Global: What Happens if the Dollar Does Not Fall?
Stephen Roach (New York)
The dollar is finally back in play again -- and possibly for some time to come. Provided the depreciation of the greenback occurs in an orderly and measured fashion, I continue to believe that this is good news for an unbalanced world economy. It is central to the adjustment process I have dubbed global rebalancing.
The global rebalancing framework views currency realignments as the functional equivalent of a shift in the world’s relative price structure. In that context, a weaker dollar is precisely what a lopsided, US-centric world needs. That’s not because of the sheer power of dollar depreciation itself. It’s that such a currency correction is an important signaling mechanism for adjustments in real interest rates, as well as shifts in the mix of global demand -- namely, spurring weaker domestic demand in the US and stronger internal demand elsewhere in the world (see my 19 November dispatch, “Why the World Needs a Weaker Dollar”). Only through such a realignment in the composition of global demand can the unprecedented dispersion of current account imbalances between deficit and surplus nations be narrowed.
A key risk to this scenario is that it has now become a consensus bet in financial markets. Even Federal Reserve Chairman Alan Greenspan, who argued earlier this year that there was “…little evidence of stress in funding US current account deficits” now seems resigned to a weaker dollar (see Greenspan’s “Lecture Before the Bundesbank” in Berlin on January 13, 2004 and, more recently, his “Remarks at the European Banking Congress” in Frankfurt on November 19, 2004). With such broad agreement on an important macro trend, this is where the contrarian is trained to pounce. And so it pays to ask, what happens if the dollar doesn’t fall?
The short answer, in my view, is trade frictions and protectionism. I reach that conclusion by underscoring the tradeoff between economics and politics as the means by which unprecedented global imbalances are likely to be vented. If pressures don’t give on one axis, I believe the impetus for rebalancing will then shift to the other axis. The biggest risk, in my view, occurs if the world’s major currencies don’t adjust. In that case, global imbalances will only continue to mount. In the US, that means that the current-account deficit, which stood at a record 5.7% of GDP in 2Q04, should rise to at least 6.5% in the next year. Moreover, there are several very credible extrapolations of a sharp further widening in the years beyond -- nearly 8% by 2008 (Nouriel Roubini and Brad Setser of NYU and Oxford) and 13% by 2010 (Catherine Mann of the International Institute of Economics). With over 90% of America’s current account deficit showing up in the form of a record trade gap, it is perfectly reasonable to presume that a worsening of the seemingly chronic US current-account problem will also be associated with the classic characteristics of ever-rising trade deficits -- namely, heightened import penetration and ongoing compression of employment in the US tradable goods sector. In my view, this would be a politically untenable result in the United States -- one that could encourage the opponents of trade liberalization and fuel the destructive forces of protectionism.
Are there any signs of such a political backlash? The rhetorical flourishes of Campaign 2004 only skimmed the surface, in my view, by touching on the jobless recovery and the offshoring debate. Yet if the dollar doesn’t weaken further and US trade deficits continue to mount, I look for Washington to get serious and consider upping the ante on possible political “remedies.” China bashing seems likely to be at the top of the list. Just as the scapegoatting of Japan became the politically correct response to America’s trade problems in the late 1980s, all eyes are now on China. After all, the US-China trade deficit is likely to hit $150 billion in 2004; that would be double the bilateral gap with Japan -- America’s second largest trade imbalance. Never mind that the US trade deficit with China -- or with any other nation, for that matter -- is an outgrowth of a staggering shortfall of domestic saving brought about by Washington-inspired budget deficits and the zero-saving mindset of American consumers. Never mind that trade with China provides America with low-cost, high quality goods that expand the purchasing power of income-short consumers. Never mind that China’s appetite for Treasuries helps prevent an interest-rate accident in an overly-levered US economy. Washington has long had a knack for pinning the blame on others rather than facing up to its own failure to deal with America’s saving dilemma. In a scenario of limited dollar adjustments and ever-widening trade deficits, I suspect that such denial and misdirected scapegoatting could well intensify.
Several contentious disputes are already percolating on the US-China trade front that could well portend tougher times ahead. A looming dispute over global textiles trade is the most immediate risk on the horizon. A decade ago, as part of a global trade agreement, the US agreed to dismantle its textiles-product quota system under the so-called Multi-Fiber Agreement; complete elimination of the quotas, as stipulated by the 1995 WTO Agreement on Textiles and Clothing, was set for December 31, 2004. With the deadline looming, the US has suddenly had a change of heart. Fearing imminent loss of market share to Chinese producers, a coalition of US textile companies, apparel firms, and labor unions has filed a compliant with the US Commerce Department, arguing for the temporary imposition of “safeguard” quotas to temper what is likely to be a surge of Chinese import penetration. China views this potential abrogation of long-agreed trade liberalization as a serious violation of WTO rules. The US case rests on charges of currency manipulation and on the persistence of state-sponsored subsidies to state-owned Chinese textile companies.
The Chinese currency issue also lies at the core of far more serious threats to US-China trade. Legislation has been introduced in both the Senate and the House that would impose very high across-the board tariffs on all Chinese products sold in the US. In both cases, the tariffs are designed to compensate US companies for what the Congress perceives to be explicit currency manipulation. The Senate version (S. 1586) argues for countervailing tariffs to compensate for what it estimates to be a 27.5% undervaluation of the RMB; while the House version (H.R. 3058) leaves the magnitude of currency manipulation and punitive tariffs unspecified, my discussions with congressional staff suggest the House remedy could be even more radical than that prescribed in the Senate version. In both cases, sponsorship is broad -- involving Democrats and Republicans, liberals and conservatives, and legislators from farm states and industrial states. Both of these bills were first introduced in September 2003 and have since “been referred to Committee” -- which basically means the bills are dormant unless resurrected by their sponsors. Yet in the event of ever-widening US trade deficits, I suspect that’s precisely what could occur -- a resurrection of these bills that could quickly become an increasingly contentious part of the debate on US-China trade policy.
Nor is the US likely to be alone in putting pressure on China. Other currencies in Asia are now adjusting to dollar weakness. The Japanese yen has increased by about 6% relative to the dollar over the past five weeks, whereas the Korean won currently stands at a seven-year high; moreover, currencies of Singapore and Taiwan are at five- and three-year peaks, respectively. Again, this is very good news for global rebalancing -- it suggests that the burden of worldwide currency adjustments in now being shared by Europe and Asia alike. But that also means that a super-competitive Chinese economy, with its fixed peg tied to a now declining dollar, sticks out all the more -- ironically, not against the US, where politicians are making the most noise, but against Europe and the rest of Asia. Stephen Li Jen notes that the trade-weighted RMB has depreciated by about 9% in real terms since early 2002 -- essentially returning to levels prevailing just before the Asian crisis in early 1997 (see his 11 November dispatch, “Chinese RMB: Inching Toward a Crawling Band”). Paradoxically, if the dollar doesn’t fall, China’s currency-related problems could diminish. But to the extent that dollar depreciation continues to play out in accordance with the script of global rebalancing, then I fear that China is likely to be put increasingly on the spot -- thereby becoming a principal target of mounting trade frictions.
For years, China has made the case that it is not ready to reform its foreign exchange mechanism. From China’s point of view, this underscores the important tradeoff between reforms -- especially banking and capital markets reforms -- and currency flexibility. The fear inside of China is that excess RMB volatility could wreak havoc on a still fragile financial system. Two things gave changed that now draw that line of reasoning into question: First, China has built up a massive reservoir of foreign exchange reserves -- some $514 billion as of September 2004 that would enable it to manage RMB fluctuations quite effectively in global foreign exchange markets. Second, global imbalances have created increasingly serious distortions and tensions elsewhere in the world that need to be addressed. The bottom line is if China does not participate in the global venting process by allowing its currency to adjust, it then runs a real risk of being hit with politically-driven pressures on the trade policy front. In that important context, the RMB peg may now be at a point where it has outlived its usefulness. The sooner the Chinese leadership prepares the world for a transition to a new and more flexible currency regime, the better its chances of neutralizing geopolitical risks.
My own base case remains one of steady dollar depreciation over the next several years -- sufficient to take the broad dollar index down at least another 10-15% in real terms. That would imply a cumulative decline of about 25-30% from the early 2002 peak, in line with currency corrections during major current-account adjustments of the past. I am hopeful that the coming realignment of the dollar will be gradual and drawn out. Unfortunately, given the extremes of today’s record global imbalances, the risk of a more abrupt and disruptive adjustment cannot be ruled out. At the other end of the spectrum, a renewed rally of the dollar cannot be dismissed out of hand either -- although that would be the least likely of the three outcomes, in my view. However, to the extent that the dollar defies economic gravity, I remain convinced that the forces of global rebalancing are powerful enough to be vented through a political response that could lead to heightened trade frictions and protectionist risks. Whatever the outcome, I suspect that pressures will intensify on China to share in the adjustments of global rebalancing. The longer it holds out, the tougher it will be for the Chinese to walk the delicate line between economic goals, international politics, and reforms. |
