Analysts risk overestimating the value of the US dollar
20 May 2002

In an interview with Channel NewsAsia on 17 May, Jan Lee, Hypoveriensbank's chief strategist, remarked that he believed that the US dollar was undervalued. This comment struck me as rather ironical.

How does one determine the value of a currency? The most fundamental way is to look at its purchasing power. The higher the purchasing power relative to other currencies, the higher the exchange rate should be. By this measure, the US dollar is generally considered overvalued, not undervalued.

But this notion of value has little value to currency traders. Exchange rates of currencies often diverge from such values for very long periods of time. Currency traders prefer to look at variables that exchange rates are more sensitive to. Such variables usually take the form of differentials. They have traditionally included the current account balance as well as the interest rate-inflation rate differential. Both of these variables, of course, are in fact linked to purchasing power, but have the added advantage of reflecting currency flows more directly. A current account surplus tells you that foreigners are buying more goods and services than selling, thus increasing demand for the currency. A large and positive interest rate-inflation rate differential allows fixed-income investments to increase in value net of inflation, which should attract funds to the country and thus increase demand for the currency.

However, since the late 1990s, another variable has taken centre-stage. That variable is economic growth rate. This variable has been used to justify the appreciation of the US dollar in the late 1990s in the face of persistent US current account deficits. Essentially, it works through the fact that the higher economic and productivity growth rates in the US is supposed to attract investments into the US, which increases demand for the currency. The capital account surplus then offsets the current account deficit.

I have no problem with this argument. The problem is when this line of reasoning is taken to an extreme. US dollar bulls insist that the superior economic growth prospect in the US completely overrides the large and persistent US current account deficit. There are two problems with this assumption.

The first problem is that the envisaged superior growth needs to be maintained over a substantial period of time in the future. If growth slows down to the same rate as other economies, the capital account surplus can disappear overnight, leaving just the current account deficit to weigh down the US currency. The fact is, economic growth rates are notoriously difficult to predict. With the exception of relatively small East Asian economies that are still catching up to the income levels of industrialised economies, exceptionally high growth rates have proven difficult to sustain. Just look at the case of the Japanese economy. Back in the 1980s, the Japanese economic juggernaut was widely admired as well as feared for its seemingly unrelenting competitiveness. Now it seems to be in unrelenting depression.

Indeed, as pointed out by Morgan Stanley's Joe Quinlan in the Global Economic Forum on 10 May 2002, already, "foreign investor appetite for US securities is just not what it used to be". While foreign investors snapped up nearly US$100 billion in US financial assets in the first two months of last year, the total in the first two months of this year was just US$26.7 billion.

The second problem is the persistence of the US current account deficit. The US Commerce Department recently announced that the March deficit was US$31.6 billion. This brings the average for the first quarter this year to US$30.5 billion, comparable to the monthly average of US$31.3 billion and US$29.0 billion for 2000 and 2001 respectively.

One reason for the persistent deficit, of course, is that the US economy is driven by consumption. Much of the additional income generated by economic growth ends up feeding further consumption and, hence, aggravating the current account deficit, or at least preventing it from shrinking.

In summary, the US capital account surplus is vulnerable while the current account deficit is stubbornly persistent. This is hardly the mark of a strong currency.

Of course, Jan Lee has been bullish on the US dollar for some time. Back in July last year, he had predicted to The Business Times that the US dollar would end 2001 at S$1.95 and rise to as high as S$2 by the end of the first quarter of 2002. Neither of these forecasts came close. The US dollar rose to a high of around S$1.85 at around year-end but has since dropped to around S$1.80 currently.

Apart from the two fundamental concerns for the US dollar mentioned above, currency analysts also face another problem in forecasting the level and direction of the US dollar. Many analysts, no doubt, would have based their forecasting models on periods that include the late 1990s, when the US currency soared while the US economy boomed. But this period also included the Asian Financial Crisis and a stock market bubble in the US. Both of these helped push up the US currency, but they are infrequent events and unless analysts take proper account of them, their forecasts may turn out to be unduly optimistic for the US dollar.

Specifically, the above forecasting error may appear in two forms. One, which I shall call Type I error for the remainder of this article, is to overestimate the US dollar's sensitivity to the economy. While this type of error would lead to currency traders being overly bullish on the dollar when the economy is unusually strong, it would also lead to currency traders selling down the currency on signs of a weaker-than-expected US economy. That could have been what happened in the second half of April, when the dollar declined from about 132 yen to 127 yen, and the euro correspondingly went up from about US$0.88 to about US$0.91 after a number of weaker-than-expected economic data in the US.

The other forecasting error, what I shall call Type II error, is to overestimate the strength of the US dollar, period. Indeed, some people seem to be perennial bulls as far as the US currency is concerned. In a commentary on 13 July 2001 for Bloomberg, Caroline Baum wrote that as far as current account deficits are concerned, "they are sustainable until they aren't". She added: "Folks have been wailing about the current account for a few years now, even as it doubled as a share of GDP." Clearly, Baum fails to realise the negative impact that the current account deficit would have on the US dollar in the absence of temporary factors like an emerging market crisis or a stock market bubble. Saying that current account deficits are sustainable until they aren't is as useful as saying that you're alive until you're dead.

On 6 May 2002, Baum ridiculed the foreign exchange market for selling off the US currency. In an article entitled "Foreign-Exchange Market Can't Handle the Truth", she wrote: "In search of a scapegoat for the dollar's latest bout of dyspepsia, the foreign-exchange market settled on U.S. Treasury Secretary Paul O'Neill." A few days earlier, U.S. Treasury Secretary Paul O'Neill had gone to Capitol Hill to testify on international economic policy, but had failed to indicate support for a strong US dollar. However, O'Neill was not really the reason for the fall in the dollar. Rather, it was weaker-than-expected economic data and possibly Type I error. At best, the forex market was looking at O'Neill to mitigate the fallout from the economic data with some supportive words. But Baum, apparently exhibiting Type II error in her bullishness on the US dollar, just failed to see that.

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