Issue: February 2004
By Ira Kalish, director, Consumer Business, Deloitte Research.
Today, the United States is borrowing vast sums from the rest of the world, roughly equal to 5% of GDP. That is not necessarily a bad thing as long as foreigners are willing to lend vast sums to the US. Indeed they readily did so in the 1990s when equity prices were rising and the US economy was growing rapidly. Lately, however, foreigners have become reluctant. A slower US economy, combined with an uncertain asset market, has caused them to become squeamish. The resulting decline in the demand for US assets has caused the value of the dollar to decline considerably. The question arises as to how this situation will be resolved, and whether it can be accomplished without creating economic problems in the US and elsewhere.
Background
During the 1990s, foreign investors were only too happy to put their money into the US. Returns on equities were high, the dollar was rising, and the economy was growing rapidly, especially compared to other developed nations. When the equity bubble burst at the start of the new millennium, foreigners became wary of US equities. With the drop in equity prices overseas, foreigners had to rebalance their portfolios by selling US assets. Moreover, with a shift toward fiscal deficits and the necessity of greater US government borrowing, the US current account deficit began to appear less sustainable. Foreign investors started to believe that, in order for that deficit to be reduced, the value of the dollar would have to decline. This would cause US exports to become cheaper and US imports to become more expensive. The result would be a decline in the trade deficit, and therefore less US borrowing from foreigners.
In financial markets, saying it’s so makes it so. Thus, when foreign investors began expecting the dollar to fall, they put their money where their mouths were and, in the process, caused the dollar to fall.
The Role of China
Interestingly, even though the dollar has fallen considerably against the euro and the British pound, it has fallen only marginally on a trade weighted basis. The reason is that Asian central banks have not permitted their currencies to float freely against the dollar. The principal culprit is China which has intervened in exchange markets to keep its currency (the renminbi) fixed in value against the dollar. The principal reason is that China fears a stronger renminbi would hurt Chinese exports, thereby putting millions of export oriented jobs at risk. China also fears that indigenous, state-owned companies are not adequately prepared to compete with imports. Further losses by such companies would complicate problems within China’s already shaky banking system.
China’s choice to maintain a fixed exchange rate has influenced the choices made by other Asian countries, especially Japan. If these countries other Asian countries were to allow their currencies to rise in value against the dollar, their currencies would also rise in relation to the Chinese renminbi. The result would be that their exports would become even less competitive against Chinese exports. So no Asian country is likely to allow a significant rise in its currency absent a rise in the renminbi. That is why Japan has expended huge resources to keep the yen from rising rapidly.
Whither the dollar?
The problem for China is that, in the process of intervening in currency markets in order to hold down its currency, it is printing renminbi in order to meet the excess demand for Chinese currency. This is inflationary. Indeed, China’s inflation rate has lately risen from near zero to around 3%. If inflation becomes problematic in the eyes of the Chinese authorities, it could compel them to revalue the currency. Due to the fact that many investors now anticipate a revaluation, speculative capital is flowing into China, forcing even more money creation, and thus more inflation.
If the renminbi is revalued (and this is likely in the next year or two), it will likely spark a chain reaction in currency markets and Central Banks around the world. The Bank of Japan would probably feel more comfortable allowing the yen to rise in relation to the dollar. That is because a stronger renminbi would improve the competitiveness of Japan’s exports to China and reduce the competitiveness of China’s exports to the US. Japan is averse to doing anything that would damage exports, a prime source of economic growth. In addition, a Chinese revaluation would make other Asian countries feel more comfortable letting their currencies rise against the dollar. With the dollar falling against Asian currencies, there would be less upward pressure on the euro and the pound. More importantly, the chances of bringing the US current account deficit down would improve as the trade weighted value of the dollar would fall considerably.
The problem, though, is that the dollar might have to fall quite far in order to significantly reduce the current account deficit. A substantial decline could be both inflationary in the US and constricting in the rest of the world – especially Europe. Moreover, failure by China to revalue would mean an even more devastating rise in the value of the euro. The result could be a new European economic slowdown. A more stable way to deal with the US imbalance would be to address the long-term US fiscal imbalance. Yet this is not likely during an election year.
What to expect
Here is a likely, or at least reasonable, scenario: First, the Chinese government engages in a series of small currency revaluations over the next two years. Japan and other Asian nations respond by allowing their currencies to rise a bit more in relation to the dollar. Some pressure on the euro is alleviated, but not much as US import prices are not immediately influenced by the Chinese move. Despite small cuts in European interest rates, the euro continues to rise steadily, hurting export growth and stymieing economic recovery. The US administration leaves fiscal policy unchanged. Meanwhile, despite a falling dollar, the current account fails to budge (it usually responds with a lag to exchange rate movements), thereby causing the dollar to fall even further.
In the medium term (two to three years), the effect of a falling dollar is to reduce import growth and increase export growth. In addition, the falling dollar creates new inflationary pressures in the US and, therefore, a tightening of monetary policy by the Federal Reserve.
Based in Los Angeles, Ira Kalish is a director of Consumer Business Research and is frequently quoted by The Wall Street Journal, The Economist and The Financial Times. Dr. Kalish holds a bachelor's degree in economics from Vassar College and a PhD in international economics from Johns Hopkins University.
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