In the end, it’s the only solution that macro can really offer: An unbalanced world needs a realignment in relative prices. As the most important relative price in a US-centric global economy, the dollar had to fall. And that’s exactly what has been happening over the past 21 months -- an 11% decline in the “broad” trade-weighted dollar index (in real terms) since February 2002. The risk, in my view, is that there’s a good deal more to come on the downside. It’s not just economics that drives me to that conclusion. It’s also the world’s faith or, in this case, lack of faith in its reserve currency. I fear there is a tear in the fabric of confidence that underpins the special role of the dollar -- a tear that is now getting larger under the stresses and strains of an unbalanced world.
Macro can provide us with a framework that defines the tensions bearing down on currency markets. It doesn’t guarantee the magnitude or the timing of the ultimate adjustment. But it does offer an analytical construct to understand the forces at work. The set-up for the dollar’s depreciation comes straight out of the traditional macro of the current account adjustment. Large and ever-widening current account deficits are not a stable outcome for any economy. It’s only a matter of when, and under what conditions, that a mounting overhang in the quantity of a deficit currency triggers a decline in its price. An oft-cited Federal Reserve study puts the typical current-account breaking point at about 5% of GDP (see Caroline Freund, “Current Account Adjustment in Industrial Countries,” International Finance Discussion Paper No. 692, Federal Reserve Board, December 2000). That’s, of course, precisely the threshold that the US hit in the first half of 2003.
But there’s far more to the US current-account adjustment than a correction in the dollar. As the world’s largest debtor nation, America currently needs about $2 billion of foreign capital per business day to finance ongoing economic activity. There are already warning signs that foreign investors are losing their appetite for dollar-denominated assets. In data just released, overseas portfolio inflows into dollar-based assets totaled only $4.2 billion in September 2003 -- far short of the $64 billion average inflows in the first eight months of the year and the $46 billion monthly bogey required to finance the US current account deficit at its prevailing rate. Moreover, with budget deficits on the rise and little hope of an offsetting surge in private saving, the daily foreign financing requirement could climb to $3 billion by the end of 2004. Such an increase in the offshore dollar overhang only reinforces expectations of a further currency correction. Eventually, there comes a point when foreign investors need to be compensated for taking such currency risk. That compensation invariably shows up in the form of higher real interest rates. That then completes the macro equation of the forces that drive the current-account adjustment. Not only does a cheaper dollar improve the competitiveness of US exporters, but it also triggers an interest rate response that leads to a compression in domestic demand. The resulting shift in the mix of aggregate demand -- more exports and less domestic consumption -- then leads to a narrowing of trade and current account deficits. ....Article Continued
Friday, November 21, 2003
Steven Roach - Macro
An expanded view by Steven Roach relating to what I posted yesterday. Our imbalances at critical stage?