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Global: The Kindness of Strangers
Stephen Roach (New York)
Drama can take many forms in the US Congress. And it certainly has in recent years. But I was unprepared for the dramatic interlude I recently experienced in Washington. I had been asked to testify in front of the Senate Banking Committee, joining former Federal Reserve Chairman Paul Volcker and former Treasury Secretary Robert Rubin to opine on America’s record balance-of-payments deficit. It has been a chronic problem for most of the past 20 years, but not something that has grabbed much attention in the Congress -- or the financial markets, for that matter. At least, until now.
Borrowing a classic line from Tennessee Williams’ A Streetcar Named Desire, Senator Paul Sarbannes, Chairman of the Senate Banking Committee, put the crux of the problem in vivid context. After a painful journey of self-examination, Blanche Dubois, the main protagonist in the play, finally confesses, "…I have always depended on the kindness of strangers." The senator pondered whether America’s increased reliance on foreign capital -- the flip side of our gaping current-account imbalance -- has left the United States just as vulnerable as poor Blanche. What might happen, he mused, should foreigners suddenly feel less kind?
The answer is pretty obvious. Foreign investors would then demand a premium for purchasing dollar-denominated assets. That hasn’t happened in years -- to be precise, since the spring of 1995, when the trade-weighted dollar hit its all time low. Since then, global investors have been enamored of America’s New Economy prowess -- more than willing to pay "top dollar" for a piece of the action. Should foreign investors ever rethink that basic premise, then something most assuredly would give. Under those circumstances, they would then demand a premium on dollar-denominated assets that would show up in the form of cheaper stocks, higher bond yields, a weaker dollar -- or some combination of all three. Our currency team is increasingly sympathetic to the view that a weaker dollar would gradually bear the brunt of such a scenario (see the dispatch of Stephen Li Jen and Joachim Fels, "Questioning the Longevity of the Dollar Dynasty" in today's forum). I concur, but wonder about how gradual the adjustment might be.
The answer is less important than the conditions that might give rise to such a shift in foreign-investor sentiment. With the dollar under a bit of pressure in recent days -- stress on the words "a bit " -- such a possibility is not idle conjecture. Of course, there are innumerable circumstances that might give rise to such an outcome. After all, currencies are relative prices, and investor sentiment could shift because of a problem in America or a rethinking of returns on non-dollar-denominated assets. My top three reasons that might trigger a dollar decline: a capitulation of the American consumer, newfound political legitimacy to Japanese reforms, and a lifting of bureaucratic inertia in Europe. It’s been a losing bet to be negative on the dollar during the past six years. The broad consensus of investors appears to have finally given up altogether on this possibility. For that reason, alone, it pays to be wary of the staying power of the Teflon-like dollar.
All of us at the congressional hearing were in broad agreement on one key premise: Currency fluctuations do not take on a life of their own -- they are by-products of imbalances in the broader global economy. We went on to agree that America’s record current-account deficit was a classic example of just such an imbalance -- a serious misalignment between the United States and its major trading partners that cannot be sustained indefinitely. Concern is one thing, but in the halls of the US Congress, they want answers. And so all of us were asked, what should be done to defuse this problem?
There were no earth-shattering policy prescriptions that came out of this hearing. We concurred that America had to increase its national saving rate. Only then can the Unites States successfully wean itself from the excessive dependence on the foreign capital inflows that are required to finance growth-enhancing investment in plant and equipment. We were less clear on how to accomplish this noble objective, especially in light of the generally disappointing experience of using fiscal policy (i.e., tax incentives) to encourage saving. While tax gimmicks have been good at shifting around the mix of saving, they have been less effective in raising the level of national saving. As for the rest of the world, there was general agreement that it needed to grow more rapidly. Further trade liberalization and structural reform were at the top of our action lists. The assembled senators yawned in response. So did I.
But I must confess that my ears perked up when I heard Paul Volcker warn about what should not be done. He was adamant in cautioning against a reflationary policy stimulus that might give rise to another boom in the US economy. This places him somewhat at odds with his successor, who has been easing monetary policy aggressively in the past six months in order to jump-start a nearly stagnant US economy. While Volcker was quite explicit in warning of the perils of recession as a means to overcome the current account deficit, he was equally clear in suggesting that it would be reckless to foster a climate of vigorous consumption that would further deplete personal saving. I couldn’t agree more. The last thing America needs is a replay of the excesses of the late 1990s -- a Nasdaq bubble, a massive IT overhang, a negative personal saving rate, and a record current-account deficit. Slower growth, rather than another boom, would be the optimal path under the circumstances still prevailing.
I guess that’s what brought the issue to a head for me. In policy circles, there is still an appetite for the quick fix -- the counter-cyclical stimulus that turns a bust back into a boom. That’s what happened in the depths of the financial crisis in late 1998, when the Federal Reserve led the way in saving the world. But it was the ensuing froth of global healing that took the US and global economy to excess in 2000. Yet that’s precisely the same script that’s being followed today -- another quick fix by the Fed. For Blanche Dubois, the script left her with the painful realization of self-doubt. In the end, she finally came to grips with the fantasies that had shaped her life’s journey. Might not those kind strangers be getting ready to pose some tough questions about all that was once thought to be so perfect about America?
Currencies: Questioning the Longevity of the Dollar Dynasty
Stephen L. Jen & Joachim Fels (Tokyo & London)
Why has the USD been so strong this year?
Since 1997, the USD has appreciated by about 29% on the Fed’s trade-weighted index: 20% between 1997 and the peak of the Nasdaq reached in April 2000, and another 7% since then. An argument based simply on growth differentials between the US and the rest of the world would have failed to predict this stellar performance of the USD, particularly after the US economy began to slow in November of 2000. Recall that we have previously suggested two explanations for the USD strength in the face of a slowing US economy, both of which are related to the safe haven status of the USD. The first explanation is uncertainty about the landing of the US. If the investment community were uncertain about the kind of landing the US would have, there would be both buyers and sellers of the USD. Further, so far this year, the US landing has been a (relatively) gentle one for Europe, but a very harsh one for Asia. An immense amount of safe haven capital from Asia has helped support the USD, since the IT shock hit Asia particularly hard. Thus, (1) uncertainty and (2) the hard landing in Asia helped support the USD even when the US economy began to slow.
The USD may have plateaued.
However, the landing in the US has turned out to be harsher than US policy makers had thought. With the prospect of a recovery still highly uncertain, there are reasons to suspect that the policy makers are having second thoughts about the five-year-old strong-USD policy. At the crux of the issue here is the new policy paradigm that aggressive Keynesian stimuli are appropriate only for the US, while the rest of the world's economies have a different policy focus. For example, Japan’s policy platform is oriented toward restructuring the supply side of the economy, while Europe is still more concerned about inflation rather than growth. This dichotomy in policy orientation has put the US in a difficult position: Now that domestic demand is bottoming, there is no external demand for exports from the US! A not-so-strong USD would be a natural response to the Keynesian-non-Keynesian split between the US and the rest of the world. President Bush’s comments last week are important in this context. While the strong USD policy had unambiguously been an "asset" to the US economy, it is now both an "asset" and a "liability." Notwithstanding Treasury Secretary O’Neill’s comments reaffirming the USD policy, we have several reactions. First, of the three stages of the USD-- strengthening, plateauing, and correcting -- the US may now have moved into the second stage. The subtle ambivalence in President Bush’s comments could suggest that the USD is approaching a threshold of tolerance of sorts. Second, a clear distinction should be made between a U-turn in the strong USD policy, on the one hand, and changing expectations of the US fundamentals. This distinction is important because maintaining a strong USD policy is a ‘necessary but not sufficient’ condition for the USD to stay strong. The USD could certainly correct if investors revise down their view of the US economy, relative to the rest of the world. Third, US policy makers are, in a way, asking the market to make a judgement on the USD based on the economic fundamentals rather than keying off of the US currency policy. What this means is that, if and when the USD corrects, the US Treasury will likely not intervene to support the USD, even if it still holds a strong USD policy.
What does history say about USD corrections?
According to our fair value calculations, the USD is overvalued by about 12% on a real trade-weighted basis. In nominal bilateral terms, the USD could be as much as 15% over-valued against the JPY and 10% against the EUR ("Correcting the US Dollar -- A Technical Note," Yilmaz & Jen, June 1, 2001). What is remarkable is that the USD is almost as overvalued as it was back in 1985, and most of the overvaluation happened this year: the USD was only 4% overvalued at the end of 2000. On average, it took around four quarters for the USD to "land" from an overvalued position (the period it took to move from the peak to fair value), a bit faster than the time it usually takes for the USD to normalise from an under-valued position. Sudden USD crashes are rare.
There are several possible triggers of a correction in the USD.
As we think an outright abandonment of the strong USD policy is unlikely, and as we don’t consider a sudden shift in sentiment a valid trigger, we focus on "real" factors. First, a collapse in oil prices is increasingly likely as declining oil demand adds pressure on the OPEC cartel. Already, of the cumulative notional supply cuts of 2.5 million barrels per day (mbpd) announced by OPEC-10 since December, only 1.5 mbpd has been taken out of the market. The compliance rate is at a dismal 60%. Protracted weak global demand conditions could compromise the integrity of the OPEC cartel. A collapse in oil prices should be positive for EUR/USD, and therefore could be a potential trigger for a generalised USD correction. Second, while the US may have been the source of the global slowdown, and the first economy to be bottoming, it is far from clear that it will recover before Europe does. If US economic weakness turns out to be protracted (i.e., Stephen Roach’s scenario), then the USD could start to correct. Third, there is the issue of the productivity growth rate of the US. In 2000, US productivity growth reached 4.3%, and it averaged around 2 1/2% over the past three years, with about half coming from total factor productivity (TFP) improvement and half from capital deepening. However, in recent weeks, various US officials have suggested that the US will soon revert to growth rates in the range of 3.0-3.5%, implying that long-run productivity growth will improve to pre-slowdown levels. But if the sectoral composition of growth in the US in the next two years (consumption-led) will be different from the investment-led growth of the last two years, how could measured labour productivity be as high as before, without capital deepening? When investors realise that long-term productivity growth in the US may not be as high as before, assets may be reallocated out of the US. Fourth, Koizumi’s policies could, given time, underpin a rally in the Nikkei, which could halt the capital outflows out of Japan.
When the USD finally corrects, we expect a soft landing rather than a crash.
The US economy is likely to experience a consumption-led recovery starting in Q4, based on the forecast of our US economists Dick Berner and Dave Greenlaw. IT demand, however, is likely to stay weak for much longer. What this means is that, as far as Asia (especially Japan) is concerned, the US recovery will look like an "L," while it will look like a "U" to the rest of the world. But if the region of the world that has the strongest bias in favour of the USD as the safe haven currency -- Asia -- will remain weak, it is likely that the safe haven flows from Asia will continue, even if the US experiences a consumption-led recovery later this year. While investors from other parts of the world may unwind their safe haven positions in the USD, Asians will still be investing in the US unless the correction in the USD is triggered by Koizumi’s reforms. In other words, the USD may experience a sharper correction if the trigger comes from a positive development in Asia. It is this disparity between consumption and investment in the US that could, through capital flows, prevent a correction in the USD from degenerating into a crash.
"Symmetry" in a prospective USD correction.
Will a USD correction be symmetric against different currencies? If a correction in the USD comes about because of a weak recovery in the US, or because the perceived potential growth rate in the US is lower, then it is reasonable to expect Japan to resist a sharp correction in USD/JPY. On the other hand, for Europe, with elections in France and Germany coming up next year, and the impending introduction of the physical euro notes and coins, it is logical to expect policy makers to welcome an appreciation in the EUR, provided that it is gradual. First, a stronger EUR would help suppress inflation, which in turn would enhance the purchasing power of consumers and therefore support economic recovery. Also, a stronger EUR would enable the ECB to cut interest rates more aggressively, which would certainly be welcomed by European politicians. Second, a gradual appreciation of the EUR in the remainder of this year should bolster European citizens’ confidence in the currency in the run-up to the launch of the new notes and coins. This would be welcome by the ECB as it would minimize risks associated with the changeover. Taken together, a rally in EUR/USD and EUR/JPY could be the best outcome for all three economies.
Bottom line
We are increasingly confident that the overvalued USD has plateaued. There are four potential fundamental triggers for a USD correction later this year: a collapse of the OPEC cartel, an only sluggish US recovery, a downward revision of investors’ perceptions of US productivity growth, and a restructuring-driven Nikkei rally in Japan. Any USD correction is likely to result in a soft landing rather than a crash. And the correction is unlikely to be symmetrical -- the EUR would benefit more than the JPY. |
