Sunday, February 17, 2008

Declining dollar story

Two recent events have made headlines and highlight the serious struggles the greenback is facing. First, Bloomberg news recently reported that Brazilian supermodel Giselle Bundchen, the world's highest paid fashion model, specifically demanded that her fees for promoting P&G's Pantene products be paid in euros and not dollars.

Second, Bill Gross, the CIO of Pacific Investments and Management Company (PIMCO), and manager of the world's largest bond fund, advised his clients, "We've told all of our clients that if you only had one idea, one investment, it would be to buy an investment in a non- dollar currency".

Another manifestation of the struggle facing the dollar is the weekend rush at the US-Canada border, with Canadians flooding into the US for their shopping. With the US dollar having fallen 67% against the Canadian dollar over the last five years, Canadians now find it cheaper to make even their regular purchases across the border. This trend is catching on among the wealthier Europeans too, who are crossing the Atlantic in ever larger numbers for their shopping excursions. The dollar has depreceiated by over 35% against the Euro since 2001.

Consider the forces at work that have driven down the dollar to historic lows. A stock market and then real estate bubble triggered a "wealth and income effect" that in turn inflated a consumption boom, which drove down household savings into negative territory over the span of less than a decade. This period coincided with the Chinese export-led growth boom, which deluged the US market with cheap imports and further indulged the US consumers. This fortunate coincidence of factors, coupled with robust economic growth kept both inflation and unemployment low. In the aftermath of the tech stocks bubble and the 2001 recession, interest rates were pared down to historic lows, as Alan Greenspan sought to reassure the financial markets.

The abundance of easy money also triggered off a massive financial boom. Banks gave a go by to old fashioned standards of credit-worthiness and started lending "teaser loans" and using off-balance sheet entities to finance highly risky ventures. A revolution in financial innovation and re-engineering got unveiled, bypassing the regulators. A whole series of exotic financial instruments with an alphabet soup of names, administered by smart mathematics and finance whizkids, using complex computer models, flooded the market. Investors, small and big, were swept away by the "irrational exuberance" and deluded into believing that "risk" was a thing of the past and an "age of the perpetual bull" was on us!

Then bad news came from the trading desks at Bear Stearns and Northern Rock, the bubble started signs of deflating. Then came more bad news of defaults and home repossessions and loan foreclosures, and then more and more...! As Ken Rogoff says, "surging capital flows into the US artificially held down interest rates and inflated asset prices, leading to laxity in banking and regulatory standards and, ultimately, to a meltdown."

In the meantime, the consumption boom and resultant surge in imports, meant that the US current account went spectacularly into the red, and burgeoned to 6.1% of GDP or $857 bn for 2006-07. Fortunately the Asian Central Banks, faced with appreciating currencies and the need to maintain their export edge, started intervening in the foreign exchange markets and amassed billions of dollars in reserves. In the absence of adequate depth and breadth in their local financial markets and chastened by the experience of the 1997 currency crisis, these Central Banks saw the US dollar and T Bonds a safe investment. Since they saw safety and liquidity as the predominant concern, they were willing to overlook the small returns these instruments were offering.

With the party now turning sour, what are its consequences on the US dollar? What has changed to make the dollar unattractive? For a start, the US deficit has become clearly unsustainable, with borrowings touching almost $2 billion a day! The sub-prime mortgage crisis provided another trigger. The wealth effect is disappearing or has already disappeared! Consumption and investment is falling, and unemployment is rising. The devil of inflation is threatening to rear its head, and a recession is looming or has already arrived. The generous Asians, faced with inflationary pressures in their own economies, and fearful of putting all their forex reserve eggs in the dollar basket, are no longer showing the same interest in gobbling up the US T Bonds. The foreign investors too have become wary of any more investments in both the US equity markets and the businesses. And now comes the final nail in the dollar's coffin from private investors like Giselle Bundchen! The conditions for a downward pressure on the dollar is unmistakable.

Low interest rates makes US debt instruments less attractive. US T Bonds are now one of the lowest yielding among the developed economies. A declining dollar makes this handicap even more obvious. It also discourages foreign investors. On the positive side, the cheap dollar has been undoubted filip to US exports, and has started making a dent on the trade deficit. But at what cost? Eco 101 teaches us that a decline like what the dollar has been experiencing should be the harbinger for run-away inflation and ultimately rising interest rates.

But as Larence Summers recently pointed out, the falling dollar should not have come as a surprise. He writes, "History suggests that periods when a country’s economy turns down, short-term interest rates are declining and financial strains are increasing are likely to be periods when a nation’s currency depreciates. Moreover the US current account has for years now been financing consumption rather than investment, with the financing coming increasingly from debt rather than equity and shorter rather than longer-term debt. There is nothing very new about a decline in currency of a country running a large current account deficit and whose economy is softening."

Martin Feldstein is among those who feel that a falling dollar is good news. He feels that a cheaper dollar and the resultant increase in US export competitiveness, will be critical in narrowing the US current account deficit and rectifying the external account imbalances. He writes, "A more competitive dollar will raise net exports, reducing the probability that the current weakness will turn into an outright recession. Looking further ahead, as the US household saving rate rises from its current low of nearly zero to a more normal level, consumer spending will slow, driving down aggregate demand. A declining dollar will then help to maintain growth and employment by raising exports and causing American consumers to shift their spending from imports to domestically produced goods and services."

In any case, it is not going to be long before the non-modelling world too decides to say - pay up in Euros, no dollars please.


Piyush Goyal said...

A beautifully written blog Gulzar but I have to caution the use of causality in the article. Too often Economic dialogue perpetrates the myth of causality, although in the case of the $, every variable was showing signs of strain and hence we can be forgiven for using causal relationships.
On the last note, you and others have suggested that Export growth will make a dent in the deficit, but I beg to differ. You mentioned yourself that the deficit was being used to finance consumption rather than investment and there in lies the problem - export growth will take investment and time to work out. The US situation seems to be tied very closely to that of the Chinese - there will be a year or two of "Importing Inflation" as the Chinese end up having to revalue the yuan and the US can do nothing other than continue to import.
This is the conundrum that the US faces, the current account deficit is not falling as fast as the $, which leaves very little room for manuevarability by the Fed and the Treasury.
A weak dollar is here to stay although some signs from the Euro area central banks show that a bottom could be reached soon given growth pressures affecting the EU & UK regions.
You can reach me at to discuss further or teach me if I am wrong :)

gulzar said...

Thanks for raising the issue piyush. there have been a few encouraging signs recently - exports have been rising, and both the trade and current account deficits have fallen in 2007. But, as you say, whether they are enough to keep pace with the precipitous decline in dollar is the issue. Evidence seems to suggest that it may not be enough. And yes, there is no substitute for raising savings and increasing investments. No amount of fiscal stimulus or monetary easing can obfuscate or wish away that reality.

You raised an interesting point, which opens up many possibilities, about the need to revalue the yuan, which is becoming inevitable given the inflation pressures building up in China itself. The resultant appreciation of yuan can be expected to contain the trade deficit with US, besides keeping a lid on domestic inflation in China.

But, it is also not a given, since Chinese exports to the US, especially of the electronic and other technology related goods have a significant import content. A dearer yuan, while making exports less competitive, also makes imports cheaper. It is quite possible that the two effects cancel each other out!

Further, as you write, dearer Chinese exports to the US, will do nothing to quell the dragon of inflationary expectations, already rearing its head. US will end up importing inflation from China! As you can see, a whole spectrum of often contrasting possibilities open up!

About causality, I am more inclined to believe that economic (especially financial market) analysis is most often caught between trying to distinguish between causation and corelation, and the final judgement can be given only in hindsight!