The Economist: Keep an eye on it (The US Dollar)

Keep an eye on it
Jul 8th 2004
From The Economist print edition
After a buoyant start to the year, the dollar seems headed for a tumble

THERE was a time, not long ago, when economists and those who dabble in the foreign-exchange market could find scarcely a good thing to say about the dollar. Last year, John Snow, America's treasury secretary, even managed to transform his country's long-standing strong-dollar policy into a weak-dollar one. All this greatly irritated Europeans, especially; as the euro rose, international meetings of the great and the good were dominated by cross discussions about the beleaguered buck. Newspapers, including this one, were full of gloomy headlines suggesting that the greenback would, indeed should, fall farther.

So it did, for a while: by early January, the dollar was worth a quarter less, in trade-weighted terms, than it had been two years before. But when everyone is betting that a market will go one way, it often goes the other. By mid-May, the dollar had risen by 8%, bucked up, as it were, by the Bank of Japan, which bought ¥14.8 trillion ($138 billion) of foreign exchange in the first quarter, almost all of it dollars, in comfortably the largest-ever act of intervention by a central bank. Then, quietly, the dollar started to drop. By July 6th, it had fallen by 4.3% from its high. Not surprisingly, perhaps: the dollar's prospects look even worse now than they did last year.

The dollar's recent decline may seem puzzling, for it began while expectations were mounting that the Federal Reserve was about to put up interest rates. The decline has continued since those expectations were confirmed on June 30th. Rising interest rates, you might have thought, would halt any such decline.

That is true only up to a point. As the American economy brought forth jobs in the spring, and the markets started to expect that the Fed would increase rates sooner rather than later, the dollar was boosted. A prime reason was that traders who had previously borrowed greenbacks in order to exchange them for other, higher-yielding currencies now needed to buy them back in a hurry. Lately, however, softer economic data have sown the idea that the Fed might not have to raise rates so far and fast after all. That has done the dollar no favours in recent days.

In the longer term, though, higher interest rates may be a curse for the dollar, not a blessing. To see why, look at that large and growing thing that goes under the name of America's current-account deficit. A country's current-account essentially comprises two things: the trade balance and net income from foreign investments. America runs a trade deficit that in April amounted to $48.3 billion, up from $46.6 billion in March. This alone implies an annual deficit pushing $600 billion, or 6% of GDP. The current-account deficit would be greater still if America did not make more money on its investments abroad than foreigners earn in the United States.

That it makes a profit is odd, because it has net foreign liabilities (ie, the value of Americans' assets abroad is less than that of foreign claims on America). According to the Department of Commerce's Bureau of Economic Analysis, net liabilities amounted to 24% of GDP last year. America has an investment-income surplus because yields are much lower at home than abroad. All things equal, says Goldman Sachs, a yield of 6% on ten-year Treasuries would add 1% of GDP to the current-account deficit within a few years.

Economists fret about America's current-account deficit because it is a measure both of America's ability (or inability) to save and its attractiveness to foreign investors. The country's heady growth of recent years has relied on foreigners' willingness to invest there: Americans, in effect, spend other people's money. That need not matter when the sums are small, but it does when they are large and getting larger. Most economists believe that at some point the dollar will need to get cheaper, maybe much cheaper, to encourage foreigners to finance the deficit. That point may be at hand.

There are two weighty pieces of evidence to support this view. The first is that America started this latest recovery much deeper in hock to the rest of the world than it did previous ones, says John Llewellyn, the chief economist at Lehman Brothers. As the chart overleaf shows, America has usually started to pull out of recession with its current account roughly in balance. This time, it began with a deficit of 3.2% of GDP. Because growth tends to increase the deficit—America has sucked in imports and borrowed more—the deficit has widened. “I can easily imagine it going to 7% and beyond,” says Mr Llewellyn.

The second piece of evidence comes from investors' behaviour. Some say that the deficit is not a problem, but simply reflects foreigners' boundless desire to invest in a vibrant economy. This may have been true once, but not any more. Net foreign direct investment (FDI) was negative, to the tune of $155 billion, in the past 12 months, says Goldman Sachs. This ought to be no surprise: in the first quarter returns on FDI in America were 5.5%, while those on FDI abroad were 11.7%.

In recent years, the current-account deficit has instead been financed by (less stable) portfolio flows into stocks and bonds. In the past year, three-quarters of such investment in America has gone into bonds. The biggest buyers have been Asian central banks, trying to keep their currencies from rising too swiftly against the dollar (or maintaining a fixed rate, in China) and parking the money in Treasuries.

But this intervention has had a cost: inflation. Because the central banks bought the dollars with newly minted local currency, inflationary pressures have risen throughout Asia. This is fine for Japan, which has deflation, but not for its neighbours. Intervention thus seems to have stopped; even Japan turned off the tap in March. The central banks might, of course, wade back in if their currencies rose too much. But given the risk of inflation, it would be brave to bet on this. And if they do not buy the buck, who will?