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The US Dollar - Which Way Next?

The Economist
September, 2003

After travelling one way for most of the past 18 months, the dollar has changed direction. Since late May it has risen by 9% against the euro, brushing a four-month high of $1.08. A few economists are even musing that it might once again reach parity. So were all those predictions of a plunge in the dollar wrong?

The dollar's gyrations have largely been against the euro, while its trade-weighted value has moved by much less. Between early 2002 and this May, the dollar tumbled by 28% against the euro, but lost only 15% in trade-weighted terms. Likewise, since May its trade-weighted value has gained only 4%. Against the yen, it has been steady for most of this year, weakening a little in the past fortnight (see chart).

The main reason for the foreign-exchange markets' change of heart is a lot of data suggesting that America's economy is picking up steam. American GDP grew by an annualised 3.1% in the second quarter of this year, and most forecasters are betting on 3.5-4% in the second half. In contrast, the latest figures from the euro zone are dire. First estimates implied that GDP in the single-currency area was flat in the second quarter. Revisions seem sure to show a contraction: output fell in Germany, France, Italy and the Netherlands. Weaker growth means lower returns on investment, goes the argument, making euro assets less attractive to foreign investors.

The dollar has also been supported by movements in relative bond yields. In May American ten-year Treasury bonds yielded 0.3 percentage points less than their German equivalents. Now they pay a quarter-point more.

Ups and downs

If currencies are mainly being driven by relative growth rates, then why hasn't the dollar fallen by much more against the yen? After all, economists have lately been sounding much more optimistic about Japan's prospects. Earlier this month the forecasters polled monthly by The Economist were predicting, on average, growth of only 0.9% both this year and next, compared with 2.3% and 3.4% in America. Now most forecasters expect Japan's GDP to rise by more than 2% this year and at least 1.5% in 2004, while their forecasts for America are little changed.

Yet the yen has held fairly steady against the dollar-mainly because the Bank of Japan has bought almost $80 billion of dollar assets this year in a bid to hold down the yen and thus to support Japan's still fragile recovery. Japan is by far the world's largest holder of American Treasuries, with 12% of the total stock. Moreover, in contrast to previous episodes, the Bank of Japan has not sterilised its latest intervention by selling government securities to mop up the extra yen. Instead it has allowed them to flow through into the money supply.

Some currency forecasters, such as those at Citigroup, reckon that the dollar will stay broadly unchanged against the euro and the yen over the next 12 months. Others think that the dollar is due for another change of direction: economists at HSBC are still betting that the dollar will fall to $1.35 against the euro and to ¥105 by the end of 2004.

The main reason to believe that the dollar will soon resume its downward path is America's huge current-account deficit. A dollar rally driven by stronger American growth is not sustainable in the medium term. America's imports are currently 50% larger than its exports, so the current-account deficit will increase even if imports grow at the same pace as exports. But if, as widely expected, the United States continues to be the locomotive for the world economy over the coming years, then its imports are likely to grow faster than its exports. If the current-account deficit is to be reduced, then either America's growth must slow or the dollar must fall to improve American firms' competitiveness.

Using the Federal Reserve's latest economic forecasts, economists at HSBC estimate that next year America's domestic demand growth will outstrip that of other G7 economies by the widest margin since 1993. The current-account deficit could grow to $800 billion (on an annualised basis), or 7% of GDP, by the end of 2004.

There is a popular view that the current-account deficit does not really matter, but is merely a reflection of America's economic success. Faster growth delivers higher rates of return, which attract portfolio and direct investment from abroad. Thus private-capital inflows are seen as driving the current-account deficit, rather than the other way round.

It is true that in the late 1990s America attracted large capital inflows because of widespread optimism about future rates of return. The trouble is that private investors have lately been less eager to buy still more dollar assets. An analysis by UBS of private-sector institutional investors' dealings in American equities conducted through the bank shows that institutions have been large net sellers this year.

Instead, central banks, mainly in Asia, financed more than half of the current-account deficit in the second quarter of this year. They now hold a bigger proportion of the total stock of Treasuries than at any time in the past quarter-century. In other words, America's deficit is now being financed mainly by foreign governments, not private investors.

If foreign central banks were to lose their appetite for dollars, American bond yields would rise further and the greenback would fall. There has been much talk about Asian central banks diversifying their foreign-exchange reserves from dollars to euros. Also, European central banks have been reducing their reserves, which are mainly in dollars, because they no longer need to hold as much ammunition to defend their currencies.

On top of this, America's current-account deficit-by definition, the gap between domestic saving and investment-has been as much the product of record low saving as of investment opportunities. Stephen Roach, an economist at Morgan Stanley, reckons that American net national saving (ie, private saving net of capital depreciation plus government dis-saving, in the shape of the budget deficit) is likely to turn negative soon for the first time in peacetime history. That would imply that America was asking foreign investors not only to subsidise its investment, but also to foot the bill for its consumption.

It is true that economists have been sounding alarm bells about America's widening current-account deficit for many years, with little sign of their predictions being borne out. Even so, the longer America's current-account deficit continues to widen, the larger the risk of a later, deeper plunge in the dollar. The recent rally ought to be put into perspective. The last time the dollar fell substantially, in 1985 and 1986, there were three periods when the dollar briefly rallied by 8-10%, just as it has done in recent weeks. The dollar then continued to decline, falling by a total of 50% against the D-mark in just two years. Expect the slide to resume.

Courtesy of: http://www.economist.com