Sounds pretty gloomy<g> - US dollar - The beginning of the end
The US’ desire to weaken its dollar will help balance the federal economy better, says A P
Published : October 2, 2003
The recent communiqué issued by the G-7 (post their meeting in Dubai) is being seen by many market observers as a potential watershed event for the US dollar.
The key paragraph in the statement related to currencies and the critical phrase was “we emphasise that more flexibility in exchange rates is desirable in major countries or economic areas to promote smooth and widespread adjustment in the financial system, based on market mechanisms.”
There are three parts of this statement that can be considered significant.
Fist of all, it is probably the first time in modern financial history that the entire G-7 has signed up to a statement requesting greater exchange rate flexibility.
This obviously seems to imply that policymakers want more movement in exchange rates and are preparing the markets for greater exchange rate volatility.
The clear implicit message is that the world needs a lower US dollar to regain economic equilibrium. The use of the term ‘widespread adjustment’ seems to be the code for a more balanced global growth dynamics.
There seems to be no other satisfactory explanation for why the US would push for a language of this type.
Secondly, the mention of major countries or economic areas, clearly targeted at China, Japan and the broader Asian bloc, seems to indicate a global willingness for more freely floating currencies.
It also seems to indicate a willingness on the part of the Europeans to accept an appreciation of the euro if accompanied by a simultaneous upward move in Asian currencies.
One of the logjams to a dollar depreciation has been the unwillingness of the Asian bloc led by Japan including China, to tolerate stronger currencies.
Japan has intervened massively in the foreign exchange markets to prevent the yen from appreciating. China has maintained a fixed peg against the dollar despite evidence that the yuan is undervalued.
Other Asian currencies have also resisted appreciation so as not to undermine their positions versus Japan and China. The idea is that if the dollar declines against a broad set of currencies, the pain imposed on individual countries will not be that great.
It would be very difficult otherwise for the euro to absorb the entire burden of dollar adjustment.
Thirdly the use of the term ‘market mechanism’ also seems to be directed towards the Asian bloc and indicates a desire on the part of the G-7 to see less FX intervention.
The above statement throws up many related questions; why the sudden desire on the part of the US to push for a lower dollar?; Will this work in engineering a smooth depreciation of the currency?; Does the world really need the dollar to depreciate?
As or the reasons behind this desire to weaken the dollar on the part of the US government, there are basically two.
First of all, the US current account deficit at over 5 per cent of GDP and growing, is clearly unsustainable over the long haul. Already the deficit is the highest in the country’s history and requires the US to attract over $ 2 billion per working day in financial flows.
The US has already become the largest debtor nation in the world, with a net external debt/GDP ratio of 25 per cent, which will hit 60 per cent within a decade at its current trajectory.
No large industrial country has ever been able to sustain foreign debt ratios at this level. Also many studies done by the IMF and Fed., all seem to suggest that developed economies hit trouble when their current account deficits cross 4.5 per cent of GDP.
America has got away with such large deficits because it seems to pay very little on its debt. Till 2001, more income was generated on the investments made by the US overseas then it paid out to foreign investors holding American assets, even though the country was a significant net debtor.
Even in 2002, the net payments of the US to overseas investors was only $ 4 billion. As the stock of foreign debt keeps rising and the composition of capital flows financing this deficit keeps moving away from FDI and private portfolio towards short-term speculative flows, the costs of building up this huge debt will start to become significant.
As the Economist points out in a recent survey, even if the US were to pay only an average of 3 per cent on its external debt, by 2007 net interest payments will rise to $150 billion from the current $ 4 billion, and could start to hurt the economy.
Theother issue is that for the US current account to remain sustainable, economists calculate that foreign investors will have to allocate nearly 80-90 per cent of their marginal investments to American assets.
This was possible over the second half of the ’90s as the typical investor significantly increased the average share of American assets in their portfolios from 30 per cent to near 50 per cent. This adjustment is now near complete and unlikely to continue.
To correct this large deficit, the obvious route would be a depreciation of the dollar, and looking at previous periods of large current account adjustments, they have always been accompanied by significant currency declines.
Weakening the dollar will help push the US economy and global economy back into better balance, and reduce the US dependence on foreign capital flows.
Besides addressing the current account sustainability issues, another motive driving the US administration has to be a lack of confidence in the economy and the absence of job growth.
Weakening the dollar will provide support by improving US trade competitiveness. It is a new lever to stimulate the economy, when the scope for further monetary and fiscal stimulus is limited.
It will also help to reduce the risks of deflation in the US by pushing up import prices.
A decline in the dollar will also enable the US administration to take on the protectionist elements surfacing in America. China bashing in the US is becoming fashionable, driven by the supposed hollowing out of American manufacturing.
Many Americans believe that China has an unfair advantage because of its undervalued currency and forcing some sort of revaluation of the Chinese Yuan, no matter how modest, is surely worth some political brownie points.
Will this desire for an orderly correction in the dollar work and most importantly will it help the US recovery?
That to my mind really depends on the willingness of countries like Japan and most critically China to accept some currency appreciation.
Japan having signed the communiqué should go along with a slow and gradual appreciation of the yen, but China is the critical wild card, not being a part of the G-7, will it go along with the desires of the statement?
Only time will tell, but one should expect some loosening of the trading band of the Chinese Yuan and some appreciation, otherwise it is highly unlikely the rest of the world including Europe and Asia will allow their currencies to strengthen.
As for helping the US, as long as the currency depreciation is slow and orderly without disrupting financial markets, it should boost growth. But any boost will impact the economy only in 2005.
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