Stephen L. Jen (London)
Twin Deficits Set to Breach 7% of GDP
For the first time since 2Q85, the combined US fiscal and
current-account (C/A) deficits look likely to breach 7% of GDP this
quarter, and move into the 8% range by 2004. In my view, this ‘twin
deficit’ problem will become so severe in the coming two years that I
believe it will overwhelm other factors that may be USD-positive. The
USD resumed its structural correction on 6 December when Secretary
O’Neill resigned, and will continue to depreciate against a broad range
of currencies throughout this year, in my view.
Third Phase in This ‘Stuttering’ USD Downtrend
This USD correction is very different from the weak USD periods of
1985-87 and 1994-95. One key difference is that the current structural
USD correction has already been interrupted several times, while the
previous two USD corrections evolved more in a straight line. The global
economic backdrop is substantially more fragile and uncertain now than
in the other periods; and extreme economic weakness and uncertainty
have proven to be USD-positive and were, in my view, behind the
stop-and-go nature of this USD correction (our ‘USD Smile’ concept). In
assessing this ‘stuttering’ USD downtrend, therefore, my focus has been
less on the simple ‘crash versus no-crash’ debate, and more on
identifying the conditions under which the USD can correct, and those
under which the USD is supported.
The USD first began its structural correction in July 2001 (see
Questioning the Longevity of the Dollar Dynasty, S. Jen & J. Fels, 26
July 2001). This correction was interrupted by the terrorist attacks in
September 2001 and the events that followed. I believe that
fear-motivated capital supported the overvalued USD between
September and March 2002. The USD did not resume its second phase
of correction until March 2002, when (1) concerns emerged about the
commitment of the Bush Administration to the strong USD policy
following the imposition of steel tariffs, (2) the financial markets
stabilised and (3) investors began to price out the risk of a double dip.
The perception that the global economy was returning to a ‘benign
environment’ released risk capital out of the US, and the USD went into
a broad-based descent between March and July of 2002 (see The
Dollar is Likely to Enter a Gentle Descent, 7 March 2002). The violent
meltdown in global equity markets last July rekindled investor fears
and, as a result, USD bonds and the USD itself benefited from such
extreme risk aversion. This helped the USD remain stable for most of
2H02.
The resignation of Secretary O’Neill on 6 December 2002 marked an
important turning point for the USD in my view, for it signalled that the
Bush Administration may take the opportunity of the personnel change
to (1) further modify its policy on the USD and (2) introduce a large
fiscal stimulus. I believe this event triggered the third phase of the USD
decline. In a note last week (Fiscal Deficit + a C/A Deficit = a Weak
USD, 9 January 2003), I argued that a further move away from former
Treasury secretary Robert Rubin’s definition of a strong USD policy
would take out the tailwind that has been so powerful in pushing foreign
capital into the US in recent years. At the same time, fiscal stimulus in a
weak global economy will exacerbate the US’s external deficit. A
simultaneous fall in the supply of and a rise in demand for foreign
financing will be USD negative.
Why Is the Twin Deficit Bad for the USD?
Twin deficits occur in economies that are both saving-short and whose
public and private sectors are out of balance. In the late 1990s, the
world was eager to invest in the already saving-short US economy
because the US was not so much seen as saving-short as
investment-rich. It was thought that the US C/A deficit was justified
because investments in the US carried persistently higher returns on
capital and that such a saving deficit was a sign of strength, not
weakness.
Things are different now. Investment in the US has collapsed, and the
world has realised that the US return-on-capital premium was more of a
mirage than a miracle. Without Keynesian stimulus, domestic demand in
the US would have weakened and the C/A deficit would have naturally
declined toward what is considered sustainable in the long run.
However, with massive monetary and, now, fiscal stimulus to resist this
weakening in domestic demand, the saving deficit is, effectively, not
allowed to shrink. The C/A deficit in the US looks set to be kept high not
because of high investment, but because of lower net savings (the
public sector dis-saves on behalf of the private sector) to match lower
investment. This is a critical change in the USD story, one that is missed
by those who believe a fiscal stimulus will boost economic growth, which
in turn will support the USD.
How Big Is the Twin Deficit Problem?
To come up with a composite measure of the severity of the twin deficit
problem, I simply added the size of the fiscal and the C/A deficits (in
percent of GDP). 7% seems to be a critical threshold. The last time this
level was breached was in 2Q85. That was also when the USD index
peaked, followed by a 30% correction over the subsequent 2-year
period. (The Plaza Accord, on 22 September 1985, was announced
several months after the USD had already begun to correct.) Based on
the latest forecasts of our US economists Dick Berner and David
Greenlaw, incorporating what we believe will be included in the latest
fiscal package, this twin deficit index will reach a historical high of 8%
by 2004! While there is nothing ‘magical’ about the threshold of 7%, that
this measure of the twin deficit problem looks set to reach the highest
level in recent years is important.
Tying This In with Our Valuation Work
My concern about the growing twin deficit problem is also conceptually
consistent with our fair valuation work on the USD, which identified four
key drivers of the long-run fair value of the USD as (1) relative
productivity, (2) terms of trade, (3) the relative fiscal position, and (4)
the net foreign asset (NFA) position of the US. The twin deficit problem
of the US essentially captures the latter two variables: relative fiscal
position and the external financing position of the US. With the
emergence of the twin deficits, the USD’s underlying fair value has been
drifting lower since the beginning of 2002. The market value of the USD
must decline if only to keep pace with the falling fair value.
How Much Further Can EUR/USD Rally?
The USD has weakened by around 6% against the EUR since the
beginning of December. How much further can EUR/USD go? It’s tough
to say. However, I note the following. First, in my view, the Euroland
economic and EUR stories are not compelling. This move is not an EUR
story; it’s decidedly a USD story. I believe the EUR has been rallying by
default, not by merit. Second, having said this, the EUR is one of the
best alternative currencies to hold, particularly for the two key groups
of foreign exchange holders in the world: the Asian central banks and
the oil-exporting countries (at current oil prices and supply levels, there
are, annually, some US$800 billion worth of fresh petrodollar receipts
slushing around). Capital exit from the USD could mean a powerful run
into the EUR. Third, the key medium-term issue arising from the rally in
EUR/USD, from Europe’s perspective, is clearly export competitiveness:
How strong a EUR could the likes of Germany absorb in the current
environment? The ratio of Euroland’s output elasticity with respect to
interest rates and that with respect to the exchange rate is roughly 6:1,
i.e., a 5% change in the average annual index value of the EUR has the
same effect on GDP as a 75 bp change in interest rates. This means
that, to offset the effects of a 10% rise in the value of the EUR this year,
the ECB would need to bring the refi rate in line with the current level of
the Federal Funds Rate. Since the average value of EUR/USD was 0.95
in 2002, the current spot is already more than 10% higher. Thus, I
would be surprised if I don’t hear some verbal intervention from the
Europeans to try to cap the rise in EUR/USD. The ascent in EUR/USD will
slow or be suspended as a result.
Bottom Line
This is still a decidedly a USD story, not a EUR-, JPY-, AUD-, or a
GBP-story. The twin deficit problem in the US is becoming very serious
and, in my view, will overwhelm other factors to drive the USD lower
this year. The sum of the fiscal and the C/A deficit will, for the first time
since 2Q85, breach 7% of GDP this quarter. Coupled with the high
likelihood of further modification on the USD policy, the USD should
continue to weaken this year to equilibrate the supply and demand of
foreign financing for the US. |
