Global: Dollar Whispers
Stephen Roach (New York)
Morgan Stanley
May 02, 2003
(additional excellent dollar analysis at URL)
Don’t look now, but the US dollar is falling. That’s especially the case against
the euro, but there has even been some slippage against the yen. And in
recent days the greenback has also begun to edge down against the
currencies of a broad basket of America’s trading partners. Could this be the
beginning of America’s long-awaited current-account adjustment?
Curiously, the dollar has fallen just as US equity markets have begun to price
in a postwar recovery. This seems to have taken many by surprise. Most like
to think of currencies as a proxy for an economy’s relative growth potential.
America has been strong, goes the logic, and the dollar should mirror that
strength. Conversely, Japan and Europe have been weak, so the yen and
euro should follow suit. Actually, that hasn’t been a bad framework over the
past eight years. After hitting record lows in the spring of 1995, the broad
trade-weighted dollar surged some 47% through early 2002 before giving up
about 8% of that gain over the past 14 months. Not by coincidence, in my
view, this sharp run-up in the dollar was accompanied by an extraordinarily
lopsided US-led global growth dynamic. The United States accounted for
fully 64% of the cumulative increase in world GDP (at market exchange
rates) over the 1995 to 2001 interval -- double its share in the world
economy. Currencies and relative growth performance have, indeed,
marched to the beat of the same drummer for quite some time. Why
shouldn’t that continue, especially if equity and credits markets are now
starting to discount another bout of US-led global growth?
The simple reason is that the relative growth paradigm may no longer be
applicable in determining currency values. In the murky realm of foreign
exchange analytics there is no guarantee that what has worked in the past will
work in the future. In my 30 years as a macro practitioner, I’ve seen a host of
currency theories fall in and out of favor -- from swings in relative interest
rates and inflation differentials to growth comparisons and currency reserves.
And now a new bogey appears to have emerged -- external financing
imbalances; on this count, I am in close agreement with the work of our
currency economist, Stephen Li Jen (see his dispatch in today’s Forum, “Our
Dollar Smile Returns”). The problem is the gap between nations with
current-account deficits (mainly the US) and surpluses (mainly Asia but also
Europe) has never been larger. And for a saving-short US economy, a
dramatic deterioration of America’s fiscal position points to an ever-wider
current account deficit over the next few years -- moving from a record 5.2%
of GDP in late 2002 into the 6.5% to 7.0% range by late 2004. Meanwhile,
with growth stymied in the rest of the world, non-US external imbalances
could well be moving into ever-wider surpluses -- leading to a highly unstable
disequilibrium between deficit and surplus regions. This is a recipe for a
significant currency realignment. The only question in my mind is whether the
dollar falls quickly or gradually. There are good cases that can be made for
either outcome.
Meanwhile, other factors are suddenly coming into play against a
long-overvalued dollar. As the Federal Reserve comes closer to deploying
non-traditional measures to combat the risk of deflation, “yield-capping” at
the long end of the Treasury curve emerges as a leading option. This would
bias the yield differential against dollar-denominated assets. The outbreak of
SARS may also be a negative for the dollar, in my view. To the extent that it
taints China, that would hurt a key member of the so-called dollar bloc --
currencies that are pegged to the dollar, such as the renminbi. That’s most
likely a transitory factor, to be sure, but when an asset class comes under
attack, it always amazes me how the negatives seem to reinforce each other.
That’s an important example of how a virtuous circle can quickly be
transformed into a vicious one. For the time being, at least, that seems to be
very much the case with respect to the sagging US dollar.
Barring the crash-landing alternative, I continue to believe that a weaker
dollar is exactly what a dysfunctional global economy needs. In my view, an
unbalanced world is in increasingly desperate need of a rebalancing -- less
domestic demand growth in America and more elsewhere around the world.
A weaker dollar may well be the only means to achieve such a result. From
the American standpoint, currency depreciation should be seen as part and
parcel of a classic current-account adjustment process. If that’s the case,
dollar weakness should trigger a number of other macro developments in the
US economy -- namely higher real interest rates, slower domestic demand
growth, and a rebuilding of private sector saving. In effect, a weaker
greenback should trigger an important and necessary shift in the mix of
aggregate demand in the United States -- away from domestic demand and
into external demand. A declining greenback could also be important in
America’s battle against deflation -- having the effect of transforming
imported deflation into imported inflation.
For the rest of the world, the impacts of weaker dollar will undoubtedly be a
good deal tougher to accept. That’s especially the case for Europe and
Japan, where anemic growth in recent years has largely been dependent on
external demand. Euro and yen appreciation would certainly undermine
competitiveness and inhibit export growth, thereby crimping a major source
of growth in both regions. Under those circumstances, Europe and Japan
would have little choice other than to bite the bullet and embrace long
overdue policies of structural reform and countercyclical stimulus in order to
stimulate domestic demand. The outcome for both regions would be the
mirror image of the shift in aggregate demand likely to occur in the US -- less
external support and more domestic demand. And presto-- a rebalancing of
the global economy would be under way.
I fully realize all this is easier said than done -- especially the responses of
Europe and Japan to further dollar weakness. Japanese authorities have, in
fact, been quite adamant recently in maintaining that they would like a much
weaker yen to deal with the nation’s persistent deflation. Some European
officials have also expressed concerns about the potential impacts of a
stronger euro. The burden of currency appreciation would be especially
heavy on Germany -- that segment of Euroland, which is currently closest to
outright deflation. Indeed, with German inflation currently running at just 1%
-- essentially half the pan-European average -- a further significant rise in the
euro might well be sufficient to tip the economy into deflation. In the
pre-EMU days, Germany would have had the option to depreciate the
deutsche mark in these circumstances. The strictures of monetary union have
all but closed off that alternative. One thing is certain, however: Irrespective
of the wishes of all major regions to have cheaper currencies, the zero-sum
paradigm of relative prices underscores the sheer impossibility of such an
outcome. History and economic theory tell us that the country with the large
external imbalance -- the US, in this instance -- will eventually win any battle
of competitive currency devaluation.
But there’s even a deeper significance to dollar depreciation. Largely for
political or other institutional reasons, both Europe and Japan have been
unwilling or unable to adopt pro-growth policy measures. Japan is fearful of
ending the “convoy system” of zombie-like companies; the resulting rise in
unemployment is an anathema to a system where social contracts still involve
some form of lifetime employment. Europe is constricted by a misguided
rules-based system of macro policy determination. Monetary policy is still
aimed at fighting inflation in an increasingly deflationary world. And fiscal
policy is set by the arbitrary constraints of the Growth and Stability Pact,
which did not take cyclical distress into serious consideration. Europe and
Japan show little or no inclination to voluntarily alter these deeply entrenched
approaches. So, in my view, it seems entirely appropriate to put pressure on
both economies to change. The currency lever is the most effective means to
accomplish this objective. If the dollar stayed strong and the world held to its
course of US-centric growth, Europe and Japan would have no incentive to
change. A weaker dollar would leave them with no other choice.
Plagued by unprecedented external imbalances, the world simply cannot
afford to stay the course of US-centric growth. A lopsided global economy
needs a shift in relative prices to find a new and more stable equilibrium. The
dollar -- the world’s most important relative price -- has to fall. Such a
decline may now be under way. And the world will have no choice other than
to figure out how to cope with the imperatives of global rebalancing.
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