New paradigm for the US dollar?
2 May 2002
US first quarter economic figures released by the Commerce Department showed 5.8 percent growth. In spite of this strong showing, the US dollar has been falling over the last few days. The reason? Analysts are worried that the strength of the economic recovery may not be sustainable.
While consumer spending grew by a healthy 3.5 per cent, business investment, a key indicator of future growth, fell 5.7 per cent in the first three months of this year, the Commerce Department report said. This trend appears to have been confirmed by another report on durable goods orders for March, which showed a 0.6 percent fall. Orders for non-defence capital goods dropped 2.8 percent in March.
As noted in UBS Warburg's weekly Economic Perspectives: "Financial Markets Viewing Strong Q1 GDP Growth As 'History That Won't Repeat Itself'". Indeed, another Commerce Department report on personal spending and incomes in the United States showed that these grew in March at the slowest rates in three months. Personal spending rose 0.4 percent, having risen 0.6 percent in February. Incomes increased 0.4 percent, after rising 0.6 percent a month earlier.
Consumer confidence reports tell the same story. The University of Michigan's final sentiment index for April showed consumer sentiment fell by more than expected to 93, down from 94.5 in March. This fall was corroborated by the New York-based Conference Board, whose Consumer Confidence Index fell to 108.8 last month from 110.7 in March.
Add to all these a weak earnings outlook and poor stock market performance on Wall Street, little wonder then that the US dollar has been coming under pressure. Like the US stock market, the US dollar may be a victim of excessive optimism. As a foreign exchange strategist reportedly said in The Business Times: "A lot of good news was already priced in to the dollar and people are looking around for other stories."
And it is probably about time that people re-examine the prospect for the US dollar, especially in relation to the performance of the US economy. In my opinion, the positive correlation between US economic growth and currency strength has been exaggerated in the first place. This positive correlation has been fed in recent years by capital flows that sought investments in competitive economies with strong productivity growths. In the late 1990s, that meant the US. But over the longer term, concepts like purchasing power and current account balances still matter. After all, to put it simplistically, how competitive can an economy be if foreigners are not buying its goods and services (i.e. its current account is in deficit), and -- or because -- its goods and services aare expensive (i.e. the purchasing power of its currency is low)?
On this basis, analysts at Morgan Stanley Dean Witter have for some time been suggesting that the US dollar is overvalued. However, in his article in the Global Economic Forum on 26 April, Stephen L. Jen suggested that despite the overvaluation, the US currency might not correct as much as fundamentals would suggest because the Chinese renminbi is, for all practical purposes, pegged to the US dollar. This means that a fall in the US dollar would cause a corresponding fall in the renminbi. He noted: "It is far from clear that a simultaneous correction in the dollar and the renminbi would lead to a significant rally in the Asian currencies… An effective devaluation of the renminbi could hurt the Asian currencies just as much as a correction in the dollar could help them."
He goes on to add: "[A] dollar correction could be very deflationary. As the dollar weakens, ceteris paribus, demand is withdrawn from the world as the purchasing power of the US is pared down. But as the renminbi weakens, supply is added to the global economy. The combination of a withdrawal of demand and an increase in supply could be very deflationary for the global economy."
By mentioning the renminbi connection, Jen's article provides a good explanation of what is happening as well as what could happen in currency markets. It also provides a new dimension to his analysis of the US currency. But the Chinese connection is not new to others. Observers in Asia have been fretting over the impact of China on the global economy in general and Asian economies in particular for quite some time. A major reason for Japan's insistence on keeping the yen down is competition from China. Capital inflows to the US, which leads to the rise in the US dollar, is partly a by-product of these attempts to keep Asian currencies down, US treasuries being an instrument through which excess US dollars are recycled by Asian countries.
In fact, back in 2001, on 26 July, Jen's Asia-based colleagues, Robert Feldman and Andy Xie, had written that "a weak yen against the dollar would raise the Japanese surplus [which] might simply recycle back to the United States". Then on 17 August, Xie wrote that "China is following a deflation-led growth model. Because China has such a huge surplus labor force in comparison to the global economy, it is difficult for wages to rise. Domestic consumption is therefore based on bringing prices down in line with Chinese labor costs. China is redefining the prices for tradable goods." He explained: "As trade prices fall, other economies have to devalue or lose export market share."
And that is essentially what has been happening. Most other currencies have been falling relative to both the renminbi and the US dollar. The latter cannot fall simply because the renminbi is pegged to it. Hence the deteriorating US current account.
In other words, ultimately, the US dollar owes much of its strength to the renminbi, not just its own economic strength. Increasingly, western observers will come to recognise this fact.
Disclaimer: The commentaries posted here represent the opinions of the author at the time of posting and should not be taken as investment advice. Readers who wish to take any investment action based on information obtained from this site should seek appropriate advice from a qualified financial adviser.