The saga of the falling dollar still has a long way left to go
The saga of the falling dollar still has a long way left to go
By Martin Wolf
Copyright The Financial Times Limited 2006
Published: December 6 2006 02:00 | Last updated: December 6 2006 02:00
Richard Nixon's Treasury secretary, John Connolly, famously remarked that "the dollar is our currency, but your problem". He would be right again now. The rest of the world normally wants a strong dollar. Yet the dollar is now in a bear market. How long might this go on? The plausible answer must be: a while yet.
Since early 2002 the dollar has been on a steep downward path: on JPMorgan's trade-weighted real exchange rate it has depreciated by 23 per cent since February 2002 (see chart). This is the third such sustained decline since Mr Connolly's remarks. The first was during the early 1970s. The second was from 1985 to 1988. On each of the two previous occasions, the depreciating real exchange rate also helped generate a big adjustment in the balance of payments. This was strikingly true in the 1980s. The same thing is happening again.
Between 1996 and 2004, real US domestic demand grew faster than real gross domestic product every year (see chart). This was necessary, I have previously argued, if GDP was to rise in line with potential, given the prevailing real exchange rates and the weak rate of growth of demand in much of the rest of the world. Over these years, cumulative growth in US real demand was 39 per cent, while GDP grew by 33 per cent. The difference was the real increase in the deficit in trade in goods and non-factor services.
This has now changed. US real GDP will have grown at almost exactly the same rate as real demand in 2005 and 2006, according to the most recent economic outlook from the Organisation for Economic Co-operation and Development. In real terms, the current account deficit is consequently stabilising at last, albeit at a very high level.
US exports are also at last growing at roughly the same rate as imports: between the third quarter of 2003 and the third quarter of this year exports of goods and services grew 27 per cent, in constant prices, while imports rose 26 per cent. This is a big change: over the previous eight years, US exports rose by a mere 31 per cent, while imports rose by 80 per cent, again in constant prices.
Does this suggest that the needed adjustment in the real exchange rate has come to an end? Probably not.
If the current account deficit were to remain close to 7 per cent of GDP, US net liabilities would probably stabilise at substantially more than 100 per cent of GDP. That would be an extraordinarily high level for such a big economy. Moreover, one would expect a rise in net liabilities from about 22 per cent of GDP at the end of last year to force substantial changes in asset prices. The larger the US share in the portfolios of the rest of the world, the higher the prospective returns that foreign investors would be expected to demand, to compensate for the risk.
Either a lower dollar, or lower US asset prices, or both, would seem the inevitable result. Moreover, it is hard to imagine that a falling exchange rate would not be a big part of this picture. The fact that the US borrows entirely in its own currency makes deficits safer for itself, but riskier for its creditors. For this reason a belief that the currency has become undervalued - and so can be expected to appreciate - would make it easier to sustain net liabilities on such a gigantic scale. This is one reason why such movements tend to overshoot.
Moreover, some three-fifths of gross US liabilities of $13,625bn (£6,903bn) at the end of last year took the form of bonds, currency, bank liabilities and similar claims. The value of such claims to foreign creditors is more vulnerable to inflation and so to the impact on domestic prices of a sizeable currency depreciation than claims on real assets. The US cannot guarantee the dollar against a fall and would not wish to, even if it could. So creditors are likely to come to a point at which they wish to see the depreciation before they continue to supply the capital flows that will be needed.
Creditors will also be more willing to go on buying US assets if they start to see a reduction in the country's deficits. That would require a period during which exports grew faster than imports, in real terms. It is at least plausible that this would also necessitate a lower real exchange rate than we have ever seen before.
Thus, even though the currency has fallen a long way, it is easy to imagine its falling more. How far it would need to fall would depend on how quickly demand grew in the rest of the world. It would also depend on what happened in the US economy itself: the weaker domestic demand and the lower the interest rate, the lower the dollar itself might go.
In short, the long bear market in the dollar is probably not over. But even if it were over, on a trade-weighted basis, that would not be the end of the story. An overall decline is only a part of what is required. Also important is some redistribution of the adjustment.
Hitherto, high-income countries that are not running large current account surpluses have experienced big appreciations against the dollar, while the developing countries that are running such surpluses have not (see charts). That is unlikely to be sustainable, not least because it has required colossal exchange rate intervention. Official reserves exceeded $4,500bn by the end of the first half of 2006, an increase of some $2,700bn since the end of 1999.
It is possible to imagine a world in which a substantial part of the US current account deficit were shifted to other high-income countries by a depreciation of the currencies of the entire extended dollar area. But it is hard to imagine the countries with floating exchange rates tolerating such a shift for long. The eurozone is a particularly unlikely candidate.
Where then have we arrived in the story? First, adjustment is beginning to happen, as the dollar has plunged substantially on a trade-weighted basis, while demand in the rest of the world has also picked up; second, the decline in the dollar has probably not reached the level needed to sustain either a big diminution of the external deficit or the needed financing; third, even if it has, the necessary adjustment of exchange rates between the countries in the extended dollar area and countries with floating exchange rates has still hardly begun.
This extended saga will finish with many chapters: the rise of the dollar while the US current account deficit exploded was the first; the fall of the dollar while the current account deficit went on rising was the second; we are now in the third, when the deficit stabilises at last. But this story is not yet over. What sort of problem the dollar will prove to be over the entire cycle is unclear. All we can say at the moment is: "So far, not too bad." Let us hope it remains so.
By Martin Wolf
Copyright The Financial Times Limited 2006
Published: December 6 2006 02:00 | Last updated: December 6 2006 02:00
Richard Nixon's Treasury secretary, John Connolly, famously remarked that "the dollar is our currency, but your problem". He would be right again now. The rest of the world normally wants a strong dollar. Yet the dollar is now in a bear market. How long might this go on? The plausible answer must be: a while yet.
Since early 2002 the dollar has been on a steep downward path: on JPMorgan's trade-weighted real exchange rate it has depreciated by 23 per cent since February 2002 (see chart). This is the third such sustained decline since Mr Connolly's remarks. The first was during the early 1970s. The second was from 1985 to 1988. On each of the two previous occasions, the depreciating real exchange rate also helped generate a big adjustment in the balance of payments. This was strikingly true in the 1980s. The same thing is happening again.
Between 1996 and 2004, real US domestic demand grew faster than real gross domestic product every year (see chart). This was necessary, I have previously argued, if GDP was to rise in line with potential, given the prevailing real exchange rates and the weak rate of growth of demand in much of the rest of the world. Over these years, cumulative growth in US real demand was 39 per cent, while GDP grew by 33 per cent. The difference was the real increase in the deficit in trade in goods and non-factor services.
This has now changed. US real GDP will have grown at almost exactly the same rate as real demand in 2005 and 2006, according to the most recent economic outlook from the Organisation for Economic Co-operation and Development. In real terms, the current account deficit is consequently stabilising at last, albeit at a very high level.
US exports are also at last growing at roughly the same rate as imports: between the third quarter of 2003 and the third quarter of this year exports of goods and services grew 27 per cent, in constant prices, while imports rose 26 per cent. This is a big change: over the previous eight years, US exports rose by a mere 31 per cent, while imports rose by 80 per cent, again in constant prices.
Does this suggest that the needed adjustment in the real exchange rate has come to an end? Probably not.
If the current account deficit were to remain close to 7 per cent of GDP, US net liabilities would probably stabilise at substantially more than 100 per cent of GDP. That would be an extraordinarily high level for such a big economy. Moreover, one would expect a rise in net liabilities from about 22 per cent of GDP at the end of last year to force substantial changes in asset prices. The larger the US share in the portfolios of the rest of the world, the higher the prospective returns that foreign investors would be expected to demand, to compensate for the risk.
Either a lower dollar, or lower US asset prices, or both, would seem the inevitable result. Moreover, it is hard to imagine that a falling exchange rate would not be a big part of this picture. The fact that the US borrows entirely in its own currency makes deficits safer for itself, but riskier for its creditors. For this reason a belief that the currency has become undervalued - and so can be expected to appreciate - would make it easier to sustain net liabilities on such a gigantic scale. This is one reason why such movements tend to overshoot.
Moreover, some three-fifths of gross US liabilities of $13,625bn (£6,903bn) at the end of last year took the form of bonds, currency, bank liabilities and similar claims. The value of such claims to foreign creditors is more vulnerable to inflation and so to the impact on domestic prices of a sizeable currency depreciation than claims on real assets. The US cannot guarantee the dollar against a fall and would not wish to, even if it could. So creditors are likely to come to a point at which they wish to see the depreciation before they continue to supply the capital flows that will be needed.
Creditors will also be more willing to go on buying US assets if they start to see a reduction in the country's deficits. That would require a period during which exports grew faster than imports, in real terms. It is at least plausible that this would also necessitate a lower real exchange rate than we have ever seen before.
Thus, even though the currency has fallen a long way, it is easy to imagine its falling more. How far it would need to fall would depend on how quickly demand grew in the rest of the world. It would also depend on what happened in the US economy itself: the weaker domestic demand and the lower the interest rate, the lower the dollar itself might go.
In short, the long bear market in the dollar is probably not over. But even if it were over, on a trade-weighted basis, that would not be the end of the story. An overall decline is only a part of what is required. Also important is some redistribution of the adjustment.
Hitherto, high-income countries that are not running large current account surpluses have experienced big appreciations against the dollar, while the developing countries that are running such surpluses have not (see charts). That is unlikely to be sustainable, not least because it has required colossal exchange rate intervention. Official reserves exceeded $4,500bn by the end of the first half of 2006, an increase of some $2,700bn since the end of 1999.
It is possible to imagine a world in which a substantial part of the US current account deficit were shifted to other high-income countries by a depreciation of the currencies of the entire extended dollar area. But it is hard to imagine the countries with floating exchange rates tolerating such a shift for long. The eurozone is a particularly unlikely candidate.
Where then have we arrived in the story? First, adjustment is beginning to happen, as the dollar has plunged substantially on a trade-weighted basis, while demand in the rest of the world has also picked up; second, the decline in the dollar has probably not reached the level needed to sustain either a big diminution of the external deficit or the needed financing; third, even if it has, the necessary adjustment of exchange rates between the countries in the extended dollar area and countries with floating exchange rates has still hardly begun.
This extended saga will finish with many chapters: the rise of the dollar while the US current account deficit exploded was the first; the fall of the dollar while the current account deficit went on rising was the second; we are now in the third, when the deficit stabilises at last. But this story is not yet over. What sort of problem the dollar will prove to be over the entire cycle is unclear. All we can say at the moment is: "So far, not too bad." Let us hope it remains so.
posted by Carlos T Mock @ 8:48 AM
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