The Hindu Business Line : Weak dollar serves the world right

If American demand can be supported only by a weaker dollar, the rest of the world has no option but to play along, until the costs of that policy become intolerable. Growth has halted in Europe and in Japan. Hence, a dearer currency is acceptable if it keeps demand in the only export market in the world alive. Thus, the world has to `want' a weaker dollar now, says V. Anantha Nageswaran.

IT WAS in March 2000 that the bubble in American stocks and, by extension, global stocks, burst. Since then, the bubble spread to the housing market in the US and in a few other countries in Europe. It has been felt in Australia too. But, at least, there are signs of a return to stability in the Australian housing market. In the US, there are no signs of abatement in the rise in home prices.

US home price surge is unabated

According to the permanent bear on US economy Mr. Stephen Roach, "the just-released report on US house prices for the third quarter of 2004 was a shocker — an 18.5 per cent annualised surge from the second quarter and a 13 per cent increase from year-earlier levels, according to the tabulation of the Office of Federal Housing Enterprise Oversight (OFHEO).

That represents a stunning acceleration from the 9.8 per cent Y-o-Y (year-on-year) increase of the second quarter and pushes nationwide house price appreciation to a 25-year high."

Many, including Dr Robert Shiller, the famous author of Irrational Exuberance, have discounted the prospect of the housing market bubble bursting in a spectacular fashion nation-wide as the stock market bubble did.

In his working paper published in September 2003, he wrote: "Clearly, one can construct an argument that home price increases nationally since 1995 have been driven by fundamentals. For more than 40 states, income growth alone explains virtually all housing price increases, and falling interest rates have reduced financing cost sufficiently to keep the ratio of annual mortgage payments to income from rising even in the boom states of Massachusetts and California. In the vast majority of states housing is actually more affordable that was the case in 1995."

Prices have surged in the last 15 months since Dr Shiller and his co-author wrote that paper. Nonetheless, we are still lacking a trigger that would precipitate a severe and disorderly correction in home prices in the US. Principal and interest payment as a percentage of median family income remains stable and the housing affordability index remains stable because interest rates have declined over the last several years and remain low.

This has supported home purchases and refinancing though the rise in median family income has been slow in the last few years.

Asian interest rate subsidy to America

However, there has been no structural decline in the real personal income growth rate in America. Therefore, home prices might, at worst, become neutral in supporting consumption. The case for it to become a severe drag on consumption remains weak.

Of course, interest rates could rise. Indeed, Mr. Roach and many others reckon that foreigners have helped to keep interest rates down in the US by their aggressive purchase of US debt — both government and corporate — in the last several years. This interest rate subsidy is loosely estimated at 1-1.5 per cent.

That is, but for the generous foreign support, the US government 10-year bond note might now be yielding around 5.5 per cent instead of 4.25 per cent with adverse consequences on interest-rate sensitive components of the economy and stock market valuation.

Hence, there are strident recommendations made particularly to East Asian governments that they should stop subsidising the American consumer and American growth. That would, goes the argument, stop Americans from defaulting on their debt stealthily by weakening the dollar, as is happening now. Such default is, at present, costless. Hence, a cost has to be imposed by demanding higher interest rates from the American government.

The problem is that this subsidy from East Asia is not a subsidy for American consumers but a subsidy for their own economic growth. It is an unusual form of fiscal policy support to domestic growth. East Asia supports American consumption to underwrite regional economic growth.

If we look at the chart of OECD nominal GDP growth in the last several years, it is clear that, without US growth, the OECD region would have experienced five years of negative growth in the seven-year period between 1996 and 2002.

Experts who scoff at East Asian subsidy to the US are at a loss to offer short-term alternatives. They reckon that China and South Korea have accumulated considerable debt in the last several years; that the Korean government has merely facilitated the transfer of debt from businesses to households in the last few years and that South-East Asia, particularly Singapore and Malaysia, remains hostage to the fortunes of the global economy.

Indonesia has just had a smooth and successful political transition and, hence, it is too soon to say if the economic policy would focus on domestic growth. Thailand has been the lone exception but the long-term consequences of Thaksinomics are better judged by historians.

East Asia has no choice but to maintain subsidy

Hence, pulling the plug on American growth is equivalent to turning the lights off on East Asian economic growth too and some of the neo-democracies in the region would be loath to risk such a brave step much as it is economically desirable in the long run.

Further, there is no immediate prospect of faster domestic or regional economic growth to facilitate the weaning process. Hence, Asian governments remain unwilling to allow their currencies to appreciate and use it as an opportunity to develop domestic pillars of economic growth.

Indeed, one of the solutions suggested by some economists could have the perverse outcome of depressing economic growth. The recommendation is to let property prices, freed from government manipulation, find their own levels in this part of the world.

The logic is that the absence of a social security pillar and high property prices combine to maintain a high household savings rate, depressing domestic consumption. Therefore, if property becomes more affordable, consumers would save less and spend more on current needs.

The problem is that, in the short-term, it would depress economic growth, as falling property prices would restrain current spending. On top of that, if East Asian governments sell US Treasuries to `punish' Americans, they will be shutting their export growth options out too. East Asia would then experience a severe economic downturn and end up punishing itself. That would be too high a price to pay to conform to economic textbooks.

America would be deeper in debt

Therefore, all stars are aligned to perpetuate the current imbalance of Asians saving on behalf of Americans. If American demand can be supported only by a weaker dollar, the rest of the world has no option but to play along, until the costs of that policy become intolerable. Domestic growth has halted in Europe and in Japan. Hence, a dearer currency is acceptable if it keeps demand in the only export market in the world alive. Thus, the world has to `want' a weaker dollar now.

This logic means that other East Asian governments would continue to buy US Treasuries too, keeping US interest rates low and cause Americans to accumulate further debt. Thus, personal savings might remain depressed in the US. On top of this, if the Federal government spending and taxation plans for the next few years do not undergo any responsible revision, the net national savings rate would achieve an unprecedented 100 per cent foreign dependence!

Dollar correction has a lot more to go

What this means is that the path of the dollar remains inexorably down. Indeed, any recovery in the currency, based on short-term technical and contrarian considerations, would only exacerbate the fundamental imbalances, setting the stage for the next round of pervasive and severe weakness. If allowed to continue, this would have grave repercussions for American dominance of global economics and politics. Hence, it would not be. However, precisely, what would drive economic sense into American consumers and into Asian governments at acceptable costs to both remains unclear.

It could be European governments seeing through this collusion between East Asia and America. Their retaliation might either take the form of trade protectionism or unprecedented monetary policy co-operation or confrontation. Or, it could be private holders of US Treasuries. Of the $3.8 trillion of marketable American government debt held by the public, nearly $800 billion is held by foreign private players. That is more than a fifth.

If they decide not to hold the debt of a perpetually falling currency, it can set in motion a chain of events culminating eventually in global economic slowdown or recession. Or, it could be the price of crude oil that has now been tamed. The price drop, induced by temporary factors, has brought complacency back. Fundamental questions have not gone away. They may come back into play to drive prices higher again in 2005.

Perhaps, the nascent bubble in American stocks might end up restoring sanity all around, when it bursts in the New Year. More on that in the last edition of this column for 2004 on December 20.

(The author is founder-director of Libran Asset Management (Pte) Ltd., Singapore. The views are personal. Address feedback to van@libranfund.com)

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