> > A section headline in Goldman Sachs' weekly economic letter:
>>
>> >The Dollar: Next Step in Deflating the US Bubble?
>>
>Did you get to read how they answered the question?
The Dollar: Next Step in Deflating the US Bubble?
The investment boom pushed up the dollar by incre asing the demand among foreign investors for dollar-denominated assets. Now that the investment boom has ended, return expectations for such assets are declining. As a consequence, the ex ante demand by foreigners for dollar-denominated assets should fall, generating persistent dollar weakness.
The growing supply of dollars that needs to be recycled back to the United States is likely to exacerbate the problem. If investors do not want to increase their holdings of US assets in tandem with the rising US current account imbalance, the prices of the dollar and dollar-denominated financial assets will have to adjust to more attractive levels to coax forth this investment.
Rising Supply and Falling Demand
The underlying problem is the potential disparity between the amount of funds that need to be recycled back into dollar-denominated assets and the willingness of foreign investors to do so at current exchange rates and financial asset prices. The amount of funds that needs to be recycled represented by the US current account deficitis likely to continue to increase over the near term for two reasons:
*The dollar has sharply appreciated over the past seven years and this has eroded US trade competitiveness.
* The inventory liquidation cycle was deepest in the United States. Thus, the US demand for imports is likely to rise more sharply than elsewhere.
From its trough in the summer of 1995 to its peak in February 2002, the Federal Reserve's broad, real trade-weighted dollar index appreciated by about 34.3%. Since that time the dollar has weakened only modestly, with that index falling only about 2% (see Exhibit 1).
Currently, the Goldman Sachs Foreign Exchange Research Group estimates that the dollar is overvalued by about 14% on a trade-weighted basis. The consequence has been a sharp decline in US export competitiveness. The OECD's measure of export performancewhich calculates export market share gains and lossesshows that the US lost more ground in 2001 than at any time since at least 1984, and the OECD anticipates even poorer export performance in 2002 (see Exhibit 2).
The arithmetic for US trade improvement is also daunting because of the big gap between the level of US imports and exports. US export growth has to be nearly 40% faster than import growth just to stabilize the US trade deficit. Thus, the current account deficit is likely to increase substantially over the next 18 months. As shown in Exhibit 3, we expect the deficit to climb to more than $500 billion by late next year, reaching nearly 5% of US GDP, both all-time records.
At the same time, the willingness of foreign investors to increase their holdings of US dollar assets appears likely to diminish for three reasons:
1. Foreign investors have already increased their holdings of US dollar-denominated assets significantly in recent years. At the end of the first quarter of 2002, foreign investors held 19.2% of Treasury securities and 21.9% of US corporate bonds outstanding, up from 9.9% and 13.0%, respectively, in 1995.
2. Interest rate differentials no longer favor dollar-denominated assets. As shown in Exhibit 4, inflation-indexed bond yield spreads and shortterm interest rate differentials have moved sharply since the investment boom ended.
3. Earnings expectations for US firms are falling. Disclosures about accounting practices are causing investors to reduce their assessment of the current level and the future growth rate of earnings.
Why the Decline Could Be Severe
A dollar decline could be severe for three reasons:
* A falling dollar will initially reduce the attractiveness of dollar-denominated assets.
* Initially, dollar weakness will cause the nominal trade deficit to increase, raising the amount of dollars that need to be recycled back to the United States.
* There are no good policy tools available to prevent or mitigate a dollar slide.
The initial impulse created by a falling dollar is higher inflation and slower growth. This can reduce the demand for dollar-denominated assets. A falling dollar is mildly inflationary because it tends to push up import prices. Historically, a 10% depreciation of the dollar has generated about a 4% increase in import prices. It also can lead to firmer domestic prices by moderating the foreign competitive pressure on domestic producers. A Federal Reserve study estimates that a 10% depreciation of the dollar would push up US consumer prices by 0.4% in the first year. A second consequence of a falling dollar is that it could hurt economic activity through two channels:
* Dollar-denominated asset prices would decline as foreign investors reduced their ex ante demand.
* A falling dollar would initially lead to a wider nominal trade deficit.
The second point that a falling dollar would initially hurt economic growth may seem counterintuitive given that a lower dollar would boost export competitiveness. As the dollar is falling, it initially leads to a wider nominal trade deficit because the price of imports tends to rise faster than the volume of imports shrinks (the so-called J-curve effect). The trade-competitiveness effects of dollar weakness eventually dominate, but much later.
Changes in the nominal trade deficit are what matter in terms of the growth impact. When the dollar is falling rapidly, the terms of trade move adversely for the United States, dampening the purchasing power of US households and business. That is because a wider trade deficit is a drain on US household and business income. Less of the income spent on foreign goods and services is recycled back to the United States. Conceptually, the higher import prices act like a tax on US households and business. The 1985-1988 experience illustrates how a falling dollar can worsen the economic environment and, thus, become self-reinforcing. The dollar peaked in March 1985 and then declined persistently until early 1988. By the Federal Reserve's real, broad tradeweighted measure, the cumulative decline was 29.7%.
But it took a long time for the dollar's fall to generate an improvement in the nominal trade balance. The real trade balance bottomed in the third quarter of 1986. However, the nominal trade balance did not begin to improve until the second quarter of 1987, three quarters later. And sharp improvement did not occur until the first half of 1988, three years after the peak in the dollar's value (see Exhibit 5).
The persistent decline in the dollar also destabilized US financial markets. The Treasury yield curve steepened sharply during the fall of 1987. Rising bond yields were the trigger mechanism that helped to generate the 1987 stock market crash.
The lack of good policy tools available to Federal Reserve and Treasury policymakers to prevent a sharp dollar drop increases the risks of that outcome. The dollar would have to decline significantly to provoke a tightening of monetary policy for two reasons. First, the US inflation outlook is not very sensitive to the foreign exchange rate value of the dollar. Second, its unclear whether a tighter monetary policy would work in forestalling a dollar decline. In recent years, shifts in interest-rate differentials have had a diminished impact on currency valuation. Instead, shifts in relative growth prospects have tended to dominate. In fact, Fed tightening designed to arrest a dollar slide could turn out to be counter-productive if it caused investors to become more pessimistic about the US growth outlook.
From the perspective of the Bush administration, it also would be difficult to forestall a dollar decline. Intervention without fundamental policy change is usually ineffective. Moreover, intervention would represent a sharp shift in policy that could unnerve investors. So far, the Bush administration has argued that it is up to the markets to determine the dollar's value.
Speed of Decline Is Critical
The 1985-88 episode underscores the importance of the speed of a dollar decline. If the dollar declines gradually, then the unfavorable impact on the inflation and growth outlook will be modest. The J-curve effects will be small and soon overwhelmed by the impact on US trade competitiveness.
In contrast, if the decline is sharp, the damage is likely to be much greater because the consequences to financial asset prices will be bigger and because the nominal trade deficit will widen more sharply. The problem is that it takes time for a weaker dollar to generate a smaller nominal trade deficit. For a considerable period of time, foreign investors will be forced to invest more funds into dollar-denominated assets even as their ex ante demand for dollardenominated assets is falling.
Timing Is Uncertain
The timing of a sharp dollar decline is highly uncertain, as it depends critically on sentiment and developments in the US economy and elsewhere. As our FX Research Group has pointed out, sentiment is already dollar-bearish. And they note that the first-quarter flow of funds data indicate no strain in the recycling of the US current account deficit back into US financial assets. Thus, it does not appear that a sharp dollar collapse is imminent. But make no mistake, a significant dollar decline appears inevitable at some point. The imbalances are too large and are growing too fast to be unwound smoothly.
Bill Dudley