US dollar dragged down by trade deficit
16 May 2003
The triumphant conclusion of the Iraq war shows that the US military is still supreme in the world, but financial markets clearly think that the heydays of the US currency is over.
On 12 May, the US dollar dropped to a four-year low against the euro. The next day, the US Commerce Department reported that the US trade deficit grew by 7.6 percent in March to US$43.5 billion from February's US$40.4 billion. The March deficit is the second worst on record after last December's US$44.9 billion deficit. The persistent trade deficit is putting enormous downward pressure on the US currency.
The euro has already risen about 40 percent from its lows against the US dollar. According to C. Fred Bergsten, director of the Institute for International Economics, to bring the annual US current account deficit of about $500 billion down to a sustainable level of $250 billion, a further 10 to 15 percent decline in the dollar is necessary. This would put the euro in the $1.26 to $1.32 range.
However, the problem for the US currency is really with the Japanese yen. The US trade deficit is mainly with Asian economies, including Japan. In theory, the most direct way of reducing the deficit is for the US dollar to depreciate against the Japanese yen in particular and against Asian currencies in general. The USD/JPY exchange rate is currently at about 116. According to Morgan Stanley, fair value for USD/JPY is 107.
Unfortunately, in practice, such a depreciation may still not have enough impact on the US trade deficit for the simple reason that a major part of that deficit is with China, whose currency is pegged to the US currency. The most it is likely to do is to transfer part of America's trade deficit to other countries that do not have rigid currency pegs.
That is assuming, of course, that other countries allow the US dollar to depreciate against their currencies. Japan, still grappling with a weak economy, has been opposing a rise in its currency for the past few years with active market interventions. The same holds true for most of the other Asian countries. And China needs to keep its currency in check because it needs continued growth in manufacturing exports to offset potential job losses from its ongoing economic restructuring.
That leaves the euro bearing the brunt of the US dollar's decline. And it is likely to do so for some time to come. The European Central Bank's anti-inflation stance is well-known. In the face of weak economic growth, it has chosen to maintain relatively high interest rates. The central bank's president, Wim Duisenberg, has indicated that he is not alarmed by the euro's advance. "The development of the euro-dollar rate isn't a cause for concern yet, but… we are alert," he told reporters after a speech in Vienna last week.
So the US dollar will continue to depreciate, with the euro being the main outlet. Some observers, however, seem to have trouble understanding why the US dollar should weaken.
David DeRosa, president of DeRosa Research & Trading and an adjunct finance professor at the Yale School of Management, used to vilify then-Treasury Secretary Paul O'Neill in his Bloomberg column for not trying harder in talking up the US dollar. He appears to be more forgiving of O'Neill's successor, John Snow. In his recent article on 14 May, he acknowledged that whatever Snow says, the Treasury Secretary "can't win".
Peter Eavis, writing for TheStreet.com, is more critical. In his article entitled "Weak-Dollar Snow Job Won't Warm Tepid Growth", also on 14 May, he chastised the Treasury Secretary for "making strangely soft remarks on the dollar". To him, a weak dollar "is a sign of a weak government and a weak economy… Devaluation leads to inflation as producers experience higher demand for their products and raise prices. As prices rise, the currency buys fewer real goods and services. No one wins." He advocated a strong defence of the US dollar. "Snow could make unambiguously tough statements about the greenback and intervene in the markets along with other countries to ambush investors making the short-dollar trade," he suggested.
Eavis is badly mistaken. A weak dollar, in this case, is a sign of an overvalued currency, not of a weak government. If the US government is at fault, it is in encouraging the US dollar to become overvalued in the first place by overstressing a strong dollar policy. However, that is mostly the fault of the previous administration -- think ex-President Bill Clinton and his Treasury Secretary Robert Rubin here -- not the current one. And the weak dollar is not a sign of a weak economy. If anything, it is a sign of a strong economy, at least relative to the other two major currency blocs, Japan and Europe. The US economy's strength, fuelled by consumption spending, is causing it to suck in too many imports and feeding its current account deficit, which is the basic cause of its weak currency.
Eavis is correct in saying that devaluation leads to inflation, resulting in the currency buying fewer real goods and services, but he is wrong in saying that no one wins as a result. The weaker purchasing power of the US dollar affects those with net wealth negatively. However, it affects those with net debt positively. Workers and their companies that are exposed to foreign competition, whether in the US or internationally, also gain. So do the unemployed who hope to gain employment in such companies. In other words, some win, some lose. The question is whether the gains outweigh the losses. My guess is that for the United States and Americans in general, they do. However, foreign holders of US assets will lose, as will foreign companies competing against US ones.
Finally, Eavis recommended that Treasury Secretary Snow defend the US dollar by talking up the currency and intervening in the foreign exchange markets. That might slow down the dollar's decline but it is unlikely to stop it. The current account deficit is simply too large. In the current economic climate, the US simply cannot attract enough capital to offset that deficit. Unless, of course, it tries to recreate another asset bubble, as in the 1990s. Or alternatively, it could try to reduce the deficit directly by discouraging consumption. That can be achieved by fiscal or monetary tightening. But such tightening would almost certainly also induce a recession.
Eavis suggested that if Snow waits much longer before taking action to stop the US dollar's decline, "it will be too late to stop". In my opinion, it already is.
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