Back in January 1999 the euro was heralded as a strong currency that would soon outshine the dollar. Europe had a surplus on its external balance of payments and tight fiscal policies. The US had a huge current account deficit, net external liabilities and budget deficits. The dollar was bound to dive. How wrong the dollar bears have been.
Nevertheless they continue to trumpet the same old arguments for expecting the dollar to lose ground this year. They cite the huge US current account deficit and external liabilities as the main reason, even though experience has contradicted this theory. If the current account deficit were enough to skittle the dollar, it would have happened eons ago.
A widening US current account deficit has not indicated a weaker dollar. Over the past three years, the external deficit has widened to over 4% of GDP and the US private sector (corporate plus household) deficit reached unprecedented levels at the peak of the equity bull market. None of this has been a catalyst for a dollar collapse. The irony is that, as the US economy slowed last year, the private-sector deficit and the gap on the current account narrowed. So the traditional dollar bear argument is getting even weaker.
There are three key reasons why the US dollar has stayed strong and will continue to do so this year. First, the huge rise in US household wealth in the past five years has fuelled the firepower to finance the trade deficit without boosting debt. Second, globalization has created world demand for dollars unaccounted for in any national external payments accounts. This sustains dollar strength whatever happens to the US balance of payments. And third, after the Asian crisis, the demise of the euro experiment and then the September terrorist attacks, the dollar still seems to be the safest package for your assets.
The traditional bear argument does not recognize that capital movements are now more important to a currency’s strength than trade balances and that computing savings gaps without making the connection to consumer balance sheets is nonsensical. For example, when you correctly measure the level of US national savings using the gains made by households on their net wealth (financial and real estate), the US savings rate, supposedly near zero, is seriously underestimated.
The huge rise in household net financial wealth has created spending power through capital gains. This means the savings deficit computed on a flow basis can be covered by monetization of wealth gains. American consumers can finance their spending and buy imported goods because their equity wealth has risen as foreigners have bought US assets. That is the new financial circuitry of the dollar’s rule. One example of this is the US mortgage refinancing boom. Households have taken advantage of the rising value of their property and the falling rate of interest to finance their borrowing.
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Most important, the US finances external payments mainly through equity flows rather than debt. Foreigners buy US companies or purchase US stocks. So the US has to sell fewer corporate bonds or treasuries to finance imports. And equities are no more of a liability to a country than to a company.
Superior wealth gains attract foreign direct investment and equity flows to the US. That means the current account/savings deficit is easily covered. Equity participates in total returns – not just in a fixed stream of coupons and principal payments. And stocks of foreign equity capital generate almost no (factor) income outflows because they reinvest their income in US assets. So, although the US is now a net debtor, the impact on the current account of net factor income outflows is tiny compared with the trade deficit.
This tells two tales. First, US overseas assets are understated in value and income flows. Second, foreign equity investment will not generate big income outflows unless America’s return on assets and capital productivity falls below those of Japan and Europe. Throughout the 1990s, US corporate investment (including IT) was much more efficient than Japanese or German corporate investment. And there is little sign that’s going to change in this decade.
Globalization also creates massive demand for dollars as the new global single currency. Oil, e-commerce, direct investment and portfolio flows are the streams flowing into this reservoir. As a result of the new economy, e-commerce is now using dollars in global transactions equivalent to Spain’s annual output.
But even that is peanuts compared with the demand created by the globalized US corporate sector. As most foreign direct investment is reinvested profits and most of it is in dollars, global demand for dollars is rising fast. US overseas affiliates provide a significant demand for dollars globally. The annual increased demand for dollars from US globalization (foreign direct investment flows and foreign affiliate sales) more than matches the US current account deficit. And that’s before counting other countries’ corporate demand for dollars.
Finally, the US remains a safe haven for people’s hard earnings. Capital continues to haemorrhage out of emerging markets and Japan into the US. Asian trade surpluses are being recycled back into US assets abroad because there appear to be no attractive alternatives to the dollar for global investors. Even Japan’s traditionally risk-averse investors are increasingly shifting export earnings abroad.
And there is no alternative to the dollar. Japan is bound for very low growth if it reforms and low growth if it doesn’t. The former would be a healthy cleansing, leading to a bright tomorrow. The latter would mean a lightless economic purgatory. But from a world economic perspective, Japan will add nothing to growth but a lot to competition – through a weak yen – for many years.
Euro-Europe is having the same crisis of self-confidence as Japan. It is half going for reform and half not. Its politicians are trying to row the economic boat back up the river of history, while its corporations are trying to row with the current. The result is a widening gyre of general confusion and lack of confidence. The ultimate outcome is assured because globalization is the most powerful cultural – more even than economic – force in the world. But how quickly or slowly you get to glory is critical to financial markets.
Moreover, the US will be twice-crowned global leader in the year to come – once as the architect of the new world order and again when it leads the world out of recession. This it will do by exporting the confidence that comes of achieving its own economic recovery before Europe or Japan. That sort of leadership fuels demand for the dollar.
Appetite for non-US dollar financial assets would only rise if the US economy fails to recover and the rest of the world performs better. But this year the opposite will be the case. Recovering US confidence, as expressed in asset prices, will cause the US economy to stabilize and then pick up. As the economy and equity markets interact to lift confidence and values, the dollar’s rule will persist.
