THE RECENT CRISIS IN THE U.S. SUBPRIME MORTGAGE MARKET provides a timely reminder, if any is needed, of the risk of financial instability. Ever since the world abandoned the Bretton Woods system of fixed-exchange rates in 1973, the dollar has been a frequent source of such instability. A weak dollar contributed to stagflation in the 1970s and to the stock market crash of October 1987; a strong dollar fueled the rise of massive U.S. current-account deficits in the 1980s and again in this decade. The world needs a reserve currency to grease the wheels of global commerce, but the U.S. has often proved unable or unwilling to maintain a stable value for that currency.
Today the dollar stands at a pivotal crossroads. The greenback has fallen by 31 percent since its peak in 2002 and is hovering near all-time lows, according to the Federal Reserve Board's major currencies index, but the U.S. continues to run an unprecedented current-account deficit of nearly $800 billion a year, or 6 percent of gross domestic product. Experts at the International Monetary Fund recently estimated that the dollar would have to fall by an additional 10 to 30 percent to reduce the trade imbalance to a sustainable level. The risk of a dollar collapse could constrain the Fed's ability to minimize the economic fallout from the subprime crisis. Meanwhile, tensions have been growing between Washington and Beijing. China has allowed the yuan to appreciate only modestly in the past two years, raising the threat of protectionist trade measures. The bilateral standoff resembles a financial version of the Cold War doctrine of mutually assured destruction, with both sides having plenty to lose from a precipitous drop in the dollar.
How will these factors play out, and what can investors do to protect themselves from currency volatility -- or profit from it? We asked four leading experts to share their views on the dollar's outlook and the challenge that the currency poses for policymakers and investors.
HEAD OF GLOBAL ECONOMIC RESEARCH
GOLDMAN, SACHS & CO.
A Weak Dollar Is Good for the World
Before the recent turmoil in the credit markets, the dollar's gentle decline that began in 2002 had shown signs of accelerating and broadening. At the start of last month, the currency had fallen by just over 20 percent from its peak early in the decade as measured by the Federal Reserve's broad trade-weighted index, probably the most useful gauge in terms of its impact on the U.S. economy. Against some currencies, of course -- notably most of the major European ones -- the decline has been even bigger. And quite significantly, the dollar has also fallen against a number of important emerging-markets currencies, notably those of the so-called BRIC economies, Brazil, Russia, India and China.
Although a continued decline might have some negative consequences, by and large a weaker dollar is a positive development for the world economy, especially in the current circumstances of soft American domestic demand and below-trend GDP growth, as well as a global economy that is growing more strongly than that of the U.S. The reasons are quite straightforward.
Most international economists have long argued that the U.S. cannot sustain a current-account deficit in the 6-to-7-percent-of-GDP range indefinitely. Without corrective action, at some stage there would be the risk of a dramatic loss of confidence in the U.S. economy and possibly an end to the dollar's role as the dominant reserve currency. Luckily, there is growing evidence that the external position of the U.S. is improving, something that many international observers have not fully appreciated. It is possible that the weaker dollar is helping.
For a number of months, the U.S. has experienced stronger export growth than import growth, the first time in nearly two decades that this has occurred for a sustained period without there being a recession in the U.S. Indeed, trade data for June showed nominal export growth of about 11 percent year-on-year, compared with import growth of just 3.8 percent. The last time such a gap occurred was during a brief period at the end of the 1980s, following the major dollar decline between 1985 and 1988. On current trends it would seem possible that as we move into 2008, the U.S. current-account deficit could be heading back to less than 5 percent of GDP.
Although welcome, such an improvement isn't sufficient. The U.S. needs to reduce its current-account deficit to about 3 percent of GDP, a level that net capital imports from the private sector can be reasonably expected to cover on a sustained basis. Deficits bigger than that, especially when investment opportunities are rising in the emerging economies of the world, such as in the BRIC countries (and some developed economies, such as Germany's), are unlikely to be covered by private investors and would leave the U.S. in a vulnerable position.
Of course, in some circumstances private capital inflows to the U.S. might seize up completely. If the current financial market concerns about subprime credit issues persist and the contagion in credit markets continues, it is possible that foreign investors would curtail their purchases of U.S. agency and corporate credits, which they have been buying at an accelerating pace in recent years. Nevertheless -- and here the value of the dollar might be an important factor -- other U.S. assets, such as equities, might at some stage appear to be cheap, both in terms of fresh foreign direct investment and in the secondary market. Indeed, thanks to the improving U.S. trade balance and the growth of exports, many companies in the Standard & Poor's 500 will derive more earnings benefits from a weaker dollar.
Many observers have voiced concern about the emergence of sovereign wealth funds and the additional risk they might pose to the dollar if they accelerate currency diversification. One should keep this factor in a sensible perspective. Many of these funds have been established for a long time, and even among those that are regarded as new, investing in currencies other than the dollar is not a novel concept. At the margin it is likely that increased diversification out of the dollar will occur, especially as many of these reserve-rich countries allow their own currencies to appreciate more. But as sovereign funds will increasingly be driven by the same profit motive as private investors, it will not always be a one-direction game.
What about the trend of the dollar? Will it go down forever? That's highly unlikely. Nothing moves in only a single direction -- even the dollar, notwithstanding all its challenges. It is difficult to see what immediate spark might cause a major dollar recovery, but with external accounts improving and the dollar now cheap on so many credible valuation metrics (Goldman Sachs' equilibrium exchange-rate model estimates the euro's fair value at $1.20), the bearish case is not as strong as it has been.
The dollar is likely to remain weak, however, particularly against Asian currencies, led by the yuan. The case for China to allow faster appreciation is growing by the day. Domestic interests increasingly coincide with foreign pressure, especially with Chinese food price inflation accelerating. As India showed recently, a quick currency rise is a handy method of dealing with such pressures. In a year or two, the yuan will probably be 15 percent or so stronger against the dollar, and the yen is likely to be about 105 to the dollar. By contrast, the overworked and extremely strong European currencies should get a reprieve, with the euro likely to trade around or slightly lower than today's level.
What is reasonably clear is that among the challenges facing the world economy, the risk of a dollar collapse (even if it weakens further) should not be at the forefront.
*C. FRED BERGSTEN
Time for a New Plaza Accord
From 1995 to early 2002, the dollar rose by a trade-weighted average of nearly 40 percent. Largely as a result, the U.S. current-account deficit grew by an average of about $75 billion a year for nearly a decade, and exceeded $800 billion -- or 6 percent of GDP -- in 2006. This development poses two major risks for the world economy.
The first is the risk of international financial and economic instability. To finance both its current-account deficit and its large foreign investments, the U.S. must attract about $7 billion of foreign capital every working day. Any significant shortfall from that level of foreign demand for dollars would drive the exchange rate down and U.S. inflation and interest rates up. Any drying up of dollar demand, and especially any net selling of the $16 trillion of existing dollar assets held around the world, would trigger even larger changes in these critical prices and thus in the equity and housing markets as well. The result would be stagflation at best and a nasty recession at worst. Other countries would also be severely affected as their currencies rise and their trade surpluses -- on which their growth depends -- decline.
The second risk posed by the U.S. current-account deficit is the possibility of trade restrictions in the U.S., which would disrupt the global trading system. Dollar overvaluation and the resulting external deficits are historically the most accurate leading indicators of U.S. protectionism because they drastically alter the domestic politics of trade, adding to the pressures for new barriers and weakening the supporters of free trade. The spate of administrative actions against China over the past several years and the numerous anti-China bills now under consideration by the Congress demonstrate the point graphically because China is by far the country with the largest surplus and its currency is so dramatically undervalued.
The U.S. current-account deficit does not have to be eliminated. It needs to be cut roughly in half, however, to stabilize the ratio of U.S. foreign debt to GDP. That ratio is now on an explosive path that could exceed 50 percent within the next few years and an unprecedented 80 percent or so in a decade. Avoiding such outcomes requires a reduction in the deficit of about $400 billion annually from current levels.
My colleagues and I at the Peterson Institute for International Economics in Washington have been pointing to these dangers, and calling for corrective action, since the end of the 1990s. The adjustment process began in early 2002. The dollar has declined in a gradual and orderly manner by 20 percent since then as the needed capital inflows have been obtained through additional price inducements from a cheaper exchange rate and higher interest rates. The budget deficit has also fallen over the past three years, limiting the savings shortfall that forces the U.S. to borrow so heavily abroad. U.S. growth has slowed while expansions have picked up in Europe and Japan and accelerated further in China and in most oil producing nations.
The adjustment to date, however, has been inadequate and unbalanced. It may have halted the deterioration of the U.S. deficit -- no mean feat given that imports now exceed exports by more than 50 percent -- but it has not yet convincingly reversed the trend. The surpluses of the largest creditor countries, Japan and, especially, China, continue to soar to record levels.
An important reason for the inadequate size of the adjustment is its skewed geographical composition. The freely floating currencies of Europe (euro, sterling and Swiss franc), Canada, Australia, South Korea and a couple of other Asian countries have risen by 30 to 50 percent against the dollar. By contrast, the heavily managed currencies in much of emerging Asia have appreciated by modest amounts if at all, while the yen has weakened because of Japan's extremely low interest rates. The currencies of most of the large oil exporters have also appreciated little. As a result, the improvement of the U.S. imbalance with Europe has been offset by continued deterioration against the energy producers and against Asian countries, much of which shows up as a deficit with China because of the country's role as the final assembly point for Asia-wide production networks. Unless the laws of economics are repealed, further adjustment of these global imbalances is inevitable. The key question is whether it will occur through market forces, including the "political market" for trade protection, or at least in part through preemptive policy actions by the major countries. The prospects for global growth, international financial stability and the world trading system depend on which path is followed.
Either path will have to include a further decline of 15 to 20 percent in the trade-weighted average of the dollar. There are two main risks in relying solely on the market for this outcome. One is the possibility of a hard landing if the dollar falls abruptly, rather than in an orderly manner, especially as it can easily overshoot its needed correction -- perhaps by a substantial amount. This risk is considerably greater than it was five years ago: The U.S. external financing requirement is much larger, U.S. net foreign debt is heading into uncharted territory, U.S. full employment means that a dollar plunge would lead to much more inflation and much higher interest rates, and the maturation of the euro offers a real alternative to the dollar. There are any number of potential triggers for a precipitous decline in the dollar, including a sharp fall in U.S. interest rates in response to the recent liquidity difficulties, a U.S. recession while the rest of the world keeps growing, diversification out of the dollar by one or more large sovereign wealth funds (or rumors thereof), a drop in the rapid U.S. productivity growth of the past decade, protectionist legislation and the 2008 elections.
The other risk of relying solely on the market is that the floating currencies (once more excluding the yen?), which have already largely adjusted, will once again bear the brunt of the dollar's decline because other countries that aggressively manage their exchange rates continue to block their essential contribution to the adjustment. This group includes China, Malaysia, Norway, Russia, Singapore, Taiwan and several Gulf exporters.
The next big currency move, which could exacerbate rather than correct the global imbalances, may be a dramatic rise in the euro. European growth has accelerated relative to U.S. growth, and Euroland interest rates are rising whereas U.S. rates have peaked and may fall. The euro is moving up alongside the dollar as a global currency, and portfolios around the world -- both private and official -- are likely to adjust considerably. Diversification from dollars into euros by emerging economies that have accumulated large reserves is likely to intensify this effect. The euro (and the Canadian dollar, as well as a few other floating currencies) could become hugely overvalued, especially against the Asian curriencies, a development that would weaken the European economy and create protectionist spillovers that add to the threat to the global trading system.
An alternative strategy for completing the global adjustment through constructive policy actions was recently developed at a conference of 30 top international economists hosted by the Peterson Institute, the Korea Institute for International Economic Policy and the Brussels-based think tank Bruegel. The plan has four key components:
* attainment of a modest budget surplus in the U.S. to make room for needed improvement in the external balance without generating higher inflation and interest rates;
* aggressive expansion of domestic demand in East Asia, especially in China and Japan, to offset the essential large cutbacks in their trade surpluses;
* continued rapid growth of domestic demand in key oil exporting countries; and
* a series of substantial exchange-rate changes, especially by countries that have not participated in the adjustment to date.
Both the Chinese yuan and Japanese yen need to rise by about 30 percent against the dollar over three to four years, with a down payment of at least 10 percent in the near term. This will require China to scale back sharply its currency intervention and may require Japan to signal (perhaps through intervention) a desire to strengthen the yen. The other surplus countries must also limit their market intervention and allow their currencies to appreciate substantially. It will be much easier for the other Asian countries to do so once China and Japan take the lead. All these currencies will rise much less on a trade-weighted average than against the dollar if they move together. Europe, South Korea and a few other floaters must accept further rises in their exchange rates against the dollar but will see little change in their trade-weighted averages.
In the 1980s the U.S. government and the Group of Five abandoned their benign neglect of problems very similar to those we now face. The Plaza Accord encouraged a substantial dollar decline in the nick of time to head off major disruption of the international monetary system, world trade and the global economy. Similar statesmanship is sorely needed again to enhance the odds that the inevitable correction will take place constructively and to avoid the enormous risks to all involved from letting nature take its course.
CHINA INTERNATIONAL CAPITAL CORP.
It's the Savings Rate That Matters
The dollar has long been expected to depreciate under the pressures of a large trade deficit and a low national savings rate. The recent problems of subprime mortgages for homeowners and related financial institutions has merely added to those pressures.
A depreciation of the dollar entails appreciation of other currencies, notably those of countries that have significant trade surpluses. China's trade surplus stood at $112.7 billion in the first half of 2007, or 8.1 percent of GDP, the second highest by value in the world. China runs the largest surplus of any country against the U.S., amounting to $73.9 billion in the first half.
The exchange rate is just one of the variables influencing trade balances, however. Savings rates play a more important role. Economic theory posits that the difference between a nation's savings and investment equals its current-account balance. In sharp contrast to the U.S., China has a savings rate that has been high at both the national and household levels. The savings rate is determined by a number of factors, one of which is demographics.
Conventional wisdom holds that a nation's savings rate is positively correlated with the percentage of its population that is of working age. China's household savings rate of close to 30 percent is high by international standards -- roughly 10 percentage points higher than Japan's when that country was industrializing -- and will continue to rise in the years to come, thanks to the high birthrate in the two and a half decades after 1949. The one-child policy that was imposed in the late 1970s has also contributed to the high savings rate because with fewer children to support them in retirement, the working-age population needs to save more. A well-designed social security system that could reduce China's savings rate will take time to build.
China's investment rate is already excessively high. Investment accounted for 43 percent of GDP in 2006, compared with a historical high of 32 percent in 1980s Japan. In contrast, the share of consumption in China's GDP is only slightly more than 50 percent, compared with an international average of 77 percent. The high investment and low consumption rates in China pose a considerable risk of overcapacity and make the domestic economy overly reliant on, and therefore vulnerable to, changes in external demand.
Notwithstanding the appreciation of the yuan and depreciation of the dollar, the trade imbalance between the countries has widened because other factors, including differences in savings rates, have more than offset the effects of exchange-rate movements. A much larger yuan revaluation may help narrow the imbalance slightly, but it is not in the interests of China or the U.S. A sharp rise in the yuan would make China's labor-intensive exports less competitive and raise the unemployment rate, which is now more than 9 percent. Such a move would also add to U.S. inflationary pressures. U.S. prices of imports from China have begun to rise in recent months, reflecting the accelerated appreciation of the yuan over that period.
Although a sharp revaluation is undesirable, China could allow the yuan to appreciate at a faster but controlled pace of perhaps 6 to 10 percent a year, compared with a rise of 3.3 percent in 2006. Such a move would have a limited impact on the trade balance, but it would help improve the effectiveness of Chinese monetary policy and alleviate domestic inflationary pressures. More important than the exchange rate, stepped-up efforts are needed to reduce the national savings rate, including pressing ahead with the creation of an adequate social safety net, requiring state-owned enterprises to pay dividends to the government and shifting the focus of public spending from promoting investment toward supporting consumption. A better-developed capital market and efficient banking system also would help lower the savings rate of enterprises, which retain a large share of profits because of their lack of access to the capital market and difficulty in borrowing from the banking system. Distortional trade policies, such as high levels of value-added tax rebates for exports, also should be cut as much and as soon as possible.
In addition to those reforms, China should take steps to reduce its capital-account surplus to manage domestic liquidity conditions, given that the current-account surplus is unlikely to decline significantly in the near term. Policies on this front would include opening the door for outward portfolio investment, promoting outward direct investment by Chinese companies and establishing a government investment corporation responsible for overseas investment.
U.S. Treasury bonds should continue to be an important part of China's $1.3 trillion worth of foreign-exchange reserves. Some observers suspect that China might dump dollar assets and increase holdings of assets denominated in other currencies or of precious metals to hedge against the risk of a depreciating dollar. China needs to strike a careful balance among the objectives of reserve management. To the extent that a large part of China's international trade is priced in the dollar and U.S. Treasury bonds remain the safest and most liquid assets in the world, China should maintain adequate holdings of dollar assets. Furthermore, as the second-largest holder of U.S. Treasury bonds (after Japan) and an important member of the international community, China understands the significance of a stable international financial market and pays due respect to other countries' interests on a mutually beneficial basis.
China is expected to establish a government investment corporation to seek greater returns on its reserves. This warrants an adjustment in the composition of the reserves, but such a shift is likely to be implemented on an incremental basis.
CHIEF EXECUTIVE OFFICER
HARVARD MANAGEMENT CO.
Focus on Euro-Asian Currency Pairs
Most of the current debates about the dollar assume one of two starting points. The first emphasizes the recent sharp decline in the trade-weighted value of the currency. The other points to the persistently high U.S. trade and current-account deficits, together with the large amount of U.S. debt instruments already held by foreigners.
These starting points give rise to a range of views about the future of the dollar. On one extreme are those arguing that given the recent decline, it is just a matter of time before the imbalances adjust and the dollar stabilizes and strengthens. At the other extreme are those who feel that the dollar will have to decline even more, given the stubborn nature of the imbalances -- a process that could become disorderly if foreigners were to reduce their holdings of U.S. assets.
So what should investors and corporations do? My suggestion is that they spend less time speculating about the overall level of the dollar and more time thinking about how it is likely to evolve vis-à-vis individual currencies. We may well be looking at a 12-to-24-month horizon during which the dollar appreciates versus some major currencies and depreciates versus others. And the range is likely to be significant.
This dualistic perspective reflects three distinct elements: first, how the currency has performed in the past five years; second, divergences in the approaches that certain countries take to exchange-rate policy; and third, the likely evolution of an important driver of the global payments imbalances.
The historical numbers are enlightening. The dollar has declined by 24 percent against a trade-weighted basket of major currencies over the five years ended in June, but its moves within the basket were all over the place. The dollar fell by 27 percent against the euro but strengthened by 3 percent against the yen. Such divergent moves reflect basic differences in policy. Europe has adopted a flexible exchange-rate policy whereas some key countries in Asia, particularly China, have maintained moremanaged pegs. As a result, the only way that markets have been able to accommodate an overall depreciation of the dollar is by forcing a particularly sharp move against countries with the most-flexible exchange rates.
This phenomenon has expanded well beyond the euro. In the past year or so, it has also affected a growing number of emerging economies, which have found it difficult or costly to resist appreciation pressures. As a result, the repricing of their currencies associated with improved domestic conditions has been turbocharged by outside forces.
No wonder there is growing pressure on China to abandon its managed peg in favor of a more flexible, market-determined exchange-rate regime. The pressure is most evident in the repeated calls that come out of certain quarters in the U.S. to label China a "currency manipulator" and impose retaliatory protectionist measures.
Although such calls are understandable, they do not take adequate account of the fact that global imbalances are a shared responsibility. Moreover, China's decision to maintain an undervalued exchange rate reflects the realities of its development stage, helping the country generate jobs for people moving from farms and state-owned enterprises and encouraging an influx of foreign direct investment. It is highly probable that China will move toward a more flexible exchange-rate regime in the next 12 to 24 months as the authorities shift their policy emphasis from benefiting domestic producers to boosting consumption, and as the distortions of an undervalued exchange rate become too costly and difficult to manage.
Should China loosen its currency policy, participants in international trade and finance would be well advised to focus on the prospects for individual currency pairs. Almost regardless of what happens to the overall value of the dollar, investors and corporates should position themselves for a likely reversal over the next 12 to 24 months of the factors that have boosted the euro against Asian currencies. Policymakers will not get in the way of such a reversal when it materializes. After all, it would serve to facilitate a gradual and orderly correction of global payments imbalances. A Chinese policy shift will also have implications for investors that go well beyond exchange rates. Such a change should favor Asian equities, foster a normalization of Japanese interest rates and reverse the forces that have facilitated low inflation in the U.S.