Without shying away from
controversy, we do away with a number of myths of
why the US dollar ought to move up or down.
Myth I: The dollar is safe because the
US has ample assets Some say the US
current-account deficit that requires foreigners
to arrange for more than $3 billion of capital
inflows every business day just to keep the dollar
from falling does not matter. These pundits say a
deficit of 6.5% of gross domestic product
(GDP) is sustainable because
the deficit is only about 1% of all private assets
held in the United States; as a result, deficits
could be carried a long, long time.
This
argument is one about the dollar going to zero, an
extreme case of the dollar losing relative to
other currencies. However, the current-account
deficit and its affect on the dollar are about
cash flow: putting it in the context of GDP is
reasonable, as GDP is a cash-flow measure of
production. Comparing it to private savings is
mixing apples with oranges.
Myth II:
The dollar is doomed because of the large US
budget deficit Just as dollar optimists
are wrong to say the dollar is safe because of the
United States' tremendous wealth, dollar
pessimists are mistaken by putting too much
emphasis on the budget deficit. By issuing debt,
the direct impact of the budget deficit can be
mitigated to the burden of interest payments. Of
course, as interest payments become excessively
large, they will weigh on the dollar eventually.
However, the linkage to the dollar is indirect.
While it is correct that large budget deficits
structurally weaken the US in the long run, it is
not appropriate to link short-term dollar
movements to the budget deficit.
Myth
III: A lower dollar will cure the trade
deficit All too often we hear how much
more competitive the US would be if it only
allowed the dollar to fall. While a weaker dollar
may be a short-term boost to earnings and make
exports a tad more competitive, it will not bring
back industries that have been outsourced. It is
most unlikely that the US will thrive on exporting
shoes to China, no matter how low the dollar will
fall.
What a weaker dollar may do is
provide temporary relief. But unless the US turns
into a society of savers and investors, a weaker
dollar will only be a pause to an even weaker
dollar as imbalances are built up yet again.
Myth IV: A lower trade deficit will
save the dollar Odds are that the
current-account deficit may be close to its peak.
However, that does not mean the dollar is out of
the woods: if an abatement in the rate at which
the current-account deficit deepens were due to a
sustained improvement in savings and investments,
it might have long-term positive implications for
the dollar.
But it looks as if the driver
behind any "improvement" (if one can talk of such
as the deficit continues to widen) will be due to
a drop in domestic consumption due to a slowing
economy. Rather than being good news for the
dollar, this discourages foreign investors to
invest in the US. American chief executive
officers focus their investments abroad, so why
should foreigners invest in the US?
As the
US economy slows and consumers can no longer
extract equity from their homes, the savings rate
ought to go up. Famous for having dipped into
negative territory, consumers have to pare back
their spending as access to easy money dries up.
Myth V: A weak economy causes a
currency to falter We agree that the US
economy is heavily dependent on growth to keep the
dollar stable. But it is a US-specific problem: in
the current environment, it may not apply to the
European Union. The key difference is that, in
recent years, the EU has focused on structural
reform rather than growth; as a result, it does
not have the severe current-account deficit the US
has. Should the world economy slow down, many
markets may suffer, but the euro might still do
comparatively well. Europe has plenty of issues,
but as far as the euro is concerned, the region is
in a very strong position.
In contrast, a
reduction of foreign-money inflows into the US is
the single biggest threat to the greenback. As a
result, the dollar has been reacting negatively to
any news signaling a slowdown of US consumer
spending. And as consumer spending is closely
linked to the fate of the housing market, negative
data on housing may reflect negatively on the
dollar. As the housing market is not very liquid,
any adjustment process is likely to be long and
grinding.
Myth VI: China is the
problem In our assessment, China is the
most responsible player in Asia. We believe other
Asian countries, including Japan, are willing to
risk a destruction of their currencies to continue
to export to American consumers. The Chinese are
taking their imbalances very seriously and are
working hard at addressing many issues facing a
nation governing 1.4 billion people. Having
invited Western investment banks to invest
billions in their local banks has provided an
encouragement for reform from within.
If
there is one thing that spooks the currency
markets more than a slowdown in US real estate, it
is the flaring-up of a protectionist-talking US
Congress. When presidential candidate Hillary
Clinton recently expressed concern about the
Chinese buying up the majority of US debt, the
dollar fell sharply. If protectionist measures
increase, foreigners will have fewer incentives to
purchase dollar-denominated assets, providing
pressure on both the dollar and interest rates.
Interestingly, nobody seems to focus on
the fact that there is an unconventional solution
to foreigners holding too much of America's debt:
live within your means and do not issue debt. Such
an old-fashioned concept would indeed strengthen
the dollar. Unfortunately, none of the
presidential candidates at either side of the
aisle seem to have heard of this notion.
Myth VII: Higher interest rates help
the dollar It seems that ever since
academics developed a theory of how interest-rate
differentials move currencies, the theory has not
worked. Yet just about every textbook continues to
teach it. Aside from the fact that expectations on
future interest rates and inflation are more
relevant than actual interest rates, there are
simply too many factors influencing currencies to
be able to focus on interest rates. Why do some
low-yielding currencies, such as the Swiss franc,
perform reasonably well, whereas many developing
countries have weak currencies despite high
interest rates?
A good year ago, the US
joined the ranks of developing nations in paying
more in interest to overseas creditors than it
receives in interest from its own investments. As
a result, higher US interest rates mean higher
payments abroad, further weakening the foundations
of the US dollar.
There are many more
myths about the dollar, but the selection above
may provide some food for thought.
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