The Hindu Business Line : US has to let dollar fall to narrow trade gap

One way to reduce the deficit would be to let the dollar continue to weaken. The US dollar had risen from 1995 to early 2002 by around 45 per cent on a trade-weighted basis, but since than it has fallen back about 20 per cent.

OVER the past couple months it has become clear that US economy is doing better than the pessimistic projections that were being made by some economists.

In a way, the Federal Reserve had encouraged such views by highlighting the risk of deflation and taking monetary measures to insure against such an event.

The US economy grew by 7.2 per cent in the last quarter and this takes the annual growth rate to 3.3 per cent, which is quite close to the trend rate of growth.

This seems to be good news but also brings a bigger problem for the US treasury and the Federal Reserve.

The US current account deficit continues to widen and is expected to be around $550 billion next year.

Trade Information Centre of the US Department of Commerce released data on net foreign purchases of US assets last week. This data shows that the net foreign purchase of US assets in September dropped to $4.4 billion.

The net flows had averaged around $46 billion per month this year.

There has been a sharp fall in the net inflows. This is a precarious situation; while the current account deficit is continuing to widen with the voracious appetite of US for foreign goods, economy is growing at a good pace and the source of funds to bridge this deficit is drying.

The interest rates in the US are now at a five-decade low and logically the risk of reversal would be high.

The Federal Reserve members are now making statements indicating that there would not be any hikes in the `considerable' future.

These efforts of Federal Reserve are aimed at containing the expectations of the markets and preventing steepening of the yield curve. Any change in perception could result in money moving away from the US treasuries. This would seriously dent the critical net inflows.

The US is now clearly showing its concern, as this is an unsustainable situation. It quickly announced reduction in quota for some Chinese garments.

The impact of this move is very small and intended to serve as a warning. At the prevailing rate, the current account deficit would reach around 6 per cent of the GDP next year.

One way to shrink the deficit would be if US would grow at a significant pace lower than the other G-7 countries.

Historical data indicates that in case US economy grows 1 per cent less than the rest of G-7, the current account deficit would shrink by around 0.2 per cent of GDP.

Hence this would look unlikely as most of the other countries in that list are just about coming out of recession and growing at sub-par rates.

Another way to reduce the deficit would be to let the dollar continue to weaken. The US dollar had risen from 1995 to early 2002 by around 45 per cent on a trade- weighted basis, but since than it has fallen back about 20 per cent.

This fall does not seem to be enough to begin a process of correcting the US external imbalance.

If one looks at the Federal Reserve's major currency index, dollar has only come back to its long-term average after the recent fall.

This may not be of any help as this fall does not give US a competitive advantage and would allow it to win market share in the export markets and cut its imbalance.

The relation between exchange rate and the current account deficit is not a straightforward one as it takes time for businesses to adjust for the changed exchange rate. This results in a lag in adjustment.

For the deficit to begin to shrink by 0.5 per cent of GDP, the dollar would have to fall by a further 20 per cent on a trade-weighted basis. The projections of the exchange rates in such a scenario would look extreme and one would be hesitant to forecast.

But this would imply a sharply higher euro and a much stronger yen. One fallout of this could also be a sudden increase in pressure on China to revalue its currency.

In case the situation becomes untenable one would expect the risk of trade wars increasing.

The US had imposed tariff on imported steel. As US has not dropped these duties, Europe has countered the measure by slapping duties on few American goods.

Historically, current account deficits of more than 4 per cent of GDP for three consecutive years have not proved to be sustainable and they have been followed by a correction driven by lower output and a weaker currency.

It does not appear reasonable to expect US economy to grow slower than the rest of industrial world in the coming year, so any prospect of a narrowing current account balance would require further dollar depreciation.

(The author is Senior Manager, Corporate Treasury Sales - Western India for HSBC. The views expressed herein are his own and not necessarily those of his employer.)

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