Given a current-account deficit in excess
of 6% of US gross domestic product (GDP), many
fear the dollar must decline. At the World
Economic Forum in Davos, Switzerland, policymakers
disagreed as to the severity of the risk, its
causes and cures.
In a nutshell, the
United States does not export enough to the rest
of the world to balance its own appetite for cheap Asian
imports. The American
consumer spends too much and saves too little. As
a result, dollars are leaving the US in return for
goods and services. Unless those dollars are
reinvested in US-denominated assets at a rate in
excess of US$2 billion a day, the dollar will
decline.
According to the Financial Times,
the top international-affairs official at the US
Treasury warned that if the United States were to
instigate policies to rein in the consumer, it
would plunge the country into a deep depression;
fallout to other countries would also be severe.
While we have explained in the past why the US has
no interest in a consumer slowdown, this is the
first time we have heard the US Treasury warn
about the risk of a depression.
To adjust
the current-account deficit without a severe
adjustment in the value of the dollar, the rest of
the world could also spend more and save less.
While China's savings rate of 30-40% of disposable
income is likely to come down at some point, we
doubt that the rest of the world can or even wants
to adopt US spending habits; Americans now have a
negative savings rate. Not only is much of the
world economy dependent on the US economy, the US
economy also dwarfs many of the emerging economies
where a pickup in consumption could be expected.
In many of our analyses we traditionally
focus on the fundamental pressures on the dollar,
including the current-account deficit described
above. While fundamentals may drive the long-term
view, short-term moves tend to be influenced by
psychological factors and perceptions on supply
and demand. From time to time, we see an argument
why the current account deficit does not matter,
but most of these "fundamental" arguments are
about as good as explanations in 1999 of why the
economy had entered a new era.
One reason
so many do not pay attention to fundamentals is
that the daily flow of information makes it
difficult to see the big picture; instead,
analysts revert to trend analysis. Why bother
about the dollar when it has "always" been
"cyclical"? The US consumer has "always" spent too
much, why worry now? Why bother about the dollar
if your expenses are also in dollars? And why
bother about it given that it is in the world's
interest that the US consumes what the world
produces?
First, and this may surprise
many "dollar bears", American consumers are,
generally speaking, far more rational than they
are given credit for. Increased debt burdens have
come with gradually lower interest rates since the
early 1980s. American consumers react to monetary
and fiscal policies, as well as cheap Asian
imports. There are side-effects that policymakers
may not have intended. For example, while in the
1950s fewer Americans owned their homes, they
truly owned them; now, banks are the true
"owners".
Most important, while we agree
that it is in the world's interest to keep the
dollar strong, it may be fatal for the government
to base its policies on that presumption. The US
dollar has enjoyed the confidence of the world as
a reserve currency for many decades because of
relatively prudent management.
One cannot
turn the world upside down and blackmail it into
producing cheap goods because it is in its
interest to build infrastructure and create
employment. While we expect policymakers in Asia
to fight tooth and nail before letting their
currencies appreciate significantly, history has
shown that the markets are ultimately more
powerful than policymakers. This does not mean we
should purchase the currencies of countries backed
by unpredictable leadership. However, it does mean
that the markets may punish the holders of US
dollars.
We believe that the currencies of
countries backed by what we call sound monetary
policy will be the beneficiary of any fallout. We
refer to countries that are less likely to
intervene in the currency markets and are less
likely to engage in competitive devaluation.
The currencies of many Asian countries
have speculative potential, but it is one thing to
try to shield yourself from a decline in the
dollar by diversifying to a basket of hard
currencies; it is another to speculate on the
unpredictable behavior of, for example, the
central bank in Japan. Japan has made it clear
over and over again that it is in its interest to
keep the yen weak to boost exports. The Japanese
market is swimming in liquidity; the Bank of Japan
is yielding to political pressure and does not mop
up this added liquidity. Instead, it has agreed to
allow the Consumer Price Index to be redefined so
that it can stand by its promise to keep rates low
while inflation is low. In the US, we argue
whether government statistics have a bias to show
too little inflation; in Japan, there is no debate
- we know the statistics cannot be trusted.
Some believe higher interest rates may
save the dollar as higher rates attract more
investments. This analysis ignores the fact that
as of the end of last year, the US pays more in
interest to overseas creditors than it receives
from overseas investment. This phenomenon is more
typically associated with Third World countries;
as interest rates rise, obligations to foreigners
increase. Foreigners mostly hold short-term
denominated debt securities, those most affected
by interest-rate increases. Since the US Treasury
suspended the sale of 30-year bonds in October
2001, government debt has become much more
interest-rate-sensitive as the duration of
outstanding debt declined. Just as US consumers
took out adjustable rate mortgages (ARMs) to
finance their spending, so in effect did the
federal government.
More important than
whether the United States has reached the peak in
interest rates is the perception that there are
not many more rate hikes, if any, in the pipeline.
At the same time, there is a perception that the
European Central Bank, for example, is going to
raise rates further. It does not really matter
that the ECB may be reluctant to raise rates and
the new US Federal Reserve chairman Ben Bernanke
may end up raising rates more than some expect. In
our assessment, in the coming months, the
perception is going to influence the dollar more
than the absolute level of interest rates.
It does not help the dollar that Bernanke
has not yet established his credibility. Bernanke
has indicated during his confirmation hearings
that any crisis can be responded to by providing
liquidity to the banking system. Adding liquidity
is helpful to avoid panics as it allows the free
market to set prices, but it may not prevent a
decline in the dollar. Transitions at the helm of
the Fed are frequently accompanied by a crisis; we
would not be surprised if a sharp decline in the
dollar was Bernanke's test.
We believe
policymakers may welcome a weaker dollar. Many
have warned that a weaker dollar would
substantially increase inflationary pressures as
it makes imports more expensive. However,
policymakers may try to force Asia to become even
more competitive and sell at even lower profit
margins.
We have also argued that a weaker
dollar is politically desirable in the absence on
a consensus on reforms in Medicare, Medicaid and
Social Security. By devaluing the purchasing power
of the dollar, nominal promises can be kept
without alienating voters.
Is the tide
shifting against the dollar? Is the decline that
lasted until late 2004 going to resume? Judging by
the the early action in 2006, it looks like it.
Precious metals have been soaring in recent weeks
- to any policymaker, this should be a warning.
We do not know what is going to happen to
the dollar for the remainder of the year. But we
see the fundamentals further deteriorating. We
also believe that dollar sentiment is turning more
negative. We see an increasing number of investors
taking steps to diversify out of the dollar "just
in case".
Similarly, while Asian economies
will try to keep their currencies weak, they want
to diversify their dollar holdings. Just as much
of Asia has been "subsidizing" sales to the US
through a weak exchange rate, Asian economies may
well be inclined to subsidize sales to Europe in
the future. I was invited to host a panel at a
conference in China last autumn: the focus of the
conference was on how to increase sales to Europe.
With its "best client", the US consumer, in
jeopardy, it is only prudent for Asia to foster
new distribution channels for its products.
Speculative money has no loyalty and is
merely looking for the next trend. More and more
speculators are pursuing the same strategies. In
the end, these "professional" investors can
influence the markets for a couple of months. We
are more concerned about corporate money from
overseas seeking better opportunities outside of
the US as consumer spending slows.
What
does all this mean for investors? If you
sympathize with these arguments, but believe a
weaker dollar does not affect you, think again.
The reason the US does not have significant "core
inflation" is because that measure focuses on
goods the United States can import from Asia. At
some point, the market is likely to force an
adjustment, and there will be few places to hide.
Maybe precious metals provide some refuge. We also
believe investors should consider adding a basket
of hard currency as an element to their portfolio.
One final note, on the media celebrations
surrounding Alan Greenspan's recent departure as
Fed chairman: during his tenure, the purchasing
power of the dollar was cut in half. That was
during "good times". Rather than hope that "bad
times" never come, prudent investors should
consider acting to seek protection against a
further decline in the dollar.
Axel
Merk is the portfolio manager of theMerk Hard Currency Fund, a
no-load mutual fund that invests in a basket of
hard currencies from countries with strong
monetary policies assembled to protect against the
depreciation of the US dollar relative to other
currencies.
(Copyright 2006 Merk Hard
Currency Fund. Used
by permission.)
