The future of sliding dollar

Published December 25, 2004

Rising consumption, high oil prices and growing military expenditure are inexorably pushing the current account deficit of the United States this year towards an all time high of $631 billion equivalent to six per cent of the national income.

This worrisome deficit is now eating up more than 75 per cent of world's surplus saving. In previous four years, the current account deficit of 4.4 per cent was largely financing productive investment in the United States.

Today, the budget deficit of $445 billion is larger and has been financing consumption which keeps on rising. The world's most vibrant economy is facing a fundamental dis-equilibrium between saving and spending.

The United States is currently borrowing over two billion dollars a day to meet the deficit. This should be a wake up call for all governments. If collective action by them is delayed, the imbalances would unhinge the global economy and plunge it into a recession.

The global economy has a stake in the stability of the dollar as the leading currency of the world. As the reserve currency, the central banks in the world hold 65 per cent of their holdings in dollars.

Oil prices are quoted in dollars. Until the late nineties and launching of the euro as the common currency of the European Community, there was no rival currency to the dollar predominance.

This is beginning to change. The defining feature of a reserve currency is that it acts as a store of value and should retain its purchasing power. The Oil producers are beginning to raise demand for payment in euros in preference to depreciating dollars.

Fred Bergsten, Director of the Institute of International Economics in Washington, has candidly stated that 'President Bush faces two international economic threats that could derail the U.S. and world economies: the current account deficits and renewed sharp rise in energy prices.' The present current deficit, according to him, could reach 10 per cent of the GDP within the next few years.

The downward slope in the value of the dollar elicited uncharacteristic confirmation from the Federal Reserve Chairman, Alan Greenspan, in his on the record statement that America's current account deficit was unsustainable because foreigners would eventually lose their appetite for more dollar denominated assets and that a rise in interest rates might take place.

The President of the European Central bank has called the euro's rise to around $ 1.30 'brutal and unwelcome'. Foreign exchange markets, where foreign currency transactions amount to 1.9 trillion dollars a day, have witnessed a brisk sale of dollars in response to what is perceived to be an irreversible decline in its value.

The vulnerability of the dollar arises from its lacklustre performance in meeting the central requirement as a store of value. Taking 1960 as the base year, the dollar has declined by two thirds against the euro (using German mark as a substitute for the euro before 1999) and the yen.

The more rapid growth of demand than supply has been a recurring feature of economic performance in the United States. Given the advantage of borrowing in its own currency, the United States has been the recipient of foreign loans on concessional basis which, in turn, creates the temptation to borrow immoderately.

Devaluation of the dollar to reduce the external deficit of the United States will lead to losses in local currencies of exporting countries and erodes its status as the reserve currency.

The opinion has been persuasively expressed by eminent economists that the dollar devaluation virtually amounts to a partial default on payment of debt to the lending countries.

Since early 2002, the sustained fall in the dollar - 35 per cent against the euro and 24 per cent against the yen- is not caused by the pressing of panic buttons in a feverish foreign exchange market. The trigger mechanism is not to be confused with the chain of causation. The underlying fundamental equation is that imports in United States exceed exports by 50 per cent.

A pervasive misperception is that the current account deficit has resulted from capital inflows into the United States responding to the attraction of high real returns.

Undoubtedly, this may have been a valid explanation in late 1990s when there were substantial inflows into America of private and equity investment as against net inflows from America of long-term investment in subsequent years.

It is not productive investments but declining savings that are the central part of the rising imbalances. Former Treasury Secretary Larry Summers has said, 'at 1.5 per cent, the net national savings rate is about half of what it was in the late 1980s and early 1990s ... In fact, net investment has declined over the last four or five years suggesting that all the deficit deterioration in the current account can be attributed to reduced savings and increased consumption than to increased investment.'

Beyond reasonable challenge, a crystal clear reason for the dollar to risk losing status as the single reserve currency is that America is getting burdened with an increasingly heavy load of foreign debts. Its current account deficit (six per cent of GDP) is currently twice as large as the figure in the second half of 1980s.

America has now ceased to be a net foreign creditor. United States' net foreign liabilities of around three trillion dollars are equal to 28 per cent of GDP towards the close of 2004.

If there is no reduction in US budget deficit, the current account deficit and net debts would predictably climb to perilous peaks. Granted the world's hunger for dollars assets, the investors would be unwillingly to keep on financing future deficits at prevailing exchange and interest rates in the United States.

In sum, the net foreign debtor status of America is incompatible with retaining the current 65 per cent share of global foreign exchange reserves. The pre-eminence of the dollar is now being challenged in the face of consolidation of the euro as an international currency.

The euro area is the world's largest exporter and unlike America, a net creditor. The growth rate in the European Community has been slower than in America. Undeniably, the United States excels in high technology and innovativeness.

At the same time, the euro area has been catching up economically with the United States. The Economist has been highlighting that 'in dollar terms the euro area's economic weight has actually grown relative to America over the past few years.'

History repeats itself although not often. For full understanding of the current account deficit in the United States, we have to go back to 1985 when the Plaza Accord was signed.

The ministers of finance and governors of central banks of France, Germany, Japan, the UK and the U.S.A. signed an accord at the Plaza Hotel in New York on September 22, 1985.

It stipulated that that "recent shifts in fundamental conditions among their countries together with policy commitments for the future have not been fully reflected in 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." As a consequence, the dollar nosedived by 30 per cent and America's current account deficit shrank noticeably.

The current account imbalance was redressed in 1991 without the realistic realization that it might re-emerge in the next decade and call for another major adjustment in world currencies.

The United States imbalances in 2004 are on a bigger scale compared to 1985 - currently six per cent of gross domestic product as against two per cent in 1985.

A close look at the Plaza Accord sheds light on the dis-equilibrium caused by mounting external account deficit in America with its unquenchable thirst for imports and the bulging surpluses of major exporting countries with a lagging domestic demand and production.

The correction of the equilibrium requires a global solution and cooperative action centering around the reduction in budget deficit and higher interest rates in the United States and the growth of domestic economies in the euro area, Japan and non-Japan Asia.

China probably recognizes the need for revaluation of renminbi but has a preference for carrying it out at a time considered appropriate and not under external pressure. May be, after upward revaluation of the currency, China might move it away from the peg to the dollar and link its value to a basket of currencies.

The present writer is engaged in discerning underlying trends and is disinclined to making predictions about the precise extent of realignment in world currencies in the coming months.

The remorseless logic of the dismal science of economics may be deflected and delayed by the exercise of political power but cannot be averted for long. In the fullness of time, the balance of economic forces in the world are likely to find expression in a multiple reserve currency system rather than in the continued predominance of the dollar.

Such a multiple reserve currency system will comprise the dollar, the euro, the yen and possibly the Chinese yuan. The multipolar currency system is the shape of things to come as the world economy unfolds and apportions relative weight to the major currencies.

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