Of Dollars and Deficits


By David Wyss The trade deficit is setting new records, surging to an all-time high of $60.3 billion in November. How long can this huge imbalance be sustained? How much farther can the dollar fall, and why hasn't its decline helped narrow the gap?

The market's usual response to a trade gap -- when the U.S. imports more goods than it exports, thus sending dollars into the market -- is a currency collapse. Unless investors from other countries are willing to mop up those dollars and invest them in the U.S., the value of the currency has to decline.

TAKING ITS TIME. In the early days of the deficit, during the late 1990s, things were reversed. The strong returns available on U.S. investment brought a surge of capital into the country. The inflow of funds drove the price of the dollar up to levels at which U.S. manufacturers could not compete, and thus the imbalance was created. The dollar surged to a high of $0.87 to the euro. As the deficit rose, and foreign inflows slowed, the trade gap offset the inflow of funds, and the dollar declined.

So, where should the dollar be? Most analysts believe the $1.19/euro rate at which the European currency was born in early 1999 was about right. Today's $1.30 rate is thus not too far out of line (10% is well within the range of uncertainty).

But I don't think the slide is over yet. The dollar has dropped more than a third from its high, at least against the euro, but the trade deficit continues to widen. Such a delay between the currency collapse and a tightening of the trade gap is normal. After the 1985 dollar depreciation, the deficit didn't start to narrow for two years. This time it is taking even longer.

SLUGGISH DEMAND. There are two major factors: First, a disproportionate share of our imports comes from countries whose currencies haven't moved against the dollar. The U.S.'s biggest bilateral trade deficit is with China, and the yuan has remained pegged to the dollar. But this may change. Recent comments by Chinese officials suggest they may be preparing to shift to a market-basket peg, tying the yuan to a weighted average of the yen, euro, and dollar. If they do so, they should shift some of the $600 billion in reserves out of the dollar and into a more even weighting of dollars, yen, and euros.

The other problem is the weak growth in other industrial countries. Even if the dollar becomes supercompetitive, and U.S. producers gain market share in the rest of the world, that increase may be balanced by the fact that demand is growing slower overseas than in the U.S. Historically, the U.S. has tended to export mostly to industrial countries and import from developing ones.

This problem is exacerbated by the desire of other industrial countries to use exports to drive their own growth. Both the Eurozone and Japan are running trade surpluses in excess of 2% of gross domestic product. If the U.S. stops running a deficit, they can't continue to run surpluses.

HIGHER RATES? Recent comments by foreign officials underscore this issue. Tatsuya Tamaru, the Bank of Japan's former executive director, stated Feb. 1 that the BOJ could afford to tighten up its current, ultraloose policy, because demand and profits are rising on the back of solid demand for exports. Officials from the European Central Bank and elsewhere in the EU have made similar comments, often in the same speeches in which they are complaining about the U.S. trade deficit.

However, the Europeans are correct when they say the U.S. must wean itself from its reliance on foreign capital. U.S. gross national saving is only 14% of GDP, and gross investment is 19%. The difference is funded by the inflow of funds from overseas, the financial counterpart of the trade deficit. If these inflows stop, either the U.S. will have to save more (by reducing government borrowing or encouraging personal saving, for example) or investment will drop, slowing economic growth.

The initial symptom of reduced inflow of foreign capital would be higher bond yields, as it would be harder to sell Treasury securities. Certainly there is no sign of that so far, with bond yields holding near 4.1%.

VULNERABLE MARKETS. But the sheer size of the U.S. deficit should keep us worried, as does the fact that so much of it has been coming from official transactions over the last year. Over the last 12 months, official inflows (by foreign governments and central banks) were $239.6 billion, or 28.9% of net inflows. For the 12 months ended November, 2003, official inflows were only $139.2 billion, or 21.5%.

This increased reliance on official inflows makes us very nervous about the dollar and how long we can sustain the trade deficit. Private inflows continue to increase. Over the last 12 months, they are up $96.9 billion from the previous 12-month period. But that wasn't enough to fund the rise in the trade gap.

As we become more dependent on foreign central banks instead of private investors to fund our trade gap, we become more susceptible to political winds. Even though there seems no reason for the central banks to stop funding our deficit -- and at this time it is in their interest to continue doing so -- do we want to make our financial markets vulnerable to possible changes in foreign policies? Wyss is chief economist for Standard & Poor's


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