Want to hear the 'ugly' scenario?
___________________________________
The U.S. currency's steady decline could be far from over -- and the odds that the global economy will escape unscathed from its correction are getting worse, writes DAVID PARKINSON
DAVID PARKINSON
The Globe and Mail
Saturday, December 4, 2004
So you're starting to feel a bit queasy from the U.S. dollar's tumble? Two syllables of advice: Gravol. The wild ride may be far from over -- and it could be bumpy.
That might seem hard to imagine, given that the world's most important currency is already down 29 per cent against seven major world currencies over the past 33 months. In the past three months alone, the greenback has slumped 12 per cent against the euro, 8 per cent against the Japanese yen and 9 per cent against the Canadian dollar. How much worse could it get?
Much. Despite the plunge, experts warn, the dollar -- for years, the darling of foreign exchange markets -- is probably still overvalued. More importantly, they say, the U.S. dollar is in the midst of a long-term correction needed to rebalance a global currency and trade picture that is dangerously out of whack.
The correction poses sobering risks for global financial markets and probably has a few more years and another 15 to 20 per cent before it's over. No less an authority than former U.S. Federal Reserve Board chairman Paul Volcker warns that there's a 75-per-cent chance of a dollar-fuelled financial crisis within the next five years, unless Washington adjusts its economic policies.
The moribund dollar, of course, is only the most visible symptom of a more systemic disease: the dangerously bloated U.S. current account deficit. This deficit -- a broad measure of all U.S. trade in goods and services -- is now running at more than $600-billion (U.S.), over 5 per cent of U.S. gross domestic product and a value equal to the entire GDP of India. These numbers are signs of an unbalanced economy that is consuming far more than it is producing, spending far more than it is saving. Record-low personal savings rates have been exacerbated by the massive U.S. federal budget deficit.
To cover the shortfall, the United States must rely on increasing amounts of foreign investment dollars entering the country -- an estimated $2.6-billion each and every business day. As Mr. Volcker said in a television interview last week: "We are increasingly reliant on the goodwill of strangers."
Because the exodus of dollars to buy foreign goods and services so far exceeds the influx of dollars from sales of U.S. exports, the currency's decline was inevitable.
A cheaper currency would also help cure the current account imbalance. It would discourage U.S. demand for imports, while making U.S. exports cheaper for foreign buyers. That's part of the best-case scenario, in which U.S. and global markets navigate safely through the treacherous waters of a long-term dollar retreat, relying both on remarkably good luck and co-operation from foreign investors willing to keep investing in U.S. assets to finance the deficit. But all sorts of pitfalls might cause these investors to lose faith.
The worst-case scenario is much less pretty:
Foreign investors, losing confidence in the U.S. dollar's stability and increasingly doubtful that the American economy can absorb the current account imbalance, yank money out of U.S. government bonds, in favour of safer harbours.
This exodus sends the dollar off a cliff. Interest rates spike higher, reflecting plunging demand for U.S.-dollar debt and the rising risk perceived by investors.
Stock markets tumble, as investors flee U.S. stocks to avoid the currency losses tied to U.S.-dollar-denominated stock prices, as well as the rising interest rates that imply less competitive returns at current stock valuations and the drag on corporate profits from rising credit costs.
Corporate and consumer spending slump under the weight of rising interest rates and import prices. The U.S. economy slows to a recession, dragging the rest of the world down with it. Policy makers stand by helplessly; if the Federal Reserve Board were to cut interest rates to stimulate the economy, it would only put more downward pressure on the dollar.
Far-fetched? Maybe. Martin Barnes, who described just such a chain of events in his independent research report The Bank Credit Analyst, acknowledges that the scenario -- he called it his "ugly" case -- is "overly gloomy."
But it has happened before. In October, 1987, a similar build-up of dollar and deficit worries culminated in the infamous Black Monday crash, the worst one-day percentage loss in U.S. stock market history.
Then, as now, the United States was grappling with a deep and growing shortfall in the current account. Then, as now, this deficit was fuelling a downward correction in the U.S. dollar. Then, as now, U.S. government officials signalled a willingness to let the markets take the dollar down further, while squabbling with trading partners over what needed to be done.
Although these weren't the only causes of the crash, market historians agree that the slumping dollar and the current account imbalance helped lay the groundwork.
Most experts doubt we're headed for a 1987-style meltdown, noting that several of the conditions that snowballed into a market crash 17 years ago aren't in place today.
"People tend to forget that there was what some would describe as a bubble in equities in 1987," says Marc Lévesque, chief North American strategist at TD Securities. "The markets had been making huge gains. That's not the case now -- you can't make the case that there's a bubble in equities."
Nor is the U.S. economy even close to the inflation and interest rate pressures it faced in 1987 when a dollar selloff helped drive inflation fears and spooked the bond market. The 10-year Treasury bond yield spiked from 7 per cent in early January to more than 10 per cent in October. Inflation jumped from barely 1 per cent to 4.5 per cent. Compare that with the current situation: The 10-year Treasury yield of 4.26 per cent is virtually unchanged from the end of last year, while year-over-year consumer price inflation stood at 3.2 per cent in October, up from 1.9 per cent in December, 2003.
"People who bring up 1987 are just trying to make good copy," says Gabriel de Kock, an economist at Smith Barney in New York.
The bond market, however, may be a different story. The high prices and resulting low yields bonds have enjoyed this year could leave bonds exposed to a big selloff if foreign holders of U.S. Treasuries dump their holdings and pull their money out of the U.S. If bonds sell off, it would mean higher yields and, therefore, higher interest rates for both corporations and consumers.
"If you want to make parallels [to 1987]," Mr. Lévesque says, "it's the bond market that really seems extremely expensive now, based on economic fundamentals. And that's where I think you could see a very serious correction."
That correction might have already begun. Bond prices have slumped since late October, sending the yield on two-year Treasury bonds up more than 40 basis points and the 10-year yield almost 30 basis points. (A basis point is 1/100th of a percentage point.)
Still, Mr. de Kock dismisses the risk of a mass exodus from the U.S. bond market. "To have this sort of a dramatic selloff, people have to think the Fed's losing control of the situation," he says. "Inflation expectations have to explode. That's when you get the dollar triggering a large bond-market move. That vulnerability in inflation expectations is just not there."
Experts also note that the biggest buyers of U.S. government debt have strong incentives to keep buying, in order to temper a bond market decline. About 60 per cent of the foreign holdings of U.S. Treasury securities are held by government treasuries and central banks. The biggest stakeholders, Japan and China, have used U.S.-dollar asset purchases to keep their own currencies low and fuel export growth. National Bank Financial assistant chief economist Stéfane Marion points out that as foreign direct investment and foreign holdings of U.S. equities have fallen over the past year, capital inflows from foreign central banks have made up the slack and increasingly been responsible for financing the current account deficit.
While it makes some observers uneasy to see the United States increasingly beholden to these foreign governments, experts say it could be a blessing in disguise.
"It is in no country's best interest to dump Treasuries because it would ensure that U.S. [interest] rates would rise sharply, slowing American demand for imported products and likely triggering a worldwide recession," BMO Nesbitt Burns chief economist Sherry Cooper wrote recently. For those reasons, pundits believe, foreign central banks will buy U.S.-dollar assets to moderate the dollar's decline and the interest rate rise.
Indeed, Japanese vice finance minister for international affairs Hiroshi Watanabe made it clear this week that Japan -- by far the biggest foreign owner of U.S. government debt, with $720.4-billion worth, more than four times the amount of second-place China -- is poised to intervene in currency markets to slow the U.S. dollar's descent against the yen.
But even if international central banks can successfully cushion the dollar's fall, U.S. investments will continue to be exposed to considerable risks.
"We've reached an important threshold when the U.S. current account deficit is at 5 per cent of GDP," says National Bank's Mr. Marion. "More and more, the question is how sustainable is this thing. The answer is, nobody really knows."
The favoured recipe for correcting the imbalance -- lowering the currency to reverse trade flows, letting interest rates drift higher to force consumers to spend less and save more, and cutting the U.S. budget deficit -- would itself impose strains on the economy and financial markets, no matter how smoothly it can be achieved.
The best-case scenario and the view held by most forecasters today: Interest rates still climb, consumer spending still decline, and businesses slow their hiring. Corporate profits would suffer, hurting stock values. And there would be slowdowns in both U.S. and world economic growth. While the depth of such a slowdown is anyone's guess, it's worth remembering that the imbalances of 1987 weren't fully erased until the U.S. slipped into recession in 1991.
In a speech last month, Fed chairman Alan Greenspan said the improved flexibility in the U.S. and global economies "suggests that market forces should over time restore, without crisis, a sustainable U.S. balance of payments." In Mr. Greenspan's view, the best way for economies to adjust to shocks and avoid crises is by keeping trade as open as possible. The subtext, however, was clear -- if a dollar-induced shock wave were to cause jittery countries to adopt protectionist policies, the ability to weather the storm could be compromised.
Mr. Greenspan also sent a clear signal to U.S. policy makers: Clean up your own house. A reduction in the bloated budget deficit, he said, "appears to be the most effective action that could be taken to augment domestic saving."
Experts agree that moves like this could help the United States avoid crisis and come out the other end with healthier markets. In fact, they point to Canada in the 1990s as an example of a government that used a weaker currency and a balanced budget to overcome a large current account deficit without precipitating economic or market collapse. But as Canadians well know, that doesn't mean the process will be painless.
"One way or another, you have to have a slowdown in U.S. economic growth," Mr. Lévesque says. "That's the only way the current account deficit can correct. The only issue now is how it happens."
--
© The Globe and Mail. |
