Dollar demise much exaggerated
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.