drought, and India has just displaced the US as the second most attractive FDI destination. Yet today (Dec. 6th) the dollar is trading at 121 yen, 1.17 euros, and 46.35 rupees. As Marvin Gaye would say, “What’s going on?”

Besides these fundamental factors (interest rates, GDP growth, stock markets), there is another small surprise in the fundamental mix-up - the value of the Chinese yuan. After complaints from all over the world for its mercantilist exchange rate and therefore trade policies, the Chinese finally "relented" and signaled to the world that they were ready to play by the "rules of the game". They appreciated their currency by a miniscule 2.1 percent on July 21, 2005. This appreciation, by all accounts, was too insignificant to make a dent in the overall mercantilist trade imbalance. Even the major US investment banks - who, perhaps due to $ signs, have been reluctant to point out in their research that the Chinese currency is today significantly more undervalued than the yen was at the time the world was forced to take notice in 1985 - were expecting some movement in the Chinese currency after the initial 2 % pinprick.

But this was not to be. While there is internal dissension, and significantly from the Chinese Central Bank, the powers that be in China know how it can laugh its way to the bank at the expense of growth in other countries. So it has kept the yuan under wraps - i.e. only a 0.5 % appreciation against the dollar since the momentous day of July 21.

This lack of movement has not only disappointed American politicians but also policy makers around the world. To date, when currencies did go out of whack, there was a correction induced by either the market (e.g. the famous Soros play on the British pound in Sept. 1992, or the Thai Baht devaluation in July 1997) or by policy makers e.g. the Plaza agreement pertaining to the yen, and to a lesser extent the European currencies, in 1985. But none of these historic landmarks have affected the Chinese view of exchange rates: "listen, we have tied ourselves to the dollar through thick and thin, and we did the world a favor by not devaluing along with Asian currencies in 1997". If the policy is one of fixed exchange rates, then how can the question of a "favor" arise, especially if fundamentals favor an appreciation (as it did with China) or fundamentals favor a depreciation (as was the case with Thailand). If the concern is with the "need" of devaluation in 1997, the Chinese conveniently forget that they pioneered the concept of large scale beggar thy neighbor devaluations i.e. in 1980 one dollar bought 1.5 yuan, in 1990 4.78 yuan and in 1994 8.62 yuan. The last devaluation was 80 percent in nominal terms, and 30 percent in real terms!

Since 1993, the Chinese currency should have further appreciated in nominal terms, to reflect differences in inflation and productivity growth. But the Chinese authorities, obviously, are not moved. They have thumbed their reserve dollars at the world, gleefully adding that they could cause major financial instability by dumping dollars if provoked enough. Given this Chinese power play, and intransigence, Marvin Gaye might have said "You know we've got to find a way, To bring some fairness (lovin') here today". And this is what I believe happened to the US dollar over the last few months. Perhaps aided by a wink-wink and a nod-nod from both developed and developing country policy makers, the "world" has decided that if China does not come to the table, the mountain will go to China. Since the world needs a Chinese revaluation, and China won't do it on its own, the world will do it for China. Note the exchange rate changes in the table since mid July, the time of the beginning of the so-called Chinese reval. The yen has depreciated by 7 %, the Euro by 2 percent; this when the expectation was that both would appreciate by at least 10 percent (remember the targets of 100 yen to the dollar and 1.40 for the Euro?). Besides the Philippine peso, the ostensibly ultra strong Asian currencies have generally stayed flat, or depreciated - with the Indian rupee depreciating the most, 6.1 percent. It must be that the Indian authorities have (correctly) decided that if undervaluation was so good for its major competitor, China, it should also be good for India. In Latin America, Brazil shows an oversized appreciation, but this is more a function of the very large devaluation that occurred there in the last few years.

How long can this unusual adjustment pattern continue? Until China realizes that globalization is a multi-player game.