Dollar bears on the brink of retreat

Making a case for further falls in the value of the dollar is fairly simple. All dollar bears need to do is point to America’s current account deficit. However, there are some good reasons to believe that America’s external finances may be about to improve.

Economic textbooks tell us that a persistent deficit is not sustainable indefinitely. They do not say when a country will have to pay back its debts and turn the deficit into a persistent surplus. All the textbooks really tell us is that a country like America will have to run a trade surplus eventually.

It seems as long as they can afford the interest payments on the accumulated debt, the day of reckoning can be postponed. As long as American growth remains strong, its creditors will not be concerned about its debts.

But there is another school of thought that suggests the current account balance, as measured using traditional national accounting techniques, does not reflect America’s true financial position with the rest of the world.

Given that America has run a sizeable deficit since 1991, and for much of that time the dollar has risen in value, two Harvard academics – Ricardo Hausmann and Federico Sturzenegger – argue that the US owns valuable “dark matter” assets that generate revenue that cannot be seen or measured.

They hypothesise that these assets might include American firms’ superior know-how, the liquidity service provided by the dollar, and the lower risk of American assets relative to emerging country assets.

Another, largely unrelated, argument has been put forward that has also comforted dollar bulls. This is that there exists a “dollar bloc” that, when considered as a whole, implies once again there is no “deficit problem”.

In essence, there is a set of nations, such as the Gulf nations and also China, that are effectively dollar economies – since many Gulf nations’ exchange rates are pegged to the dollar, and China operates a crawling peg. When one adds up the current account positions of all of these countries with America, the dollar-bloc current account position, with the non-dollar bloc, only runs a deficit of about 2%.

But are there perhaps other, more prosaic, reasons to be sanguine about the fate of the dollar?

The dollar is 13% lower than it was in 2002. To the bulls, it is a comfort that the dollar has already fallen a significant amount. However, dollar bears – unconvinced by arguments about dark matter and dollar blocs – remain concerned that the dollar is still 15% higher than it was in 1995 and that despite the decline since 2002, the current account deficit has expanded from 4.5% of GDP in 2002 to 7.3% today.

A phenomenon known as the ‘J’ curve effect may have played some part in the apparently delayed response of the trade position to the relatively substantial fall in the dollar since 2002.

The theory suggests that it takes time for changes in purchasing power to reverse consumers’ behaviour. That is, following currency devaluation, spending trends continue in the short term, even as the cost of imports rises.

Also, the headline current account numbers have possibly masked some improvement in the underlying position. Stripping out the effect of rising energy import costs, there has been some improvement in America’s finances.

There are other reasons why one might expect the current account to improve from here. The first is stronger Japanese and eurozone economic growth.

The stronger growth environment in these two large economies should continue for the foreseeable future, generating demand for American exports of goods and services, which will in turn improve the American current account.

Another important structural change with respect to the current account relates to Uncle Sam’s finances. The Federal government’s finances have been on an improving trend for the past two years.

On current trends, and with the American economy probably already over its recent housing market-related soft patch, there is every reason for this trend to continue.

In the near term, further support for the dollar should come from the Fed’s policy rate, which looks set to remain higher for longer than many market participants expect.

And finally, although central banks have shown some signs in the past of diversifying away from dollar assets, as far as most central banks are concerned the dollar remains the reserve asset of choice.

America’s current account deficit gives plenty of reason to believe the dollar still has a long way to fall. However, we are less convinced. In the short term, there are good reasons to feel upbeat about the dollar’s prospects, and over the longer term there are reasons to believe the current account deficit is at last on the turn.

Strategy net debt graphs