Dollar drops: Good news and bad
By Jack Crooks

Many believe a lower dollar is the only plausible policy tool available to the United States if it's to reduce its massive current account deficit. It is why, increasingly, analysts are calling for a coordinated effort on the part of central banks around the globe to push the dollar lower. But it's not an easy task. Failure could spark protectionism, a dollar crisis, and a global financial crisis. And there's still no clear proof that a lower dollar is the best solution.

The problem
The US economy is hooked on consumption and imports, while Asia is hooked on savings and exports. It's an unbalanced financial world. The following is a chart of US consumption as a percentage of gross domestic product (GDP). It now stands at more than 70%. US consumer-demand growth averaged 4% annually (in real terms) over the 1995-2003 period; that's almost twice the 2.2% growth elsewhere in industrialized countries, according to Morgan Stanley. This wouldn't be all bad were the consumption being funded out of growing income levels. But it's not. It's coming out of savings.

The drawdown of savings has produced this buying binge on the part of US consumers. This chart shows savings as a percentage of personal income has fallen to 0.2%. Yikes!

So it's no wonder the US relies on foreigners to the tune of US$2.6 billion a day to fund this gaping current account deficit, absorbing about 80% of the world's surplus savings from Asia, Europe and the Middle East in the process. The chart below shows that the deficit (in red) rose to a whopping $166.2 billion for the second quarter of 2004. Annualized, that's $664.8 billion. The blue line represents the trade-weighted value of the US dollar - its decline is now tracking closely with the increase in the deficit.



The problem is, despite calls for a lower dollar to help close the current account gap, it's poised to get worse before it improves. Here's why, says Morgan Stanley economist Richard Berner:

1) Import of goods, services and income is 40% bigger than exports. And this ratio is on the rise again.
2) Higher US interest rates will increase debt payments to foreign debt holders.
3) Iraq war and redevelopment.
4) Slowdown in global growth, especially in Asia.
5) Soaring cost of imported oil.

It means US funding need will continue to grow. Already foreign central banks, especially in Asia, have been carrying the bulk of the funding load. Over the 12-month period ending September 2004, foreign central banks have accounted for 28% of total net foreign purchases of long-term US securities - nearly double the 15% share of the prior 12-month period, according to Morgan Stanley.

But US reliance on Asian funding won't last forever. In fact, it could end sooner than later. Dr Jiang Ruiping, director of international economics at the China Foreign Affairs University, pointed out the following as a warning to the US in an article titled "Crisis looms due to weaker dollar" in the China Daily newspaper:

Since China holds huge amounts of dollar-denominated foreign-exchange reserves, the authorities should consider taking prompt measures to ward off possible risks.

Given the deteriorating relations between the US and the Arab world, quite a few Middle Eastern oil-exporting countries have begun to increase the proportion of euro in international settlements. Russia is reportedly going to follow suit.

About two-thirds of the reserve [Chinese] is dominated by the dollar. As the dollar goes down, China will suffer great financial losses.

The low earning rate of US treasury bonds, only 2% - much lower than investment in domestic projects - could cost China's capital dearly ... If the bubble bursts, China will suffer serious losses.

To ward off foreign-exchange risks, China needs to readjust the current foreign-exchange holding structure, increasing the proportion of euro in its forex reserves.

Considering the improving Sino-Japanese trade relations, more yen may also become an option.

China could also encourage its enterprises to "go global" to weaken its dependence on US treasury bonds.

Using US assets to increase the strategic resource reserves, such as oil reserves, could be another alternative.

Just how much more debt can the US pump out to the world? Are we close to saturation? The chart below compares the total amount of US dollar debt held by the rest of the world (red line) - a cool $4.37 trillion - to the trade-weighted value of the US dollar (blue line). The period between 2002 and the second quarter of 2004 has been shaded, showing the massive US Federal Reserve credit-expansion campaign engineered by the pushdown on the Fed funds rate (chart below), dragging the dollar down with it.



That summarizes why the dollar is heading lower. It's an unbalanced financial world and the US needs to get its financial house in order. If the recommended solution is followed, it means the dollar goes even lower. But if all the players don't agree on the recommended solution, we could face a dollar and global financial crisis.

The solution: A new Plaza Accord
In an article in the Financial Times, financial analyst Peter Bernstein says it is time for another Plaza Accord. On September 22, 1985, the ministers of finance and governors of central banks of France, Germany, Japan, the United Kingdom and the United States signed an accord at the Plaza Hotel in New York stating that the signatories "were of the view that recent shifts in fundamental economic conditions among their countries, together with policy commitments for the future, have not been reflected fully in exchange markets ... In view of the present and prospective changes in the fundamentals, some further orderly appreciation of the main non-dollar currencies against the dollar is desirable. They stand ready to cooperate more closely to encourage this when to do so would be helpful."

Bernstein points out that the dollar dropped 30% in the next two years and by 1991, the current account was "just about in balance". But the financial environment now is difficult and complicated. The risks are greater. Bernstein believes it is important for the dollar to fall in an orderly fashion. The funding arrangement can't go on indefinitely in this environment.

Private capital inflows into the US are already shrinking. There is a point at which one or other central bank will cry "Enough!" and the house of cards will cave in. Indeed, China has already begun diversifying its foreign-exchange reserves into other currencies and investments. Protectionist pressures are developing within the US, which - to borrow the Plaza Accord's words - "if not resisted, could lead to mutually destructive retaliation with serious damage to the world economy". At the same time, Americans are creating the means for foreign nations to blackmail them over unpopular US policies by threatening to cease accumulating dollars, thus prompting the dreaded crisis.

It's clear there is no easy way out of this mess. Another Plaza Accord is the best available alternative, according to Bernstein and many others. Otherwise, we could see a sharp rise in protectionism in the US, which "would immediately invite retaliation abroad".

Here is how a coordinated decline in the US dollar is supposed to rebalance an unbalanced world: 1) A global agreement to let the dollar fall (explicit or implicit) leads to: (i) Gradual increase in US interest rates (ii) Dampening of US consumer demand (iii) Increased domestic savings, reducing the dependence on foreign funds (iv) Making US bonds more attractive for new buyers to help maintain capital flows to US. 2) A weaker dollar pressures European and Asian exports by: (i) Forcing them to focus on domestic demand compensating for lower exports and decline in US consumer demand (ii) Increasing US exports and reduces global trade tensions 3) Ultimately leading to improvement in the US current account and more productive use of surpluses in Europe and Asia.

That's the theory. But it requires that the players read from the same sheet of music.

If the dollar continues to fall, but Asia does not allow its currencies to rise in response, the burden of dollar weakness will be borne by Europe. And European policymakers are not about to sit idly and let that play out. (We are already seeing it as the euro rally continues.) At present, without a dollar accord, the United States' benign neglect is acting as a wedge to pressure Europe to push harder for Chinese revaluation. But it's unclear whether China is willing to "bear its burden".

Li Ruogu, deputy governor of the People's Bank of China, in a recent interview said the US "blames others" for its problems. China is in no hurry to change the yuan's peg to the dollar, he said. "Under heavy speculation we cannot move [toward greater flexibility] and under heavy external pressures we cannot."

If China doesn't revalue in some form or fashion, protectionism could rear its ugly head. But if China does revalue, some think it could be the worst possible outcome. There is no solution without risk. It shows just how delicate the balance is in a dynamic financial system.

A gamble either way
When Japan "revalued" the yen back in the early '80s, it created an enormous bubble in its stock and property markets. It's another matter that traders are ready to pounce if China "toes the line".

But China is already in Bubblesville. "It's extremely unlikely they could create a bigger one," believes Andy Xie of Morgan Stanley. Xie believes a Chinese revaluation would be disastrous for the Chinese economy because the financial system is not sophisticated enough to deal with more financial pressure.

Xie is not the only one worried. In a recent interview, Bank of Japan governor Toshihiko Fukui said: "I understand the feelings of people who tend to focus on just China's exchange rate [regime], but this should be combined with the wider issue of how to make the Chinese economic system more flexible. This includes the deregulation of the financial system, capital account convertibility, and achieving soundness of the banking system. Without these across-the-board initiatives, just changing the exchange-rate regime would cause disruption to the Chinese economy."

The China peg is a stabilizer, says Xie. A lifting of the peg could lead to a "dollar crash" because demand from ethnic Chinese would plummet. In fact, we are already seeing Chinese citizens dumping the dollar in favor of their own "hard" currency.

Domestic Chinese sold $20 billion in US dollars during the first six months of 2004, according to the State Administration of Foreign Exchange.

There are interesting financial parallels shaping up between now and the mid-1980s:

Then	Now
Go-go '60s stock market boom (conglomerates craze)	'90s stock market boom (Internet craze)
Vietnam quagmire and communist dominoes	Iraq quagmire and "war on terror"
Soaring budget deficit	Soaring budget deficit
Rising energy prices	Rising energy prices
Rising interest rates to stem inflation	Rising interest rates to "normalize" the Fed funds rate
Soaring commodity prices (inflation-driven)	Rising commodity prices (for now, supply/demand imbalance)
Japanese revaluation	Chinese revaluation?

If the delicate relationship between the dollar and global capital flows isn't engineered with some degree of precision, we could be adding a stock market crash to the columns of "Then" vs "Now". And keep in mind, the 1987 crash was a global affair.

We are in a precarious macro environment. Have we seen this all before?

1) Fed funds rate slashed lower into 2004 ...







2) Fed funds rate slashed lower into 1987 ...






 3) Rising euro (falling dollar) coinciding with a sharp rise in the stock market ... from 2002 through 2004 ...







4) Rising euro (falling dollar) coinciding with a sharp rise in the stock market ... 1985 through 1987 ... before it crashed!







The pressure grows on China, internally and externally, for some type of revaluation. Its decision could ultimately spawn global financial healing or spark a global financial crisis.

Pick a color. Pick a number. Lay down your money. And spin the wheel.

Jack Crooks has traded in global equity, fixed income, commodity, and currency markets for more than 20 years. He is president of Black Swan Capital, a currency and commodities market advisory firm - BlackSwanTrading.com .

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