The Hindu Business Line : The dollar dilemma — Is US current account a global responsibility?

THE US Treasury Secretary, Mr John Snow's remark that the "US current account deficit is a shared responsibility" has thrown open a debate on what and how much should the global central banks do in the current situation. Is it in the best interest of the ECB and the Asian central banks to check the dollar decline?

What is the best course of action that these banks can take to safeguard their own national interests? To answer these questions we need to first analyse the reasons behind the dollar's decline and the expected course of action of the US Fed and Government.

Twin deficits

The dollar has been weakening for much of the past year, pressured by worries over the US' record budget deficit, which stands at approximately 5.5 per cent of the $12-trillion GDP. In other words, $2 billion are needed to run the US economy every single day.

The currency markets are also concerned about the US current account deficit (CAD). If oil prices stay high, the US economy is on track to reaching a CAD of $70 billion during 2005. Imports are currently growing slightly faster than exports (in percentage terms). Yet, even if imports grew at the same pace as exports, the large gap between the size of the import base and that of the export base would make the trade balance deteriorate.

These trade deficits are large — absolutely, relative to US GDP and relative to the US' small export base. They imply an even larger deficit in the broader measure of the US' external balance, the current account. These large CADs, large fiscal deficits and the resulting increase in the US' net foreign liabilities have led to increasing concerns about the sustainability of these external imbalances.

Living beyond their means

US society is largely made up of an over-leveraged group of people who have been piling up credit-card debt and re-mortgaging their homes. The Bush administration cut taxes, launched two wars in West Asia, and is now bleeding lives and money in an Iraqi insurgency.

The US trade deficit is the counterpart to low savings. The US' consumption and other components of expenditure have been growing faster than income in the last decade. Since 2001 the current account deficit has reflected a widening government deficit, not strong private investment.

And where does this deficit get financed from? No matter what their cause, large ongoing deficits have to be financed by borrowing from abroad. Sustained deficits have made the US a major net debtor. The broadest measure of the amount the US owes the rest of the world — the net international investment position, or NIIP, is approximately $3.25 trillion. Relative to GDP, the net debt rose from 5 per cent of GDP in 1997 to 24 per cent of GDP at the end of 2003 and to an expected 28 per cent by the end of 2004.

Why do the foreign central banks still continue to hold the dollar? Central banks in China and Japan, which hold their assets in dollars, have seen their holdings decline in value substantially. The central banks have to issue domestic bonds to offset the excess money floating in the country from the dollar earnings of their exporters, and have to pay a higher interest on their bonds than the rates they receive from US Treasury securities. This means that holding these dollar assets has become a losing business.

If the central banks do not hold dollar assets, their currencies will appreciate against the dollar, which will lead to a decline in their export revenues. Exports are the major source of income for these countries and they would rather accept losses in the value of their dollar holdings than a decline in their exports.

The point of inflexion for the dollar's final plunge is expected to come when even these countries start letting go of their dollar reserves and claims. This will happen when the capital losses due to the depreciating dollar and rising domestic interest rates (meant to offset the excess dollars in the economy through export earnings) more than offset the gains in export earnings due to the low value of the domestic currencies versus the dollar (which are artificially maintained by those countries holding US treasury instruments).

Likely responses of US Government and Fed

Fiscal management: America can reduce the federal budget deficit by a roll-back of the Bush tax cuts. This will reduce the amount of interest paid to other countries to finance that deficit. Reduction in government expenditure is not a policy recommended for the long run. We would suggest an increase of government expenditure in sectors that improve the productivity of US industry, thus bringing about buoyancy in the US equity market and attracting capital inflows in the long run. Thus, a slight reduction in fiscal balance in favour of a long-term favourable impact is advisable.

Hike interest rates, but only gradually: A rise in the US Treasury interest rates will increase domestic savings as well as make US Treasuries attractive for other central banks. Thus, there will be an excess demand for dollars, arresting its fall and bringing it back up; the savings-investment gap in the economy will also be narrowed. However, raising interest rates is like playing with fire.

The government is exposing itself to the risk of insolvency and attracting a lot of hot money into the economy. If there is a shock in the economy, this hot money is the first to flee and the government runs the risk of facing a maturity mismatch between its receivables and its payables. The Fed Chief, Mr Alan Greenspan's policy of a steady rise in interest rates is, therefore, both watchful and also checks the dollar's fall. This policy is expected to be pursued.

Let the dollar devalue and reach equilibrium: If, subject to market forces, the US dollar will devalue by 15 per cent and bring the CAD to zero. Devaluation will reduce the import bill and make US exports more attractive for other countries. This will improve the current imbalances in the US economy.

What can Europe do?

The most obvious solution to the problem seems to be the economic and industrial growth of European countries. By promoting industrial growth, Europe increases its own exports; at the same time greater employment opportunities in Europe will add to the financial strength of the European middle class and this can be expected to give a push to US exports to Europe as well. But it is not so simple. An export-led European growth depends on the value of the euro remaining competitive against the dollar. In other words, there is a vicious cycle at work.

Growth in the European economy requires the maintenance of the value of the dollar, but a high dollar leads to a widening US trade deficit, thereby worsening the financial imbalances in the global economy. Hence the dilemma being faced by European Central Bank is whether to let the dollar weaken and hamper European exports or to let it strengthen and in turn isolate the biggest consumer society in the world by forcing them to cut their consumption.

Likely ECB response

The likely response of the ECB will be to hold its US Treasury Securities till the gains arising out of propping up the dollar outweigh the losses arising out of the depreciation in the $/euro.

Once this position turns loss-making, the ECB should sell off its US Treasury Bonds and look at improving its exports through other routes like subsidies and tax-relief to exporting companies hoping to attract a lot of players in the export arena, thus improving export revenue.

Also, the ECB should try to build stronger terms with low-cost Asian manufacturers to improve their trade balance.

Asian economies

China's trade surplus with the US was more than $120 billion last year and has been increasing at a record rate. The US has been demanding that this imbalance be addressed through an upward valuation of the yuan and, eventually, full currency flexibility. But Chinese authorities have been resisting this for fear of a bank crisis.

Greater flexibility in the yuan and other Asian currencies may be dangerous. Asian central banks have spent hundreds of billions of dollars purchasing US financial assets in order to keep the value of their currencies low vis-a-vis the US dollar, ensuring that their exports remain competitive in the American market.

An upward movement of these currencies will drastically reduce their export earnings, which form a major proportion of their total income and GDP. According to calculations by the New York Federal Reserve, if the yuan were to appreciate 10 per cent against the dollar, China would suffer a capital loss equivalent to almost 3 per cent of its GDP. If the won rose by 10 per cent, South Korea would experience a similar loss. For other economies the blow would be even more severe. Singapore would experience a loss equivalent to 10 per cent of GDP and Taiwan 8 per cent.

To prevent such an appreciation of their domestic currencies, Asian central banks would have to amass even greater holdings of dollars. But this would only expose them to greater capital losses down the road. Alternatively, they can diversify into other reserve currencies such as the euro and avoid the consequences of a dollar fall. But that would only bring the dollar crashing down all the more quickly. In other words, Asian central banks are caught in an awkward dilemma: either they try to break the dollar's fall, or they try to escape from underneath its collapse.

Recommended response of Asian economies

With the devaluation of the dollar inevitable, Asian economies have to look at ways to stem their losses. A possible response could be to gradually start converting their reserves from dollars to euros. This has already been started by Russia and Japan to some extent.

Also, they should look at increasing the proportion of exports to Europe as compared to the US so that a depreciation of the dollar does not affect their export revenues. A possible way the Asian governments could help in this is by giving subsidies to encourage exports to Europe.

(The authors are final-year students of IIM Bangalore.)

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