The Dollar: Their Currency... Our Problem

Brian Durrant - Mon 10 Dec, 2007

News that the dollar has recorded record lows against the euro on the foreign exchanges is taken by some as an ominous indication that the long period of US economic supremacy is at an end. In other words, we are experiencing a seismic shift in the global economic balance of power towards Europe. Is this really the case? The causes of dollar weakness are varied but the consequences are far more important to us...

News that the dollar has recorded record lows against the euro on the foreign exchanges is taken by some as an ominous indication that the long period of US economic supremacy is at an end. In other words, we are experiencing a seismic shift in the global economic balance of power towards Europe. Is this really the case? The causes of dollar weakness are varied but the consequences are far more important to us.

In the past we have talked about a marriage of convenience between the US and Asian economies. It goes something like this. Asian economies have extraordinarily high savings rates and are huge net exporters to the US. America, on the other hand, spends in excess of its income. This imbalance is funded by Asian central banks re-circulating its loot by lending to the US principally through the buying of US Treasuries. These purchases in turn prevent the dollar depreciating thereby maintaining the competitiveness of Asian exports.

This process leads to an ever wider US trade deficit. In 2006, America ran a current account deficit of more than 6% of GDP. This situation is sustainable provided creditor countries are prepared to lend to the US by purchasing dollar-based assets. Now, in a situation where America buys Asian goods and in return, Asia gives America the money back in the form of a loan, it is perhaps no surprise that it took a credit market crash to call this arrangement into question.

Indeed, the latest statistical evidence suggests that this marriage of convenience is entering a rocky period. Financial flows back into the US appear to have dried up this summer. US Treasury International Capital system (TIC) data show a marked drop in net foreign purchases of US long-term securities since the end of June. In 2005 and 2006 there was a net inflow into the US averaging about $70bn a month. This June the monthly net inflow was strong at $100bn, but this figure dropped to minus $20bn in July, minus $71bn in August and plus $26bn in September. These accounting entries represent a serious reassessment of the wisdom of piling into dollars.

The dollar's weakness reflects new market apprehensions about both the US economy and the greenback's status as a reserve currency in the Middle East and Asia. The credit crisis has undermined the dollar in three ways. First, foreign investors were substantial owners of US mortgage-backed securities. Their desire to exit the market can only serve to depress the dollar. Second, the problems in the housing market and associated credit squeeze are undermining prospects for the US economy as a whole. Third, the risks to the American economy are forcing the Federal Reserve to ease monetary policy when other central banks are reluctant to act. Accordingly, the change in interest rate differentials makes the dollar less attractive.

The US dollar has been in retreat since 2001, but it is the latest spate of weakness that is really testing people's patience. It is not just the well published demands of supermodel, Gisele Bundchen, to be paid in euros rather than dollars, others have the same idea. Three of the big oil exporters - Iran, Venezuela, and Russia - are demanding payment in euros. Korea's Central Bank has instructed its shipbuilders to demand payment in local currency rather than the dollar.

More seriously, there is now a great debate in the Gulf about whether they should maintain their traditional links to the US currency. The oil boom has increased inflation throughout a region which employs millions of expatriate workers who are remitting money home in a depreciating currency. For example, so far this year the Indian rupee is up 11% against the dollar. These exchange rate losses are fuelling labour unrest. Kuwait revalued its currency six months ago to counter internal inflation pressures, while the central bank governor of the UAE suggested last month that all the countries in the Gulf Co-operation Council should revalue. The only important Gulf central bank still defending the dollar is Saudi Arabia. The Saudis recognise that any decision to give up the dollar link would only produce further losses on their considerable dollar assets and create another source of tension in the region. This is because Saudi Arabia's large dollar holdings are partial compensation for the US providing security in the Gulf.

But if Gulf states are experiencing inflation pressures, what about China? Economic growth seems to be running at about 11.3% so far this year. Capital investment was 43% of GDP in the first quarter of 2007, and has risen 85% over the last four years. Not surprisingly inflation is picking up and running at 6.5%, the highest rate for more than a decade. The big problem is food price inflation, which constitutes a third of people's outlays. (Non-food inflation is only running at 1.1%). The supply of food has been restricted by drought, disease and reduced acreage as a result of industrialisation. And these are not one-off influences. Environmental degradation is reducing the supply of productive land. Soil erosion occurs in two thirds of agricultural land because of indiscriminate fertiliser use. Water is also scarce, with per capita resources at one quarter of the world average. Meanwhile on the demand side, rising incomes in urban areas has seen a tremendous increase in meat protein consumption per head and the production of meat is seriously land hungry. China has been a major importer of grain since 2000.

The Chinese authorities will be watching the food situation closely. There have been deaths in the scramble for discount cooking oil at Tesco of all places. It looks as if food shortages will lead to further price rises, while in turn Chinese manufacturers are starting to complain about the rising wage pressures and raw material prices. The Chinese central bank must be seriously thinking of a sizeable revaluation of the renminbi. This will reduce at a stroke the price of food imports and imported raw materials and at the same time beat off the protectionist lobbies in the US and Europe. US Congress is threatening new tariffs on Chinese imports unless Beijing revalues by 20%-30%. A revaluation would also head off an inflationary bust in the Chinese economy, while Chinese demand for raw materials would continue to be brisk. This means the outlook for major miners like BHP Billiton would remain favourable. The only downside is the same as Saudi Arabia; the Bank of China holds stacks of dollar assets.

It is clear that dollar weakness does not solely stem from sub-prime concerns and the greatest emerging risks come from Beijing and the Gulf. Moreover, the dollar's recent decline has violated a little-known tradition. Since 1970, sharp falls in the dollar have coincided with periods when the US Treasury Secretary has hailed from Texas.

There have been three distinct periods of dollar weakness: 1970-79, 1985-1995 and 2001 onwards. The first phase of dollar weakness was kicked off by Texan John Connally, who famously in 1971 told a delegation of Europeans worried about exchange rate fluctuations that the dollar was "our currency, but your problem". In 1985 the US currency plunged when James Baker, another Texan was at the helm. But in the latest phase of dollar weakness there has not been a Texan at the Treasury but one in the White House instead! But is this just a coincidence or is there some reasoning behind this relationship? Well, it is said that Texans instinctively welcome currency weakness as it bolsters commodity prices. Whatever the reason behind the dollar's decline, it is more important to look at the consequences rather than causes of dollar weakness.

The cover stories of business magazines are using the weak dollar as a symbol of American economic power in permanent decline, with households neck-high in debt and the housing market crashing all around them. The reality is more prosaic. We've been here before and the US economy is not in recession.

Between 1985 and 1995 the dollar fell by over 55% against the deutschemark, somewhat more than it has against the euro in the last six years. The period was marked by pundits talking about the unsustainability of the US trade deficit and dire proclamations of the end of US economic power. But in fact, dollar weakness provided the launch pad for America's strongest period of economic growth in the past 35 years.

And it's happening again. While Wall Street sages and opinion formers have been screaming about recession, the actual figures released last week tell a different story. For some reason it was not headline news in the Financial Times, but hidden away on page 12. US economic growth in the third quarter of this year was running at 4.9%, the strongest growth performance for four years. The pattern of growth was predictable with a 19% jump in exports contributing 1.4 percentage points to the growth figure that offset a slump in housing investment, which subtracted one percentage point from the growth figure.

This pattern is likely to be more pronounced in coming quarters as the slowdown of US consumer demand hits import growth, while American exports are boosted by the ultra-competitive dollar. This will lead to a sharp contraction in the US trade deficit.

Interestingly the reduction in the trade deficit will not be mirrored by lower surpluses in China, Japan and the OPEC countries, but through Europe plunging into a trade deficit. This is because the 'weak dollar story' should be more accurately described as a 'strong euro story'. The fact is that the dollar has scarcely devalued against the important Asian currencies, but over the last three years the pound and euro have appreciated by not only 20% against the dollar, but also the yen and renminbi. Moreover American goods tend to compete head on with European goods in third party markets.

In short the weak dollar, rather than being an indication of America's economic demise, will provide the springboard for a boom for US exports that will squeeze out their European rivals. The dollar is certainly their currency, but it is our problem.

Regards,

Brian Durrant 
for The Daily Reckoning 

Editor’s Note: A Cambridge economics graduate with nearly 25 years experience in the City, Brian Durrant is investment director of The Fleet Street Letter (founded 1938). He has worked in stock broking, the foreign exchange markets, and also headed the research department at one of London's leading futures and options brokers.

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