Is Dollar Weakness Signalling Problems Ahead?
International Perspective, by Marshall Auerback
May 6, 2003
“As you know, core prices by many measures have increased very slowly over the last six months. With price inflation already at a low level, substantial further disinflation would be an unwelcome development, especially to the extent it put pressure on profit margins and impeded the revival of business spending.”
– Federal Reserve Chairman Alan Greenspan, April 30, 2003
Late last year foreign purchases of U.S. equities fell to a very low level but remained positive. Since November the sharp rise of dollar holdings in the Federal Reserve foreign custody accounts suggests that official sector buying has financed almost the entirety of the U.S. current account deficit as private foreign investors have pulled back. Very recently dollar weakness has intensified. And, over the last week, the dollar has broken to new multi-year lows against the euro, Swiss franc, the Australian and Canadian dollars, and a whole host of Latin American currencies. Recently released figures from US Treasury confirm that private capital flows, as opposed to the official sector, are generating this weakness; the data demonstrates an increasing propensity by private investors abroad to sell dollar assets including U.S. equities. The multifold problems of the US economy – its huge external imbalances, its precarious reliance on debt, and its post-bubble traumas – have all been around for many years. So why the change in sentiment toward the greenback now?
Despite the swift U.S. victory in the Iraq war and continued upside progress in the U.S. stock market, it appears that mounting worries about a messy occupation in Iraq, and a rising fear of the SARS epidemic is starting to weigh heavily on the dollar (indirectly via China), as is the generally poor constellation of economic data that has come out recently in the US itself. With April's job cuts, total layoffs over the past three months topped a half-million workers, a performance usually seen only during the depths of a recession. The long economic expansion during the 1990s was fuelled by an unprecedented rise in private expenditure relative to income, financed by a growing flow of net credit to the private sector, not a “New Economy paradigm” in which the normal laws of economics were superseded. With Alan Greenspan quietly indicating renewed alarm at the state of the US economy at the end of his Congressional testimony last week (as the quote above illustrates), the markets could not have asked for a clearer signal that short rates were going to stay at these rock-bottom levels or move somewhat lower for a very long time. As the Federal Reserve comes closer to deploying unconventional measures to combat the risk of deflation, “yield- capping” at the long end of the Treasury curve appears to have emerged as a leading option. This, argues Morgan Stanley chief economist Stephen Roach, will bias the yield differential against dollar-denominated assets.
Needless to say, these are not policies optimally designed to attract foreign portfolio flows. In fact, Greenspan’s acknowledgement that “substantial further disinflation” constituted “an unwelcome development” marks an implicit recognition that high (reported) labour productivity is not supporting profit margins, but rather feeding through into non-financial corporate product price deflation which is offsetting the benefits of unit labour cost deflation.
The US Treasury releases securities data with a long lag, with the February data released last week. The report indicates that there was net selling of $4.74bn of Treasuries by the foreign sector, the first net selling since April 2002. More revealing was the actual composition of the flows: Large net Treasury buying from Japan ($5.58bn) and China ($1.80bn) is consistent with our belief that the official sectors of both countries are still accumulating mountainous reserves which they have been using to prevent any natural rebalancing process from taking place in the US external account.
Conversely, there has been widespread selling from the Euro area (-$3.4bn), the UK (-$2.9bn) and Canada (-$1.9bn). Of even greater concern, however, was net selling of -$4.19bn from the “other Asia” region, generally dominated by Middle East countries. We had raised the possibility of this issue a few months ago, and cited such widespread liquidation of US securities as potential blowback from the Islamic world in response to the US position on Iraq. For those inclined to diminish the significance of the latter, former CIA operative, Robert Baer, notes that Saudi Arabia (as but one example) keeps
“as much as a trillion dollars on deposit in US banks – an agreement worked out in the early eighties by the Reagan Administration, in an effort to get the Saudis to offset US government budget deficits. The Saudis hold another trillion dollars or so in the US stock markets. This gives them a remarkable degree of leverage in Washington” (“The Fall of the House of Saud”, Atlantic Monthly, May 2003).
To diversify even a small proportion of this money out of dollars is quite relevant in the context of threats to the external value of the currency.
That the US has moved quickly to withdraw the bulk of its troop presence from Saudi Arabia post the Iraqi conflict is further illustration that this symbiotic relationship between the Kingdom and the US is starting to break down. Moreover, though the comparative ease of victory in Iraq was deemed to be supportive of the dollar and the US economy, questions regarding the duration and the nature of the occupation remain foremost in overseas’ creditors minds. Such concerns may ultimately override the initial victory euphoria. A prolonged and expensive occupation may revive uncomfortable questions about US imperial overstretch, and raise doubts as to whether American rule in Iraq will create a beacon of secular democracy in the Arab world, or follow Israel's track in Lebanon or the Soviet Union's in Afghanistan. Paradoxically, the quick exit that might alleviate the burden of occupation is not on the cards: were the US to fail to commit the time, effort, and funds to support the difficult transition to a stable, post-Saddam Iraq, then this would likely undercut any residual support for the regime change, leaving the rest of the west even less incentive to lend economic and diplomatic support.
Linked to this political problem is the exogenous shock created by the outbreak of severe acute respiratory syndrome (SARS). Many health officials now argue that panic and the spreading fear of the disease has actually been worse than the epidemic itself. Be that as it may, this “overreaction” has had real economic consequences, which have indirectly impacted the dollar as well. The HK and Chinese economies have been smashed by the epidemic: last month, Hong Kong’s economy experienced its worst monthly contraction in at least 5 years, largely as a consequence of the outbreak of SARS. In China, service-sector industries such as tourism and restaurants have been brought close to collapse. The entire retail sector is suffering badly. The fragile banking industry is tottering, and the enormous level of foreign investment China has enjoyed over the past decade is under threat. Since their respective currencies are pegged to the dollar, the only means of alleviating the resulting deflationary shock may have been through the expedient of devaluation, which by virtue of the peg, could only eventuate in the event of dollar weakness.
Given China’s primary role in helping to establish the external value of the US dollar (by virtue of its mountainous accumulation of dollar reserves in the past), the SARS crisis has depressed the rate of accumulation in official reserves, which were being habitually cycled into dollars. This put greater pressure on the Europeans and others to soak up the excess dollars sloshing around as a function of the burgeoning current account deficit, and they were unable/unwilling to do so until the dollar assumed a weaker position vis-à-vis the euro.
The process has contributed to a further problem in relation to US trade and the corresponding goal to alleviate the country’s external imbalances: Quite apart for the fact that the dollar has been weaker against the wrong currencies, its strength against the euro has not translated into real pressure yet on core Europe. Whatever US officials might say about “punishing” the anti-war bloc of “Old Europe”, net exports and current accounts in Germany, France and Belgium are still positive, and healthily so. The euro is working fine for core Europe. Anyone in the US administration who thinks that devaluation is an easy or straightforward option for “disciplining” America’s recalcitrant allies might need to reconsider. The only real beneficiaries here, according to Goldman Sachs economist John Youngdahl, are the economies of emerging Asia, in that “a weaker dollar is the means by which the Asian NICs try to lay off some of their SARS-related deterioration onto the Europeans.”
SARS was just the last thing a teetering global economy needed at this point. The U.S. and world economy has generally been weaker this year than the consensus expected. Despite this, cyclical stocks have done well, while defensive stocks have done poorly. The most notable aspect of this tendency toward strength in the overall market is in some technology sectors such as semiconductors, where the SOX index had risen 20% on the year when the market peaked several days ago.
To some extent this striking outperformance of tech shares in particular reflects an increasingly widespread conviction that history is repeating itself and that we are on the verge of seeing 1998 redux. Notwithstanding a NASDAQ that is still some 70 per cent off its peak, there remains an entrenched optimism among professional money managers, which exists independent of any belief in a strong economic rebound and its probable implications for profits. In 1998, the massive reliquefication of the credit system engendered one final speculative blow-off in the tech sector, even as analysts such as Fred Hickey warned of massively deteriorating fundamentals (warnings which were subsequently borne out in spades). To survive as a money manager during the 1990s meant getting long beta on any bull market move regardless of the fundamentals and history. This “lesson” has not yet been unlearned, despite 3 years of catastrophic losses since March 2000.
It is also worth noting that successive bites at the “mortgage refi cherry” are yielding correspondingly less economic bang for the buck from the American consumer. This is despite the fact that consumer confidence measures have recovered a significant part of their earlier decline in response to the positive outcome of the war in Iraq. The “Baghdad bounce” appears to have confirmed the view of many economic commentators (including the Fed chairman) that winning the Iraq war handily would buoy the sentiments of U.S. consumers, corporations and investors, and lead at a minimum to a 2-3 month window in which consumer and corporate spending would surge and stock prices would rally.
In the post-war euphoria, however, very little thought has hitherto been devoted to the high costs of occupation, which the U.S. army chief of staff, General Eric Shinseki, estimated last year might require as many as 200,000 troops at a cost of $50 billion a year (this was based on his experiences conducting the war in Bosnia). Many have also assumed that Gulf War II, like Gulf War I, would become a self-financing proposition in which Iraqi oil exports would pay for occupation and reconstruction, even though it is clear that Shinseki’s estimates was a minimal amount required for foodstuffs and supplies for the Iraqi people. The market place has expectations about the occupation that could ultimately be sorely disappointed, particularly since the initial phase of the occupation has resulting in looting, civil anarchy and a power vacuum which has been rapidly filled by anti-American Islamic clerics. An indigenous political structure may now be created in the immediate post war power vacuum that the U.S. occupiers can now only dislodge with a degree of oppression they do not have the appetite to engage in. If so, there will be no effective U.S. occupation.
The “feel good” response of Western investors to the U.S. invasion in Iraq has been based on market expectations of a new order in the Middle East. This optimism is clearly not shared abroad, where many remain profoundly suspicious of US objectives in the area. Comparing the current US occupation of Iraq to the historical precedent of the Israeli occupation of Lebanon (where the IDF was initially welcomed as a liberating force as well), the Boston Globe’s Neil Swidey notes the following:
“In nearly every occupation, there is a tipping point-a defining incident that crystallizes the popular reception of the occupier. Right now, the views of many Iraqis toward the US occupation force are extremely fluid, changing depending on the circumstances of the day-or hour. They cheer US forces for bringing down a despised regime and delight in their newfound freedom to talk frankly or celebrate long-forbidden religious rituals. They curse the US forces for the darkness, for the lack of water, and for the looting.
These are temporary reactions to temporary conditions. At some point-no one knows when-the views of Iraqis toward Americans will become more fixed. As in Lebanon, the views of different communities may coalesce at different times. But those tipping points, say scholars, are what US leaders need to be most concerned about, even now, before the US transition civilian administration is fully in gear in Baghdad.”
If the U.S. occupation of Iraq is aborted by indigenous political developments, Wall Street’s Rosy Scenario for Iraq will come in question. Herein lays another adverse shock to investor sentiment and probably consumer and business attitudes that might exacerbate the weakness in the dollar and abort the rising U.S. equity market trend that has been given impetus by celebration over the U.S.’s quick victory in Iraq. There has been no final decisive moment of victory for the coalition forces that could lead to a further celebration. Instead, the war appears to be evolving into an occupation that may be extremely costly and possibly chaotic. If all of the good war news is out, market participants may now be inclined to focus on the negative economic news that they have been ignoring. This might be catalyzing a reduced propensity to hold dollars.
But isn’t dollar weakness a necessary corrective to ensure less US-centric growth and more rebalancing of America’s external imbalances?
In theory, this is true. In fact, as a matter of simple accounting identities, the ex-post government deficit, the current account and overall private sector financial position must all balance. But the ex-ante flows become the crucial determinant as to how these balances are achieved. In practice, it is unclear that foreign creditors would tolerate the corresponding threat to their capital gains and would therefore demand an equilibrating interest rate from the standpoint of ex-ante flows. At the short end, however, this is not going to happen any time soon, as Alan Greenspan has just told us and if it happens at the long end, it creates additional risks for debt-ridden private households. It is also the case that the fall in net export demand implied by reduced US domestic demand must be offset by some sort of domestic stimulus package in Euroland and Asia, neither of which yet appears on the cards. In the absence of an expansionary effort on an international scale (with a greater share to be taken by the rest of the world) dollar weakness will achieve nothing and the prospect of a severe growth recession will increase.
The prospect of further increases of debt in the US is clearly unsustainable. But the dollar devaluation now underway in the US will fail to achieve global rebalancing unless changes are afoot in Europe and Asia. A recurrent theme of our earlier reports was that the United States' rising balance of payments deficit was generating an increasingly negative net asset position. This would eventually constrain the United States, as it would any country, when the cost of servicing the debt started to explode. Until recently, our fears have proved unfounded. A combination of deteriorating domestic fundamentals, coupled with the exogenous shocks engendered by the Iraqi war aftermath and the SARS epidemic, are beginning to change overseas’ perceptions, refocusing attention on the increasingly tenuous nature of America’s economic prosperity. The management of monetary policy via the manipulation of short-term interest rates, however sensitively and skillfully this may be carried out, is totally inadequate as a means of dealing with the serious structural problems that threaten the future prosperity both of the United States and the rest of the world. Perhaps it is hoped that dollar weakness is the means by which America forces Europe and Japan to shift the world away from US-centric growth. But the response thus far to the dollar’s weakness does not, as yet, appear to presage the first step toward a more co-ordinated global expansionist policy or, indeed, any kind of co-operative economic multilateralism at all. Rather, it indicates nothing more than credit revulsion on the part of foreign investors. Will this credit revulsion ultimately expose the limits of US unilateralism?
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