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.