For the U.S. dollar, the first administration of George W. Bush was the worst era since the crash of 1987. Since it peaked in October 2000, the value of the dollar has fallen by more than 40% relative to the euro – which means a 55% rise for the European currency. From a height of 1.179 euros to the dollar – or $0.821 to the euro, it has reached its current historic low of 0.7 euros to the dollar. (The euro is now worth $1.30). As the downward spiral of the dollar continues, a chorus of voices warns about the scope of the depreciation, and demands measures to reduce the U.S. current account deficit.
The great burden of the dollar continues to be the structural deficit in U.S. financial accounts. In a nutshell, the United States buys more than it spends. When it comes to the budget, the federal government spends more than it earns. “The net rate of national spending in the U.S. fell to a range of between 1 and 2 percent during 2003-4. This historic low point tells us that this nation is living far above its means,” Stephen Roach, chief economist of the Morgan Stanley investment bank, noted in a recent report. “This excess has led to many serious economic imbalances.”
The list of problems is long: The unprecedented deficit in the national deficit; an historic high deficit in the current account, the record-high indebtedness of families, and enormous budget deficits. Now that the elections are over, the moment has arrived for U.S. officials to use their extraordinary skills to rescue their currency. A cyclical change in the Federal Reserve’s monetary policy could become the first mechanism for defending the dollar. “The expectations of the market are that the central bank will continue its recent inclination to increase interest rates, step by step, sending an unmistakable signal to the market that it intends to maintain the value of the currency,” explains Salvador Rojí, professor of international financial markets at the Complutense University of Madrid.
From Twins to Triplets
A lot has been said about a phenomenon known as ‘twin deficits’ – public and trade – which are both drags on the dollar. Some economists, including Roach, add a third deficit – savings – as an extra burden. When it comes to flows of trade and capital, the current account deficit is approaching $600 billion, equivalent to 6 percent of this year’s GDP. That means the U.S. has to borrow that much money in foreign markets in order to import such consumer goods as televisions and cars. Beyond all that, there is the cost of energy. “Bush can be a good or bad president for the country from various points of view – cultural, economic, social, and so forth,” says Rojí.
“However, the currency is an instrument that does not suffer by itself. It’s the population of the country who suffer the consequences of a dollar when it is too high or too low. In any situation, some groups of people win and others lose. For example, a weak dollar means that imported products are more expensive. As a result, the dollar is an inflationary factor. However, exporting sectors derive a competitive advantage because their prices go down.”
Regarding the budget deficit, no solution seems to be on the horizon. The tax reduction plans adopted by Bush during his first administration – and the possibility of new tax cuts could deprive the federal government’s coffers of more than $1 trillion, according to various estimates.
In its annual report on credit in the United States, the Moody’s agency stresses the dollar’s presence in every corner of the world. “Nevertheless, the tax cut and the spending policies have continued to have a negative effect on the country’s finances,” says Steven A. Hess of Moody’s Investors Service. “Because the dollar is maintained as the dominant currency of trade and international finance, the American government does not hold debt in foreign currencies. The ratio of public debt to the GDP is about 63%, about the same level as in the other 18 countries that have an AAA rating,” argues Hess. ‘Triple A’ is the best credit rating that exists.
The Downward Spiral
The dollar has been suffering its greatest depreciation relative to the British pound and the euro since the stock market crash of 1987. (These calculations use Deutschmarks for the years prior to 1999.) Between 1985 and 1987, the U.S. currency dropped by 50% relative to the world’s other major currencies. Inflation rose, along with returns provided by bonds. Then, in October 1987, the stock market crashed. In an article that appeared before the November 2, 2004 elections, the weekly Economist warned that the current-account deficit was twice as high as in 1987. As a result, the total decline of the dollar – and its repercussion on other financial markets – could be larger. According to the magazine, the greenback has been providing warnings that its downward progress could go deeper.
The Economist is echoing the consensus of the market. “We expect a significant depreciation relative to major currencies in a few years, in accordance with an eventual correction of the record-high current-account deficit. Despite the foreign trade deficit, the dollar is significantly higher than it was at the beginning of the 1990s, the most recent period in which the deficit was almost in balance,” says a report by Citigroup Smith Barney.
Since January, the U.S. currency has lost 9% relative to the South African rand, a currency associated with changes in the price of gold. Gold itself plays a role as an active antagonist of the dollar in currency markets. Investors have been using gold as a hedge against inflation, shielding their U.S. portfolios each time there is a fall in the dollar. An analysis of the marketplace continues to show that the dollar will drop in practically every market around the world. The greenback has dropped 7.7% relative to the Canadian dollar, and 7% versus the South Korean won. Its depreciation against the euro has reached 3%, and 1.5% versus the Japanese yen. Meanwhile, the British pound and the Swedish kronor have appreciated 4% relative to the dollar since January.
Foreign Financing Needs
When a country produces deficits, its indebtedness grows. According to current estimates, the U.S. needs $2.5 billion in financing each day to prop up the value of the dollar. As a result, the U.S. needs to attract about $1 trillion in foreign capital every year in order to maintain the value of its currency. To achieve that goal, the country must raise the rate of return on its assets. In a report that came out before the elections, Tim Wilson, chief global strategist for Newton, a fund manager, called for caution when investing in dollars. “We are cautious about the U.S. dollar because of the scope of the trade and budget deficits. We continue to maintain an ‘under-weighted’ position with regard to U.S. bonds, because there is greater profitability elsewhere and in stocks; and because the market is relatively expensive compared with historical prices and other world stock markets,” writes Wilson.
Other fund managers have plenty of reasons for recommending caution. Put yourself in the shoes of a European investor who deposited his euros four years ago in U.S. assets and now wants to liquidate his investment. If he has not taken measures to cover his currency risk, he will probably lose money.
According to a report by Smith Barney, “the increase in the cost of assets in dollars” favors a scenario in which the currency drops so much that “it becomes less attractive to foreign capital.” American bonds have lost much of their appeal to Europeans, for example, as a result of the decline in the value of the U.S. dollar. The modest return of a two-year U.S. bond (yield minus inflation) provides a good demonstration of how dollar assets have lost their appeal. Even the stingy bonds offered by Japan have managed to outperform those of the U.S., thanks to the deflation Japan is suffering.”
Where does the capital financing the dollar come from? Who buys U.S. Treasury bonds? Mainly, Asians. Japan, South Korea and China, for example, are some of the countries that have taken a common approach to a currency that is clearly undervalued, but which they support with significant reserve purchases of dollars. “During the first half of the year, massive foreign intervention by governments helped to delay the downward correction of the dollar,” notes the report by Smith Barney. The Asian economies continue to act this way so their exports will remain cheap enough to maintain their high growth rates. That’s why these countries are prepared to keep buying dollars indefinitely. Meanwhile, in buying U.S. Treasury bonds, they help reduce interest rates in the U.S., which helps consumer spending, and guarantees that Americans will continue to buy Asian goods.
What would happen if the foreign investment faucet toward the U.S. stopped running? Warnings about this delicate situation are coming from the Federal Reserve itself. In October, Robert McTeer, governor of the Dallas Fed, warned about the deep trade and fiscal deficits, and focused on the sources of foreign financing of the deficit. McTeer observed that, in theory, “the day will come when foreign capital flows stop financing the deficit.” At that point, the dollar will suffer a crisis that leads to a rapid devaluation of the currency, and a rapid rise in interest rates.
China is at the center of these macro-economic developments. For the past nine years, the Chinese yuan has been fixed to the dollar in a rate that fluctuates in a narrow range of between 8.276 and 8.28 yuan per dollar. From the macroeconomic point of view, the yuan is undervalued and should appreciate. That way, the United States could rebalance its huge trade deficit with China, which rose to more than $120 billion last year. This year, the deficit is growing even more rapidly, despite modest Chinese attempts to slow down their economy and reduce pressure on their largest trading partner.
Change in the Interest Rate Cycle
Monetary policy is another major factor in the value of the dollar. One of the main reasons for the depreciation of the dollar during the past two and a half years has been the differential between interest rates in the U.S. and rates in the world’s other leading economies. From the end of 2000 to June 2003, the U.S. Federal Reserve cut interest rates 13 times, from 6.5% down to 1%. Meanwhile, the European Central Bank has cut its rates only seven times, dropping them from 4.5% to 2%. Lowering the rates was the chief medicine used by Alan Greenspan, president of the Federal Reserve, to revive the economy. Nevertheless, a side-effect of this drug has been indirect intervention in currency markets. In June, the Federal Reserve began an anticipated – and feared – cycle of raising interest rates. After four such hikes, rates have risen from 1% to 2%. “If things continue to move this way, the differential in rates with Europe will be reduced. In coming months, I believe that that interest rate trends will revert to earlier conditions. Nevertheless, there is no clear cause-and-effect relationship between policies, expectations and realities,” says Rojí.
“There is no rapid solution for an American economy that is not saving enough; (but) the reduction in the public-sector deficit, combined with a weaker dollar head my list of urgent macroeconomic remedies,” writes Roach of Morgan Stanley. From the same firm, Stephen L. Jen pointed out months ago that the dollar has a special position within free markets. “Investors should have a double standard when they consider current-account and currency deficits. Because the dollar is the leading currency in the world, it plays by its own rules. Its external financial limitations are less of a headache than those involved with other world currencies,” says Jen. In any case, because of its privileged position, the dollar will continue to make a downward adjustment, in order to bring the U.S. deficit back into balance as quickly as possible. The federal government of the U.S. has maintained an official position in support of a “strong dollar,” to use the words of John Snow, the U.S. treasury secretary.
However, the government qualifies that message with a reminder that “the value of the currency must be fixed by the laws of supply and demand.” Over the past three years, this fundamental law of economics has been working against the dollar, and it threatens to continue to do so. “Everyone agrees that the new government should cut the deficit,” concludes Rojí. “Despite the fact that the Fed’s recent increase rate hikes reduce the pressure, this sort of (significant) reduction will be hard to achieve because of the Iraq war. On top of that, political factors are tied into tax policy, especially now that [the Bush administration] has won the elections by a comfortable margin.”