December 18, 2006
Econoblog on "Dollars, Debt and the Trade Gap"
Thoughts on the Dropping Dollar
Here were my opening (pre-edited) thoughts:
Years from now, history students may wonder why the anxiety the U.S. current account deficit and the dollar's path once provoked. Or, they might date the beginning of a long slide in the dollar's value -- and resulting macroeconomic turmoil -- to late 2006.
I've written in other places why a slide in the dollar might be troubling. But to begin with, it might be useful to discuss why the dollar is declining now. In my view, the key reason for the recent decline is a plain-vanilla interest differential story. With the U.S. economy softening considerably in the fourth quarter, money and currency market participants -- rightly or wrongly -- see the Fed reducing the target federal-funds rate in the coming year. Combine this with an European Central Bank perceived as hawkish on inflation, and the stage is set for a widening real interest differential in favor of the euro. Over the short horizon, interest rates are a key determinant of the attractiveness of a currency, since investor returns expressed in common currency terms typically rise with rates.
About three weeks ago, in the space of a few days, the dollar lost 1.6% of its value against other major currencies. Even now, the dollar is roughly at the same value as it was after the drop. Against a broader basket of currencies, the drop was about half that, but market volatility suggests the dollar is sensitive to revisions in expectations. I think observers are nervous because they are wondering if a dollar decline will trigger a more fundamental set of moves on the part of central banks and other quasi-state entities -- in terms of holdings -- and on the part of private actors like hedge funds. The importance of hedge funds, combined with the rapid expansion of derivatives markets injects a heightened degree of uncertainty into the current situation.
In other words, while investment bank and professional forecasters are predicting a slow and steady depreciation of the dollar over the next year, a sharp move in the dollar might push the system over a tipping point so that a much more discontinuous decline occurs. If market participants are myopic, that provides yet another scenario for a big drop. On the other hand, this precarious balancing act of the dollar has proven far more durable than many observers had believed possible, and so may survive this challenge.
Here's an excerpt from Kash:
I think you're exactly right, Menzie. What is really worrying is the size -- in absolute terms -- of the adjustment needed to the U.S. current account balance. Still, it's important to remember that the consequences of a rapid dollar decline could also be severe for the rest of the world, especially in emerging markets.
This may particularly be the case for the 800-pound gorilla in the room: China. If the dollar plummets rapidly, the Chinese central bank (PBOC) would suffer massive capital losses on its more than $1 trillion in reserves. In addition, the real Chinese economy would suffer a dramatic to its massive export sector.
That's why I'm actually relatively sanguine about the possibility that foreign central banks could trigger a sudden dollar decline simply out of a desire to diversify their porfolios; I think that the PBOC and other central banks around the world, such as the Persian Gulf countries, have too much depending on a stable dollar. Instead, what worries me is the possibility that private investors around the world would decide to dump dollars, presumably because they foresee capital losses due to an incipient decline in the dollar. Perhaps myopically, international investors don't act like they expect those capital losses right now. But at some point they might.
While not exactly disagreeing strongly, I expand the area of anxiety thus:
China clearly doesn't have an interest in seeing the dollar decline quickly. So I'm certain that -- in part -- explains why the PBOC is tightly managing the yuan's appreciation against the dollar. But even if PBOC and other holders of large dollar reserves don't want the dollar to depreciate rapidly, they also don't want to be the last one out the door. That's why I view the current equilibrium as balanced on a knife's edge. Any decline in the dollar might be enough to prompt some central banks to try to diversify their holdings. The big question will be how China will respond once the dollar decline takes off.
So, while I used to worry a lot about China, now I worry a lot about China and the oil exporting countries. As Brad Setser points out, the oil exporters of the Persian Gulf maintain a much more rigid peg against the dollar than does China. The pace of reserve accumulation is certainly of a comparable magnitude, and when one adds in Russia, the oil exporters probably weigh more heavily in this dimension.
You can read the whole discussion at the Wall Street Journal's free link, and add your own thoughts on these issues either in the comments section here or at the Wall Street Journal's discussion board.
Posted by Menzie Chinn at December 18, 2006 04:00 PMdigg this | reddit
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Tracked on December 19, 2006 04:17 PM
You're right - you fellows didn't disagree very much. But it was an enlightening discussion from two of Blogland's best. Thanks!
Posted by: pgl at December 18, 2006 03:58 PM
(1) I will have to fact-check the estimable Dr. Mansori here. China has "only" $700B in dollar-denominated reserves to suffer from:
This may particularly be the case for the 800-pound gorilla in the room: China. If the dollar plummets rapidly, the Chinese central bank (PBOC) would suffer massive capital losses on its more than $1 trillion in reserves.
(2) Dr. Chinn: I have been thinking about a related point that you alluded to in your WSJ post that I excerpt below. Why should we think that the yield curve wouldn't still be inverted if the US issued less government debt?
At first I thought it made sense and argued so. Then, I thought that there would still be buyers interested in matching the terms of their liabilities (like life insurance) with securities of similar duration. So, if demand hopelessly skewed, there's nothing that will save the inverted yield curve. Any further thoughts?
It'l also reduce the necessity for issuing so much federal debt, and at the same time make us less vulnerable to the whims of the PBOC and other state actors in the international economy.
Posted by: Emmanuel at December 18, 2006 06:02 PM
Worry about the planet's 300 million American consumers. Collectively they are the real 800 pound gorilla. Private investors, hedge funds, Asian and Middle Eastern foreign reserve balances all must ultimately bow-down to US personal consumption. Consumerism in America can only be tamed by much much higher interest rates at home. That means a dollar rising not falling.
Posted by: John Booke at December 18, 2006 08:42 PM
Could someone explain why over the long term USD would drop sharply, esp. against the majors, unless the Fed is seen as losing control over inflation?
Posted by: HZ at December 18, 2006 11:08 PM
I find it interesting that a decline in the dollar pressures dollar-denominated commodity prices upward. So as we try and correct the trade imbalance, we find that the "correction" whereby the dollar depreciates sustains a high imbalance in regards to oil. And oil has become a major source of this trade imbalance.
But let's send Bernanke and Paulson over to China for a Chinese history lesson, but let's not take profits from the oil companies and tell the American consumer they will need to consume less oil as they need to consume fewer cheap Chinese imports.
I'm eager to see how this same American consumer will service a 130% household debt/DPI ratio when interest rates rise?
Posted by: Jenson at December 19, 2006 12:18 AM
If they could, I think China and the rest of asia would happily keep the status quo. But, in order to maintain their growth they need to import resources. As the cost of these resources goes up, because of the massive growth in demand, they will need to strengthen their currency in order to get the buying power leverage over their competitors.
Why would the PBOC care about the value of their US holdings? The purpose of the PBOC is to maintain growth, not to make a profit. I have never understood this thinking. Maybe its because too may people look at it from a Western perspective, rather than the Chinese Communist view.
Posted by: vorpal at December 19, 2006 07:32 AM
The discussion focuses only on the current account deficit and the consumption forces that underlie it. The deficit is offset by savings offshore to the US. The value of the dollar is a balance between the deficit and the dollar savings surplus flowing into Ts and other assets. One can't understand the value of the dollar only by looking at the current account--it's like looking only at supply and not the interplay of supply and demand.
Posted by: John at December 19, 2006 08:57 AM
A properly valued Yuan will cause China's economy to crash & badly hurt the US economy. Their export-based economy was generated by a cheap Yuan & cheap credit & will be devastated when it that disappears. The US economy will suffer high long-term interest rates & inflation.
Nobody in power has an interest in a market-priced Yuan. But it must come eventually.
Posted by: algernon at December 19, 2006 09:22 AM
As I see it the US Current Account (CA) deficit can be resolved by two different mechanisms (though a combination is not impossible). The first is what I call "radical deflation". The second is via changing exchange rates. It is my considered opinion that powerful forces in China and more relevantly the US favor the first approach. Let me try to outline each potential adjustment path and consequences that flow from them.
1. The "Fixed" approach - The dollar/RMB peg remains sacrosanct or changes so slowly as to be meaningless (as is currently the case). In this scenario the US raises its savings rate via some combination of policies including higher taxes ($5 gasoline tax, 10% VAT, massive income tax hikes) and higher interest rates. Raising the savings rate enough to eliminate the need foreign capital drastically reduces domestic spending.
The reduction in spending both reduces imports directly (fewer Mercedes and 50" plasma TVs) and releases resources for export. Calculations have shown that a 17% fall in GDP is required to eliminate the CA deficit via this mechanism. See Why America is switch to a weak dollar policy. A 17% fall in GDP is what most people would describe as a depression. I have used the phrase "radical deflation" for this outcome.
How would the Chinese benefit from this tact? A 17% fall in GDP via tax hikes and higher interest rates would cause the CPI to decline (as it did after 1929). Chinese holdings of dollar assets would increase in value. Of course, much of America could be purchased for a song during the new "Great Depression".
This is the adjustment path that the advocates of fixed exchange rates advocate. I would include Mundell, McKinnon, Mankiw, and perhaps Stiglitz in this category. It is also the modern version of how trade imbalances were resolved under the gold standard (which Mundell advocates). Under the gold standard specie flowed out of a country with a trade deficit reducing the internal money supply and inducing economic contraction. Eventually the deflation reduced imports and expanded exports to the point where the trade deficit was eliminated. Of course, the consequences for employment and economic stability were harrowing.
2. The "Floating" approach - Of course, this really means a large devaluation in the dollar. How much? Perhaps 50%, perhaps more. Take a look at Trade-Weighted Exchange Value of U.S. Dollar for how much the dollar fell after the Plaza/Louve accords. Note that this devaluation eliminated a (roughly) 3% CA deficit. The current CA deficit is more than twice as large.
Per se, devaluing the dollar can not close the CA deficit. However, related economic shifts will. If foreigners stop funding the US CA deficit, as the dollar falls (why hold a declining asset), then US 10 year treasury yields will spike. This will reduce both housing and equity values and thereby raise savings. However, assume for a moment that doesn't happen. As the dollar fall, demand for exports will rise and import prices will escalate. Both effects will tend to raise the CPI. Stated differently, total demand for US production (and labor) will exceed resource availability raising prices.
The Fed will have to counter this effect by raising US interest rates to cool domestic demand (increasing savings) so that resources can be released in export production.
What does this approach mean to the Chinese? Their holdings of dollar assets loose value two ways. First, thier dollar assets are now worth materially fewer RMB. They suffer capital losses on their dollar portfolio. Second, US prices tend to increase (Fed policy could strictly limit this) making each Chinese owned dollar asset worth less. Of course, with export demand offsetting the decline in domestic demand there isn't a US depression. No opportunity to buy America on the cheap.
What does this approach mean for the US? Perhaps higher inflation, although not much based on the experience of the late 1980s. Certainly no repeat of the 1930s. However, if the Chinese are forced to accept losses on their dollar asset portfolio they won't be happy. They might decide to cut off the investment banker gravy train. The Goldman bonus pool might take a hit.
The choice here should be obvious. The sad part is how many people regard fixed exchange rates as sacred and favor deflation as an adjustment mechanism.
It should be clear that China and the United States are not solely responsible for global/US imbalances. The OPEC states appear to currently enjoy trade/CA surpluses larger than China. Only a fraction of the US trade deficit is with China. Other Asian (and a few non-Asian) nations have large trade surpluses as well. The US dollar is overvalued against many currencies, not just the RMB.
However, in one very important respect China is central to the resolving the US CA deficit. Apparently, many Asian nations won't allow their currencies to rise against the dollar until the RMB revalues. That makes breaking the dollar/RMB peg crucial.
Posted by: Peter Schaeffer at December 19, 2006 09:39 AM
Sorry about the double spacing.
Posted by: Peter Schaeffer at December 19, 2006 09:42 AM
The fact that all central banks holding large dollar reserves would suffer a capital loss in case of a dollar decline does not mean that no single central bank could hope to benefit from selling the dollar. Selling the dollar first could be very good for reserve value. The PBOC and the BoJ are big enough to hurt themselves, as well as every other holder of dollars. Other, smaller central banks are at risk if either of the big ones sell, but can probably help themselves at the risk of hurting others. That is a tricky situation for the dollar.
Posted by: kharris at December 19, 2006 10:19 AM
kharris makes a good point. It may be smaller central banks that trigger the eventual exit from the US $.
Posted by: algernon at December 19, 2006 11:36 AM
"First, get the budget deficit under control. That includes increasing tax receipts, cutting government spending, reining in entitlements -- these are all going to be necessary first steps to redressing the profligacy of the last six years" [from Menzie on Econoblog]
I guess we can dream, but this won't happen even under the democrats. Something bad and probably abrupt is in our future. It's silly to even suggest that we will take the rational and necessary steps to avoid what's coming.
Posted by: FredW at December 19, 2006 12:11 PM
As a central banker myself let me draw your attention to the following dilemma: central bankers face when they see sharply growing reserves high volatility of banks' balance sheets. On the one hand their decisions cannot affect markets, as especially in the case of large banks it would imply possible valuation losses. On the other hand, with reserves reaching or topping 50 percent of GDP in some cases, by adding 1 percent to average annual return central bank can speed up GDP growth by 0.5% of GDP (assuming extra revenues end up in governemnt coffers and are wisely invested increasing country potential output). This opportunity cost of forgone GDP growth is increasing sharply with rising reserves. It is hard to enhance return and reduce the above opportunity cost by investing in core markets in government paper. My guess is that different countries will solve this dilemma at different speed in the coming years, but economists should not forget that the era of investing reserves with a goal to preserve capital is a distant past. I cover this and related topis on my blog www.rybinski.eu
Posted by: Rybinski at December 19, 2006 01:28 PM
pgl: Thanks for the compliments and the encouragement!
Emmanuel: On item (1), China has roughly USD 1 trillion of reserves. How much is in dollars and how much in other currencies is a mystery. Brad Setser, who follows these matters closely, guesses roughly 70% in USD, so yes, USD 700 billion in exposure. But we don't know if the composition of the other component -- they may be in currencies highly correlated with dollar movements.
Regarding item (2), it's not clear where foreign purchases of Treasuries have their impact -- along the entire spectrum or just at the 10 year horizon. But I'm not certain whether this matters in terms of whether the yield curve is signalling a recession or not. If the yield curve is inverted because of foreign purchases, then removal of foreign purchases doesn't necessarily reduce the probability of a recession. Hence, whether to worry about the yield curve matters on the source of the inversion -- either recession, or diminishment of the inflation-risk premium, or depressing of the long term rate due to "new" sources like the PBoC.
John Booke: Consumption reduced by (exogenously induced) higher interest rates makes sense. But where the dollar ends up depends on the source and nature of the exogenous shock. A higher exchange risk premium associated with dollar denominated assets would mean both higher real interest rates and a weaker dollar. Of course, this requires a belief in a portfolio balance model (this pertains to HZ's query).
vorpal: Despite the fact that China is a transition economy, I think (especially if the Party views the PBoC and the Government's balance sheet as integrated) that nobody views hundreds of billions of yuan's worth of reserves disappearing with equanimity.
algernon: I don't think many informed observers are advocating a market-valued yuan in the near future. Rather, some adjustment for both domestic reasons (cooling off the economy) and international rebalancing reasons argue for some adjustment.
Peter Shaeffer: Thanks for the extensive remarks. I agree on several points; see my Council on Foreign Relations report on this subject from September 2005.
kharris and algernon: I agree, the trigger could be some smaller central bank diversifying their reserves, or just stopping accumulation of dollars.
FredW: I agree that it will be difficult to undertake fiscal consolidation, but when one talks about policy, one has to at least agree on the desired course of action. For the last 6 years, the Administration and Congress pushed a policy framework at variance with the one I proposed. At least there is growing realization that the course we have been pursuing is the path to ruin. I do hold hope exactly because during the 1990's, spending was restrained, and the budget balance did improve, partly because of PAYGO rules. Whether that can be repeated, when the fiscal challenges of entitlements (including the newly burdening Medicare Part D) are so much greater, remains to be seen.
Posted by: menzie chinn at December 19, 2006 01:29 PM
Thank you for your response. I still don't see what China loses. What, exactly, was the PBoC going to do with those US Treasuries? How is the Chinese governnt relying on that money? What tangible thing to they lose? All of those holdings do not come from debts, but rather from savings. It already has been earned by the lower standard of living that the Chinese worker has had to endure in order to cut into the American market. Are the Chinese people each expecting a $1000 check from their gov't?
I would think that the PBoC would have its hands full just maintaining growth and suppressing inflation. If they don't do these things, they have a revolution on their hands.
Posted by: vorpal at December 19, 2006 06:13 PM
Okay, we Americans need to save more. My question is, if this is so, why aren't interest rates higher? I'm not putting my money into a CD making 4% interest. I'd rather buy a 42" Plasma at $1000 from some unknown Chinese company. That, quite frankly, is a better use of my money.
And even now, I can get a home equity loan for an obscenely low interest rate. Again, why wouldn't I spend the money? Interest rates simply don't allow me to make a return that is attractive.
The only rational reason that Americans don't save is that interest rates are so low. I don't think that it is a coincidence that American savings rates peaked in the '70s, when interest rates were high, and plunged along with interest rates since then.
In regards to oil, if oil imports is driving the trade deficit, the only option might be a huge tarrif.
Posted by: Buzzcut at December 21, 2006 08:48 AM