ANN: Dollars and sense

Last Wednesday, US Federal Reserve Chairman Jerome Powell announced a cut in the Fed Funds rate by 25 basis points, citing slower global growth and muted inflation. This was evidently insufficient to appease either the markets or President Donald Trump, who openly asked for a “large cut” just before the Federal Open Market Committee (FOMC) meeting. 

After the announcement, he tweeted, “As usual, Powell let us down.” Perhaps reflecting Trump’s sentiment, US markets fell by 1 per cent and the dollar actually strengthened slightly against other currencies.

How do we make sense of what is happening to the dollar, the most important reserve currency in the world?

The dollar is important, because it accounts for 44 per cent of daily global foreign exchange trading and roughly 60 per cent of total official foreign exchange reserves. Because the dollar has a very liquid market both on-shore and offshore, companies and governments like to borrow in dollars, especially when the interest rates are low. As the BIS reported, there are now $11 trillion (Bt337 trillion) in dollar debt that are booked offshore. In addition, the US has a net international investment position (debt) of $9.5 trillion or 47.4 per cent of GDP at the end of 2018. 

Noting that the US federal budget deficit is running at more than $1 trillion annually, bringing gross debt to an estimated 113.2 per cent of GDP and net investment deficit of 51.4 per cent of GDP by 2024, the International Monetary Fund has warned bluntly that “US public debt is on an unsustainable path”. 

The same June 2019 IMF report card on the US economy (technically called the Article IV consultation report) also says: “The US economy is in the longest expansion in recorded history. Unemployment is at levels not seen since the 1960s, real wages are rising, and inflationary pressures remain subdued.” That doesn’t sound like an economy in trouble.

We all know what worries Mr Trump. If the economy, and especially the stock market, tanks in the run up to the November 2020 elections, then his re-election would be in trouble. But why should the financial markets be worried?

The answer lies in the fact that there is a very close relationship between the stock market and central bank balance sheets. Since 2015, when the Fed started to “normalise” interest rates (by raising them) and reversing quantitative easing (expanding its balance sheets), the S&P500 stock market index roughly topped and moved sideways. 

Everything is relative. During this period, both the European Central Bank and Bank of Japan have been easing, concerned about the slow growth of their economies. The People’s Bank of China has eased to relieve liquidity during a period of deleveraging, in order not to over-tighten during a period of trade tensions. Hence, if the world is slowing down overall faster than expected, monetary policy cannot be too tight to push the economies into recession territory.

But the US has now begun to politicise the dollar by increasing the rhetoric on currency manipulation, excessive surpluses and threats on using tariffs and sanctions on trading partners and rivals to try and contain its unsustainable trade deficits and debt trajectory. This is because Trump and some in his administration think that the dollar is overvalued, and wants lower interest rates to help alleviate the upward valuation pressure.

But the US administration may be boxed in by its own asymmetric dollar trap. The Fed is in charge of monetary policy (the main tool that affects the external price of the dollar), but responsibility for the exchange rate lies with the US Treasury. If the Treasury ramps up sanctions, threats of currency manipulation and/or tariff increases, the major trading partners could easily negate these by either easier monetary policy or allowing their exchange rates to depreciate.

Exchange rates are by nature bilateral. Given the massive size of global foreign exchange markets, the US cannot unilaterally depreciate its dollar without the help of concerted cooperation of major reserve currency central banks. Today they may or may not cooperate since the US has threatened almost all of them for “unfair trade”, currency manipulation and the like. 
The last time the dollar successfully depreciated through intervention was through the Plaza Accord of 1985, when Japan, Germany, France, the UK and the US jointly intervened in the foreign exchange markets to depreciate the dollar.

This time around, the US would not be able to convene another Plaza Accord because Europe, Japan, and China may not want to cooperate. Indeed, fundamental disagreements over sanctions using the dollar on trading with Iran and other countries have caused the Europeans, China, India, Russia, and others to consider non-dollar alternative payment mechanisms. Furthermore, going forward, the growing trade surplus countries are more in Europe (particularly Germany and Netherlands) than in Japan or China, as the IMF External Sector Report 2019 showed. 

Much will depend on whether the Germans or the Dutch are willing to reflate fiscally, but based on the bad experience of Chinese reflation in 2009, these fiscally conservative countries are likely to push the deficit nations (mainly the US) to address their structural imbalances rather than bear the costs of getting their own economies out of whack.

Even though the US has considerable “exhorbitant privileges” in enjoying the benefits of the dollar as the dominant reserve currency, in the long run, this cannot be sustainable unless the US is willing to take tough pain to correct its structural savings deficit. Even though Trump may want America First, the other global players will play for the long haul and wait for the US to plead for mutual cooperation and assistance. 

There is no such thing as a free lunch. The US must work within the global financial system through cooperation rather than coercion. To go it alone, as what happened with Smoot-Hawley protectionist moves in the 1930s, risks sending the world into another global recession. 

In this highly interconnected world, no country, not even the US, can go it alone – for long.

Andrew Sheng writes on global issues with an Asian perspective. The views expressed here are solely his own.