INSIGHT: 'STRONG DOLLAR' POLICY CLASHING WITH US TRADE DEFICIT REALITY
By Steven K. Beckner
Market News International - Under the direction of Treasury Secretary Lawrence Summers, as under his predecessor Robert Rubin, U.S. dollar policy has consisted of frequent reiterations of the assertion that "a strong dollar is in our national interest," but increasingly that policy has been tempered by healthy doses of what used to be called "benign neglect" of dollar weakness against certain currencies.
There is little reason to think that will change much in the year to come. Indeed, until the U.S. trade deficit stops widening and begins to retreat, it will become even more critical that the United States tolerate some degree of dollar depreciation, even as it continues to assert the ideal of dollar strength. Indeed, Market News International is informed, some depreciation is considered "inevitable."
But those concerned with dollar policy recognize there is a big difference between allowing some depreciation for the sake of external adjustment and veering into a situation where a rapid dollar decline aggravates inflationary concerns and risks financial stability. A growing sense of the dollar's vulnerability is causing official disquiet.
So far, on a trade-weighted basis, the dollar has remained fairly strong, thanks in good part to the residual effects of the Asian financial crisis and other developments, which drove huge amounts of foreign capital into U.S. assets. Though off its high, the Fed's broad index of the trade weighted value of the dollar stood at 116.14 as of Dec. 17, up from 113.97 on Dec. 31, 1998 and 112.60 in December 1997, while its index relative to major currencies was up from 92.53 to 93.58 compared to a year earlier.
And, of course, the dollar has appreciated impressively against the euro in 1999, as the single European currency unit went from a premium $1.17 at the beginning of the year to near parity.
However, the dollar has fallen dramatically against the yen, going from an exaggerated high of 147 yen per dollar in June 1998 to around 113 yen at the end of last year to between 101 and 102 at present. And the dollar weakness against the yen could give way to weakness against the euro and other currencies in the year to come. Whether the yen can continue appreciating as a recovering Japan confronts its massive fiscal deficits remains to be seen.
If the U.S. mantra has been, "A strong dollar is in our national interest," the continuous European refrain throughout the past year has been that the euro has enormous "potential for appreciation." That assertion could finally come true in the year ahead. Once a dollar slide begins, who can say where it will stop?
So the Fed and Treasury, which by and large see eye to eye on dollar policy, know there is a fine line to be walked. Fed and Treasury officials believe some depreciation of the dollar, provided it is orderly, is both desirable and inevitable over the medium term because of the large and growing U.S. current account deficit. But they do not want a dollar decline to become so steep as to destabilize financial markets. Nor do they want dollar depreciation to become so pronounced as to become a source of inflation through the dual channels of higher import prices and export demand stimulus.
The desire to prevent too much of a good thing led Summers and Fed Chairman Alan Greenspan to push for a Group of Seven expression of concern about yen strength in late September. At their Sept. 25 meeting, when the dollar was on the 100 yen precipice, G-7 finance ministers and central bank governors "shared Japan's concern about the potential impact of the yen's appreciation for the Japanese economy and the world economy" and "welcomed indications by the Japanese authorities that policies would be conducted appropriately in view of this potential impact." The G-7 officials further pledged to "continue to monitor developments in exchange markets and cooperate as appropriate."
Although it hasn't happened yet, there could come a time when sudden and disruptive dollar weakness against the yen could force coordinated intervention. But such action, should it ever transpire, would not mark any fundamental shift in dollar policy.
The basic reality confronting dollar policymakers is the widening U.S. current account deficit. It rose to a $89.9 billion in the third quarter from $80.9 billion in the second and $68.7 billion in the first. The deficit on trade and goods and services hit a record $25.9 billion in October.
At the Fed, these deficits are viewed as symptoms of the savings-investment imbalance in the United States and the excess growth of domestic demand relative to potential supply. A vulnerable dollar is seen as an outgrowth of this phenomenon.
As Greenspan has indicated publicly, U.S. officials know that foreign investors will not inevitably build up their stocks of dollar-denominated assets to finance widening deficits, particularly in a world of improving opportunities outside the United States.
The preferred method of adjustment is for the U.S. economy to slow relative to growth abroad. The Fed puts more emphasis on slower U.S. growth and hence demand for foreign goods and services. The Treasury puts more emphasis on accelerating foreign growth. But, in any case, there is a strong suspicion that changes in relative growth rates will not be enough to reduce the current account deficit: some dollar depreciation will surely also be needed.
Whenever a nation's current account deficit approaches 4% of GDP, its currency tends to become subject to sudden depreciation. The United States is something of a special case, of course. It still has the world's most important reserve and transactions currency and the world's largest and deepest markets. What's more, there are still ample foreign savings for the United States to draw on to finance its current account deficit, and its external indebtedness is not that large.
The big question is whether U.S. investments remain attractive to foreigners. Just as it has been the key, domestically, to maintaining noninflationary growth and job creation, improved productivity has been a major factor in the appeal of U.S. equities. Should productivity growth falter or if for other reasons U.S. assets begin to appear overvalued, there could be an outrush of foreign capital that might trigger both a stock market correction and a dollar drop that could conceivably become steep. The euro could at last realize all that "potential" which European Central Bank President Wim Duisenberg has spoken of so often.
The fear is that a large or sudden dollar depreciation would have adverse economic consequences negating any benefit from reducing the trade imbalance. At the extreme, it could cause a spike in bond yields, a market crash and an economic downturn. Alternatively, dollar depreciation could cause imported inflation, both by pushing up import prices and by stimulating demand in the export sector. Inflation in turn would force more dramatic Fed tightening and a sharper than desired contraction of economic activity.
Continued acceleration of productivity growth could obviate such problems. Officialdom can always hope but cannot be confident of such a gain.
The hope then is that the dollar exchange rate will adjust gradually in line with the fundamentals, so that the dollar, like the economy, has a soft landing. But currencies have a way of overshooting the runway. |
