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.


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.


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.


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.


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I think that the problem of US government debt is even more likely given that the national funds will lose money because of low commodity prices and will spend much of their assets saving their own economies…

Posted by Lisa | Report as abusive

Mr.John Kemp:

A well stated artical, however, I would like to dissagree on three points.
First: the national debt is over 11 trillion dollars and in the last three months the US government has all most doubled it with 9.4 trillion more.
Second: It seems as though you are refering to oversees investers as fiscaly-not so bright. Not sure how that is going to go over?
Third: the dollar has just started showing signs of weakness, relating to gold. For every dollar movement of gold, the dow industrals would move about $35. They stayed together in that range. In the past five days gold has shown a plus 6.4% seperation. ( There is now, again, a 1/35 movement – just a 6.4% differance in total.


Posted by Diamond | Report as abusive

Mr. Kemp,

This is the most refreshing and most intelligent view of the U.S. trade deficit and the USD and how both have been inter-dependent and inter-related to foreign money pouring into the U.S. I wish policy makers would take this analysis and think about it thoroughly…

p.s. you should consider applying for a Sr. position on Obama’s econmic dreamteam!!

Posted by Frank | Report as abusive

I agree with Frank! I also liked your article very much!

Posted by Lisa | Report as abusive

Very good and clear analysis. One additional point that can be made is that currency value is a straightforward balance between those buying and those selling. The 160 billion $ of foreign private investment is about 23% of the total of the foreign purchases of treasury securities – no small piece of the pie.

Governments may gradually reduce their exposure to avoid cannibalizing their legacy holdings, but private investors who still represent a sizable portion of the market needed by the U.S. to finance it’s debt may see things quite differently.

The current upsurge in the dollar is also due to repatriation back into dollars by large institutions requiring capital to remain solvent. When this massive migration ends and the private foreign treasury investors start their phased withdrawal, its hard to see how the US$ goes anywhere but down. I would love to hear arguments to this analysis.

I would say that betting on the dollar to remain strong in the next few quarters is a poor bet at best.

Posted by Jonathan Cole | Report as abusive

The real strength of a currency depends on the strength of the economy that underlies it, and on that count it’s not looking too rosy medium term for the dollar. Anything else is artifice. Jonathon Cole got it right, the dollar’s strength right now is very much due to repatriation, once those dollar loans have been paid off it’ll come down with a bump. Same with the yen too, it’s current strength comes from the unwinding of the carry trade, or have I missed some wonderful news about the heroically strong Japanese economy along the way recently?

I’m buying gold instead.

Posted by Chris | Report as abusive

I totally agree with Jonathan: once the capital repatriation ends, we will see more clearly the real value of the dollar. Also, there has been talk that G20 wants to adjust or replace the Bretton Woods accords which ensure the hegemony of the US dollar.

Posted by Horatio | Report as abusive

Great analysis, except I disagree on whether the dollar will collapse. I think it will. Watch the price of gold over then next year as a good indication.

Posted by John | Report as abusive

What a clear and realistic summary! I would point out to dollar bears just this: The repatriation has played a role. However, when the repatriations to Japan and the US are over, the next phase will depend on the relative strength of the major economies. I would be surprised if the options, Yen or Euro, appear more valuable in that next phase. I’ll keep an open mind, though, and pay attention.

Posted by Alan | Report as abusive

You would make a good choice for the Obama cabinet, because they are getting it wrong as well. We are quickly becoming a risk to our creditors and our money supply has risen dramatically. The outcome will be hyperinflation. Read Peter Schiff. He has called it right for years. Buy gold, the anti-dollar.

Posted by Billyboy | Report as abusive


A good article of late and some intresting analysis.
Over the past couple of years foreign goverments especially china bought US treasuries because they were issued to offset the deficit. With your analysis of a recession adjusting the deficit in US, but the government’s stimulus plan necessiating it I suspect who among the current buyers of treasuries will have the same euphemism when the need of the hour for them is to divert more of their existing funds to their domestic economies to offset the recession.

Posted by Gopi | Report as abusive

I agree with Billy. You would be excellent at helping Obama build an Empire on fiat paper with a 20 Trillian dollar annual deficit plus interest. In actuality, the total owed by the US is 50 Trillian dollars. Although, annual debt is shocking enough- so keep focusing on that. I will also be buying gold, guns, and food.

I hope the dollar printed by private company run by the heads of all of the banks we’re bailing out will make it. I’m not done stocking up on gold yet.

Posted by Jack Handey | Report as abusive

The only way to prevent inflation is a revaluation of US government gold (currently valued at $42.2214 per ounce) and for the US government to buy all of the International Monetary Fund’s bullion holdings at $1000 per ounce. The bullion banks know this and that is why two of them have made indirect statements to this regard. Central banks have all but stopped lending gold to commercial and investment banks and other participants in the precious metals market, in a move that has sent the cost of borrowing bullion for one-month to more than twenty times its usual level.

Posted by David | Report as abusive

when you compare the value of currencies remember we are comparing fiat money with fiat money; other countries are running up their debt and creating money rapidly. We have said for a year the problem was lack of liquidity; the lunacy oftrying to borrow your way out of debt will be upon us soon. when you mix vinegar and baking soda anywhere in the world you get the same result. the same with printing money it will inflate your currency. this is like a tidal wave as deleveraging is giving the allusion of deflation forming a wave of inflation that will hit the world. Austrian free market economists have been right about cause and effect for qite a while; the first answer pointedto peter schiff, he seems a prophet now. Also look up Jim Rogers these men have vastly different views and have been correct in assesing the situation for years.

Posted by brian mcnamee | Report as abusive

If what you say is the real picture I would say the Dollar is now becoming a high risk currency and sits on a tipping point which could go either way…up or down depending on foreigners’ risk appetite. I’m not a betting man and would therefore feel safer running to gold or even the Euro.

Posted by Niko | Report as abusive

A truly bizarre situation. Given that the lack of financial regulation in the mortgage markets + all the huge mega bonuses given to all these investment banks based on unsecured assets, it seems that the US has a proven poor track record, yet its currency grows. Very strange. Also given that the US needs to export more to generate more jobs, the rising dollar is only going to make the US economy worse as foreign countries decide not to buy as many more expensive US goods.

Posted by Harry Way | Report as abusive

Hmmm. Isn´t this the next bubble? Something just doesn´t add up. I believe gold will be the real star of 2009, the dollar bubble will implode around about may – june 2009. Let´s just hope it´s not too messy.

Posted by Grant | Report as abusive

Wait til they start printing that money ($200B) the Federal Reserve plans to put out there…

Posted by Cat | Report as abusive

No surprise at all, we amercans give ourselves no credit. We have one of the safest countries in the world with a unity unheard of in most other places. We like to argue and scream at each other but when all is said and done we are the best at business and government. Be proud that the rest of the world sees it too.

Posted by Robert Young | Report as abusive

The demise of the dollar will start when it is no longer the world’s preferred currency. In today’s international trade, crude oil is the biggest component with around $2 Trillion in value. Once the world moves over to alternative energy sources and since that energy is likely to be mostly locally generated than imported from certain concentrated locations (like crude oil from middle east currently), there will be less demand for dollars. That will be the first sign of a dollar weakness or outright collapse. Till then, dollar will enjoy preference.

Posted by Eskay | Report as abusive

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