Dr. P.V. Viswanath
The wolf at the door
A further steep decline in the dollar seems inevitable
MOST economists, and this newspaper, have been fretting about America's huge current-account deficit and predicting the dollar's sharp decline for years. The trouble with crying wolf too often is that people stop believing you. After slipping 14% in broad trade-weighted terms since 2002, the dollar had stabilised this year, even as the current-account deficit continued to grow. This has encouraged some economists to offer theories explaining why America's current-account deficit does not matter and why the dollar need not fall further. But the dollar has now started to slide again: this week it hit $1.28 against the euro, within a whisker of its all-time low of $1.29. Trust us, the wolf is real.
The dollar's latest slide seems to have been triggered by uncertainty about the presidential election and a flurry of comments from Fed officials. Robert McTeer, the president of the Dallas Federal Reserve, mused (only “theoretically” of course) that when capital inflows into America dry up, “there will be a crisis that will result in rapidly rising interest rates and a rapidly depreciating dollar that will be very disruptive”.
Policymakers' usual reply when asked about exchange rates is to say that they are set by the market. But if the dollar was truly being set by the market it would now be much weaker. The dollar has fallen by over 30% against the euro since 2001, but its trade-weighted index has fallen by much less because of heavy intervention by Asian central banks, aimed at holding down their currencies against the dollar. This policy seems likely to continue, despite China's decision this week to raise interest rates for the first time in nine years. That decision was aimed at curbing its overheating domestic economy, rather than bolstering its currency.
Because Asian currencies have been held down against the dollar, America's
current-account deficit has continued to swell, reaching almost 6% of
GDP in the second quarter. The dollar is already below most estimates
of its fair value against the euro, but it will need to undershoot if
the deficit is to be reduced. Economists at UBS estimate that the dollar's
trade-weighted value might need to fall by another 20-30% to trim the
deficit by enough to stabilise the ratio of America's external liabilities
to GDP. Though it might seem unthinkable, that could imply a rate of around
$1.70 against the euro.
Other economists, however, argue that America can sustain its large current-account deficit for at least another decade, without a sharp fall in the dollar, because it will be happily financed by China and other Asian countries. In a series of papers Michael Dooley, David Folkerts-Landau and Peter Garber at Deutsche Bank have argued that the present arrangements resemble a revived Bretton Woods, the system of fixed exchange rates after the second world war.
Asian economies, they argue, have chosen to link their currencies to the dollar at undervalued rates, supported by heavy purchases of dollar reserves. Asian countries want to keep their exports cheap to support rapid growth and are in consequence happy to keep acquiring dollars indefinitely. In turn, by buying Treasury bonds, they reduce interest rates, which supports spending and ensures that American consumers keep buying Asian goods.
Since 2001, Asia's official reserves have increased by $1.2 trillion, equivalent to two-thirds of America's cumulative deficit over that period. Currency intervention by Asian central banks helps to explain why America has so far been able to finance its deficit without higher American bond yields or a bigger fall in the dollar. However, the claim that the deficit is sustainable for another decade is highly dubious.
An excellent paper by George Magnus, an economist at UBS, argues that the parallels with Bretton Woods are superficial. One big difference is that in the 1960s the United States ran a current-account surplus and was a net creditor to the rest of the world. Today, America is the world's biggest debtor, which could undermine the dollar's role as an anchor currency.
Second, it is wrong to describe the Asian countries as habitual “peggers”. In the 25 years to 1998, non-Japanese Asian currencies typically fell against the dollar, and over the same period their countries mainly ran current-account deficits, not surpluses. Their more-firmly-tied exchange rates and current-account surpluses generally date only from 1998 when these countries needed to rebuild reserves after the Asian crisis. Their desire to tie their currencies to the dollar may be a temporary response to a cyclical problem.
A third important difference is that, unlike under the Bretton Woods regime, most Asian countries have scrapped capital controls or where they still exist, as in China, they are leaky. This requires much greater “sterilisation” by central banks to prevent an increase in reserves spilling into faster credit growth. As sterilisation has become less effective, excessive credit growth is pushing up inflation and causing overinvestment in property, especially in China. As the inflationary costs of maintaining their link to the dollar grow, Asian countries may shift to more flexible regimes.
Lastly, under Bretton Woods there was no real alternative to the dollar as a reserve currency. Today there is the euro, into which Asians could diversify.
Until recently, some argued that America's current-account deficit was sustainable because foreign investors were eager to buy American assets to take advantage of the economy's faster productivity growth and hence its higher returns. But private inward investment has slumped, leaving America dependent on foreign central banks. And foreign savings are no longer financing investment and hence future productivity gains as they were in the late 1990s. Foreigners are now financing consumption and government borrowing.
America's current-account deficit largely reflects puny domestic saving, so dollar bulls often argue that a fall in the dollar is neither necessary nor sufficient to trim the deficit. But Stephen Roach, chief economist at Morgan Stanley, reckons that a weaker dollar would spark a rise in real bond yields, as foreign creditors demanded extra compensation for currency risk. That would slow consumer spending, boost saving and reduce the deficit.
In the three years from 1985, the dollar fell by 50% against the other main currencies. Inflation and bond yields rose and, in October 1987, the stockmarket crashed. America's current-account deficit is now almost twice as big as it was then, so the total fall in the dollar—and the fall-out in other financial markets—could well be larger. The wolf is licking his lips.