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A Magazine of Ideas

Q&A: How to Think About the U.S. Dollar

Friday, March 27, 2009

It has become fashionable to predict the imminent collapse of the dollar. What might really happen?

With the prospect of very large U.S. budget deficits for many years to come, it has become fashionable in academic and financial circles to predict the imminent collapse of the U.S. dollar. In answering a series of questions on the dollar, Desmond Lachman suggests that despite its very poor underlying fundamentals, at least in the next year or two it may strengthen, particularly against the euro, the world’s second most important international reserve currency.

What determines the value of the U.S. dollar?

Up until the collapse of the Bretton Woods fixed exchange rate system, the dollar’s exchange rate against other currencies was essentially fixed by the government in concert with other International Monetary Fund (IMF) member countries. Since 1971, however, the dollar’s exchange rate has been allowed to float freely and to be determined by market forces with practically no official government intervention.

Like any other commodity, the dollar’s exchange rate against other currencies is now determined by demand and supply. If at any given exchange rate, there are more buyers than sellers, the dollar will strengthen. If the opposite is the case, the dollar will weaken.

What are the sources of dollar demand and supply?

There are two principal sources of demand and supply for U.S. dollars. The first relates to “current account” transactions associated with the export and import of goods and services. The second relates to “capital account” transactions associated with Americans investing in foreign financial markets and companies and with foreign investors doing the same in U.S. financial markets and companies. Such transactions would include the purchase and sale of foreign equities and bonds as well as the direct investment in foreign companies.

When an American company exports abroad, it will earn foreign currency that it will generally want to sell in the foreign exchange market for dollars. This will tend to strengthen the U.S. dollar since it will increase the demand for dollars. Conversely, when a U.S. company imports from abroad, it will generally need to buy foreign currency with dollars to pay for those imports, which will tend to weaken the U.S. dollar.

The same reasoning applies to U.S. investors needing to buy foreign currency to invest in foreign financial markets or companies; that tends to weaken the U.S. dollar. The same applies to foreign investors needing to buy dollars, which tends to strengthen the U.S. dollar.

How strong are the dollar’s external fundamentals?

By most measures, the U.S. conditions underpinning the dollar’s value are poor and are unlikely to improve very much in the medium term. In the past 15 years, there has been a progressive deterioration in the U.S. external current account deficit mainly as a result of a concurrent precipitous decline in savings by American households. From a position of near balance in the early 1990s, the U.S. external current account deficit has progressively widened to reach around US$800 billion, or around 6 percent of U.S. GDP in 2008.

U.S. Current-Account 1

Looking ahead, one should not expect much improvement in the U.S. external current account balance. It is true that U.S. households are very likely to increase their savings rate appreciably in response to the housing and equity market busts. However, this increased private-sector savings effort will almost certainly be largely offset by increased spending by the government. The Congressional Budget Office now expects that the U.S. budget deficit will widen to around 12 percent of GDP in 2009 and it will remain at around US$1 trillion a year between 2010 and 2019.

A disturbing aspect of the U.S. external position has been the United States’ move from being the world’s largest creditor nation in the mid-1980s to the world’s largest debtor nation at present. Currently, the U.S. gross external debt position is around 120 percent of GDP while its net external debt position is more than 20 percent of GDP and rising.

U.S. External Debt 2

It is also of concern that most of the U.S. external current account deficit is now being financed by central banks, particularly in the OPEC countries and China, rather than by private investors. Foreign central bank dollar holdings now exceed US$6 trillion, of which more than one-quarter is held by the Chinese central bank. Earlier this month, the Chinese premier expressed his unease about China’s very large exposure to changes in the value of the U.S. dollar that was posed by China’s holdings of U.S. government bonds.

US Trade Balance and Global Official3

Is the collapse of the dollar inevitable?

The very weak U.S. external fundamentals would suggest that the U.S. dollar must continue its downward slide that has been in evidence since 2002. However, for the U.S. dollar to depreciate, it has to depreciate against another currency. So the real question for the U.S. dollar is whether the U.S. external fundamentals, as bad as they might be, are materially worse than those of Europe and Japan, whose currencies would be those that pose the greatest threat to the U.S. dollar.

Europe’s economy is presently in the grips of a recession as severe as that in the United States, and its banks are beset by the same sort of loan losses as American ones. Further complicating the European banks’ situation is their US$1.5 trillion exposure to Europe’s troubled Eastern periphery. It is now widely expected that as a response to Europe’s difficult economic and financial situation, the European Central Bank will soon be forced to cut interest to the same very low levels as in the United States. This would remove the positive interest-rate differential presently favoring the euro.

Worse still for the euro is the growing perception in the markets that Europe’s  Mediterranean countries and Ireland might experience increased difficulty managing their present problems within the straitjacket of Euro-zone membership. This perception is being reflected in the much higher interest rates that these countries have to pay on the debt that their government issues.

Sovereign 4

Greece and Italy have very poor public finances, and Greece, Portugal, and Spain all have external current account deficits in excess of 10 percent of GDP. The rating agencies have already downgraded the government bonds of Greece, Ireland, and Spain and they have warned that further downgrades are possible unless there is improvement in these countries’ economic outlooks.

For its part, Japan is experiencing a decline in GDP at an annualized rate approaching 12 percent, while the real threat of deflation is again surfacing. This is likely to preclude any real improvement in Japan’s seriously impaired public finances as reflected in a public debt-to-GDP ratio of around 180 percent.   

How has the dollar performed in recent years?

Between 2002 and mid-2008, the U.S. dollar lost approximately one-third of its value as investors focused on the large U.S. external current account deficit.

US Trade Weighted 5

Since mid-2008, however, there has been around a 15 percent effective appreciation of the U.S. dollar. The U.S. dollar has come to be viewed as a safe haven currency in the global economic and financial crisis. The dollar’s movements against the euro have been equally dramatic: After approximately halving in value from 2002 to mid-2008, the dollar has since recovered to around 130 U.S. cents to the euro.

Exchange Rate USD 6

What can the government do to influence the value of the dollar?

The only way that the government can beneficially influence the value of the dollar on a sustained basis is by pursuing policies that strengthen the country’s external fundamentals. More specifically, the government could strengthen the dollar by implementing policies that increased the domestic savings rate, that kept inflation low, and that improved the attractiveness of the United States as a place in which to invest and do business.

Viewed through this lens, the present policy mix in the United States must raise fundamental questions about the dollar’s longer run prospects. The Obama administration’s fiscal stimulus package will compromise U.S. savings for many years to come, and the Federal Reserve’s zero interest rate policy and its massive liquidity injections into the banking system raise the prospect of higher inflation once an economic recovery gets underway. At the same time, the lack of decisive policy action to restore the financial system undermines the attractiveness of the United States as a place in which to invest.

Is there a role for direct intervention in the exchange market?

Many failed attempts at intervention have taught policymakers that direct government intervention in the exchange market has at best only a very transitory impact on the dollar’s value. This is because with the free movement of capital across international borders, the foreign exchange market has become too large in relation to the amounts of intervention that the government is prepared to undertake. As a result, the U.S. Treasury very seldom engages in foreign exchange intervention and when it does so it is strictly in response to “disorderly conditions” in the market.

In place of direct foreign exchange intervention, over the past 15 years the United States has engaged in verbal intervention by frequently espousing that the U.S. government believes in “a strong dollar policy.” Whatever the merits of such pronouncements by the U.S. Treasury Secretary Robert Rubin might have been when he originally made them in the 1990s, they now ring hollow particularly in face of the decline in the dollar’s value since 2002. Markets respond much better to concrete policy actions aimed at strengthening the U.S. economy’s external fundamentals than they do to statements of intent not backed by specific policy measures.

Is China manipulating its exchange rate?

In written congressional testimony, Treasury Secretary Timothy Geithner asserted that “President Obama—backed by the conclusions of a broad range of economists—believes that China is manipulating its currency.”

There can be little doubt that China has been manipulating its currency for competitive advantage. It has been doing so by heavily intervening in its foreign exchange market to prevent its currency from appreciating under the weight of a persistently large external current account surplus. Indeed, over the past two years, China has been accumulating international reserves at an annual rate of around $400 billion. This has boosted China’s international reserve holding to over $2 trillion, or to a level far in excess of what China reasonably might need as a currency cushion for a rainy day.

Dominique Strauss-Kahn, the IMF Managing Director, has repeatedly expressed the view that on a fundamental basis the Chinese currency is “significantly undervalued.” Supporting Strauss-Kahn’s view, China is presently running the world’s largest external current account surplus—close to 10 percent of its GDP—and it shows little sign of decreasing anytime soon.

It is questionable whether a confrontational approach toward China on the currency issue is the best strategy to deal with this problem, especially given that the United States is so dependent on China for financing its gaping budget deficit. With total U.S. dollar holdings in excess of $1.3 trillion, China is already the world’s largest holder of American government and agency bonds.

China is not known to be a country that responds well to external threats. Indeed, one might expect China to respond to any serious U.S. threat about redressing the currency issue by significantly reducing its purchase of U.S. government bonds. Any such reaction by China could have very unpleasant consequences—for American financial markets in general and for the dollar in particular—at a time when the U.S. government needs to sell more than $1 trillion of its bonds each year for many years to come.

Why is China proposing the introduction of a new reserve currency and what are the prospects for its early introduction?

Ahead of the London G-20 Summit on April 2, China is now proposing the introduction of a new international reserve currency through the substantial increase of the IMF’s Special Drawing Rights. It is proposing this idea since it would like to have a stable international reserve currency for its substantial international reserve holdings that are presently mainly held in U.S. dollars.

The chances of China’s proposal making much progress in the foreseeable future are minimal. Treasury Secretary Geithner has indicated that this proposal would not be supported by the United States. For the proposal to advance, U.S. support is crucial since the United States has an effective veto at the IMF.

Desmond Lachman is a resident fellow at the American Enterprise Institute.

Images by Dianna Ingram/Darren Wamboldt/The Bergman Group.