Dollar demise much exaggerated

December 2, 2008

John Kemp Great Debate– John Kemp is a Reuters columnist. The opinions expressed are his own –

Perhaps the most surprising development over the last three months has been the surging value of the currency at the heart of the crisis. It is almost as if investors have responded to a fire alarm by running towards the source of the fire.

From a recent low on July 15, the U.S. dollar’s trade-weighted value has risen 19 percent. The dollar has been broadly stable against China’s yuan (+1 percent) while posting massive gains against the Swiss franc (+20 percent), the euro (+26 percent), the British pound (+35 percent) and the Australian dollar (+52 percent). Only against Japan’s yen has the currency slipped marginally (-6 percent).

Since 1997, commentators and policymakers have openly worried about America’s gaping trade deficit, resulting dependence on foreign capital inflows, and the risk of a sharp correction in the value of both U.S. government bonds and the currency if investors started to balk at financing the resulting payments gap.

The economy’s expansion witnessed a large decline in the dollar’s value by almost 40 percent between Feb 2002 and March 2008. As the crisis intensified and the U.S. slipped towards recession, commentators and policymakers raised a renewed alarm about a possible currency collapse.

Instead, the dollar has witnessed its most broad-based and sustained appreciation since the late 1990s. In the last month, the currency has traded at its highest level against the euro for two years.

ADJUSTMENT BY RECESSION

For 10 years, the widening deficit in the current account of the U.S. balance of payments has been the main source of perceived dollar risk. The deficit ballooned from $125 billion in 1996 (1.6 percent of GDP) to $788 billion by 2006 (6.0 percent of GDP).

Persistent deficits in the trade balance could not be covered by a moderately positive net inflow of profits, interest and dividend earnings from abroad. So the United States resorted to massive sales of government and private debt (including U.S. Treasuries and securitized mortgages), corporate equities, whole companies, and other forms of real property to foreigners to fund the import surge.

The financing requirement absorbed more than half of all funds that investors worldwide made available for investing outside their home country. The net external debt of the United States quintupled in just a decade from $456 billion in 1996 (5.8 percent of GDP) to a staggering $2.442 trillion in 2007 (18 percent of GDP).

It is a moot point whether the deficit in the current account spurred the issuance of record quantities of often poor-quality debt (as critics of the Federal Reserve have charged); or whether a global savings glut coupled with strong overseas appetite for U.S. assets created a capital account surplus and forced the United States to run a large trade deficit (as Fed Chairman Ben Bernanke has claimed).

In reality, the balance of payments is an integrated whole and part of the wider international flow of funds. China’s willingness to lend (by accumulating reserve assets) found ready willingness to borrow in the United States (mostly to fund consumption and a massive build out of new homes). The end result is that China has ended up owning a lot of U.S. government paper, and the U.S. has ended up owing a lot of money.

Policymakers have warned for more than a decade that these “global imbalances” were unsustainable and would eventually need to be reversed. The hope was adjustment would come about mainly through a significant but orderly devaluation of the dollar and rise in U.S. exports, rather than a deep recession in the United States that would cut import demand.

In the end, policymakers have been spared the choice.

The unfolding credit crisis is producing a deep recession, cutting U.S. demand for imports, and forcing the long-overdue adjustment in the trade deficit. Because the recession is centered on the United States, U.S. import demand is falling more rapidly than the demand for the country’s exports in Europe, Asia and the rest of the world, producing the necessary current account adjustment.

It is a bitter irony that recession has removed one of the main sources of downward pressure on the U.S. currency.

SLOWING CAPITAL OUTFLOWS

Only a minority of the financial resources obtained from the rest of the world in recent years have been used to fund the current account deficit. Most have been used to pay for the acquisition of other assets overseas.

According to the “Flow of Funds Accounts of the United States”, published by the Federal Reserve (Table F.107), the United States obtained about $3.5 trillion in funding from overseas investors in 2006-2007. But of this total, less than half was used to finance the current account deficit ($1.5 trillion). The remainder ($2 trillion) financed the acquisition of other assets overseas.

U.S. residents went on a buying spree for around $399 billion worth of foreign bonds, $255 billion worth of foreign equities, and almost $575 billion worth of overseas company takeovers. Since the United States was not generating a current surplus to pay for these acquisitions, they were, in effect, being financed by borrowing money from abroad.

But as the credit crunch intensifies, net acquisitions of overseas assets by U.S. residents have slowed abruptly. Net acquisitions have halved from an annualised rate of $812 billion in Q3 2007 to $399 billion in Q1 2008; and in Q2 U.S. residents actually disposed of $41 billion worth of foreign assets on a net basis.

As U.S. residents invest less abroad, their need to attract foreign financing to cover the payment gap in the absence of a current account surplus will diminish. Financial crisis and recession have therefore made a balance of payments crisis less likely on the capital-account side as well as the current-account one.

OFFICIAL RESERVE POLICIES

Looking forward, the main risk to the U.S. currency comes from the need to place substantial amounts of U.S. Treasury paper in the market over the next two years to finance the cost of financial rescues and the incoming administration’s proposed fiscal stimulus. Funding of as much as $3-4 trillion will be needed in fiscal 2009 with further substantial requirements in fiscal 2010.

Foreign buyers have absorbed more than half of the Treasury securities issued to the public in recent years. If they balk, the currency could come under sustained pressure.

But foreign governments and central banks have been much more important buyers of Treasuries and agency securities ($706 billion in 2006-2007) than foreign private investors ($160 billion). The motivations of foreign buyers are not strictly commercial.

China and other official holders of U.S. Treasuries and agency securities have the most to lose from any crisis of confidence that sparked a fall in bond prices or a decline in the dollar. China and the other big reserve holders need to carry on lending new money to hold yields down and protect the valuation of their legacy stock of assets.

Foreign asset holders might decide to stop throwing good money after bad, and risk taking a one-time hit on the value of their existing Treasury holdings from a rise in yields or a dollar devaluation. But all the signs are that they will continue lending into weakness instead.

Over the last three months, foreign official holdings of U.S. Treasury and agency securities in the custody of the Federal Reserve Banks have risen more than $100 billion (with a rise in Treasury holdings more than offsetting a decline in agency bonds).

With recession taking care of the current account deficit, financial crisis reducing gross capital outflows, and foreign official buyers continuing to support the Treasury market, the U.S. currency has been a strange beneficiary of the crisis. If the dollar’s earlier decline was a symptom of over-fast growth, its rise is a by-product of recession.

23 comments

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The FED is not an arm of the US Government (USG). Therefore, the government has NO control over FED policy.
If you owed your bank $19 Trillion dollars, do you really think that you are in any position to dictate finance policy? Neither is the USG.

The more money printed without having tangible redemption value only serves to decrease the value of the respective currency. For example, the USD has lost 97% of it’s purchasing power since 1913. Prior to the Bear Stearns loan guarantee earlier this year, the US national debt (not trade deficit) was hovering around 9.5 trillion.
Add Fannie and Freddie, and their yet to be determined losses, the $850B Wall Street bail out package (which Paulson used to buy $65B worth of bank stock for $125B),
the FED’s acquisition of AIG with US dollars, and the FED’s rumoured intent to acquire depreciated US Treasury bonds so it can print more USD without depending on the US government to issue them.
Not only that, but since the FED as previously mentioned is not a USG entity, it is able to conduct financial transactions globally using the USD without such actions being santioned by the USG, meaning that the USG will not get to use that new money first, when it is most valuable.

The “credit crunch” has been in effect for some six months now, as we can all agree. Mass deleveraging in financial instruments based in USD are what is causing the rise in the USD value. Once the bulk of this deleveraging has occurred, or what the author calls ‘repatriation’, then the USD will resume it’s inflationary progress. Only thing is, it has missed out realizing value on the creation of some new $5 trillion USD through the monetization of toxic debts such as CDS.

If the USD is so strong and sought after as a safe haven, being the currency of the country which triggered this crisis (conflict of logic?) why is there such a shortage of gold and silver?
Which, by the way should be the bubble to burst on top of the USD deflation. There is at least a 20% descrepancy in relation to the COMEX gold value, and what gold is selling for on the grey market. Bear in mind that the COMEX delivery is in progress on unprecedented levels. ‘Investors’ are demanding the delivery of the physical gold instead of rolling their positions over for another term. In many circles, there is expected to be a default on a high percentge of COMEX deliveries.
As Churchill once said,
“This is not the beginning of the end, but perhaps it is the end of the beginning.”

Posted by Baron von Lufthoven | Report as abusive

When the treasury cant pay its debts, the value of the dollar will have to be scraped off the floor. People are only using the USA dollar because its Supposed to be safe, but not any more. The Euro or yuan will be the next “dollar”.

Posted by not long to go now | Report as abusive

I think that the dollar’s perceived gains are dubious. The U.S. economy has been tanking for some time driving the dollar’s value down into the first half of 2008. With so much capital from other nations flowing across international borders, it is not be much of a leap to predict that foreign investment in the U.S. economy would be adversely affected. In short, the dollar didn’t get stronger. Other currencies have plummeted due to their nations recent poor economic performance. You know how it is, let’s make everyone else look bad so we look better.

Posted by Anubis | Report as abusive