The Correction of the Dollar and Foreign Intervention in the Currency Markets
Testimony before the Committee on Small Business
United States House of Representatives
The dollar rose by a trade-weighted average of 35-50 percent (depending on which index is used) from early 1995 until February 2002. Since every one percent increase in the dollar produces an increase of $10 billion in the annual US current account deficit after a phase-in period of two to three years, this appreciation accounts for the bulk of the total deficit that now exceeds $500 billion (about 5 percent of GDP) per year. These deficits have risen by almost one full percentage point of GDP in four of the last five years (excepting only the recession year of 2001).
As a result of the external deficits of the past twenty years, the negative net international investment position (NIIP) of the United States now probably exceeds $3 trillion and is climbing by about 20 percent per year. To finance both the current account deficit and our own sizable capital exports, the United States must import about $1 trillion of foreign capital every year or more than $4 billion every working day. The situation is clearly unsustainable.
The Correction to Date
The dollar has thus been declining in a gradual and orderly manner since early 2002. Its fall to date cumulates to 10-20 percent (again depending on which index is used). Hence it has reversed one third to one half of the runup of the previous six-and-one-half years. As a result, the annual current account deficit should decline by $100-200 billion over the coming couple of years from where it would otherwise have been.2 There have been no noticeable adverse effects of the dollar's decline on the US economy: inflation is nowhere to be seen (and indeed deflation is the greater risk), interest rates are at fifty-year lows and the equity markets have recently surged. The Administration has wisely accepted the correction, frequently reiterating that the exchange rate should be left to market forces and discouraging any thoughts that it might intervene to interrupt the decline.3
Analysis at our Institute for International Economics suggests that the United States can sustain a current account deficit at about half the current level or $250-300 billion per year (2 1/2- 3 percent of present GDP). At this level, the ratio of the US NIIP to GDP could level off at 30-35 percent, fairly high but still short of the traditional "danger zone" of 40 percent or more. Given the relationship noted above, that every one percent decline in the dollar will produce a reduction of $10 billion in the external imbalance, our trade-weighted exchange rate needed to fall by 25-30 percent from its recent peak. Hence the depreciation of the dollar to date has probably gone about half the needed distance.
The dollar decline to date, however, has been quite unbalanced among the major trading partners of the United States. The dollar has fallen by about 30 percent against the euro but only about 15 percent against the yen. It has not fallen at all against the Chinese renminbi. This outcome is paradoxical since Japan is by far the world's largest surplus and creditor country while China is the second largest holder of foreign-exchange reserves.
Two complementary steps are needed to complete the essential correction of the dollar and thus of the current account imbalance of the United States.
First, as already noted, the trade-weighted average exchange rate of the dollar needs to fall by another 10-15 percent to restore a sustainable external position for the United States. It would be highly desirable if this further adjustment occurred, over the next year or so, at a similarly gradual and orderly pace to the depreciation of the past seventeen months.
Second, this upcoming "second wave" of dollar decline should occur against a broader group of currencies and with greater corresponding appreciations in East Asia. Continued reliance on dollar correction against the euro would almost certainly produce an overvaluation of that currency, a significant further spur to trade protectionism throughout Europe that could hurt US exports, and additional political resentment on top of the acute transAtlantic tension that already exists. The Europeans would strongly (and correctly) resist such continued asymmetry of the adjustment process and almost certainly take forceful steps to prevent it, hence limiting the ultimate dollar correction.
East Asia should thus be the focal point of the currency realignments of the coming year. In particular, Japan must desist from intervening directly in the foreign exchange markets to limit the appreciation of the yen. Japan's massive purchases of dollars over the past eighteen months, which totaled about $33 billion in May alone, have probably kept the yen from rising by at least another ten percent.4
Secretary Snow has been very clear in stating the view of the US Government that exchange rates should be determined by market forces rather than by intervention by national monetary authorities. The Secretary should now inform the Japanese that the US authorities will sell a dollar for every dollar that the Japanese authorities buy, to offset their intervention and return the yen-dollar rate to determination by market forces. The "theory of the second best" indeed calls for governmental distortions of markets to be countered by offsetting governmental interventions in the other direction. Even a suggestion to the Japanese that the United States was considering this course should suffice to dissuade them from further market intervention.56
The other major currency problem in East Asia lies in China. China pegs its currency to the dollar. Hence there has been no correction of the dollar against the world's most rapidly growing economy, which also holds the world's second largest hoard of foreign exchange reserves ($300 billion, despite its low per capita income of about $1000).
Moreover, because of its dollar peg, the renminbi has been "riding the dollar down" and falling against virtually all other currencies along with the dollar. China is already widely viewed as the world's most formidable competitor in many sectors and this decline in its currency strengthens its competitiveness further. This deters other major countries such as Korea, Singapore, Taiwan and even Japan from letting their currencies rise against the dollar. The essentially fixed peg of the renminbi to the dollar thus blocks, or at least severely limits, all of East Asia from playing its appropriate and necessary role in the global adjustment process. Under these circumstances, it will be very difficult to complete the required correction of the dollar and the needed adjustment of the US external imbalance.7
It is thus imperative that China let its currency start to rise in the exchange markets, to contribute directly to the needed US adjustment and to permit other East Asian currencies (including the yen) to rise more extensively as well.8 Secretary Snow has recently encouraged the Chinese to move in that direction. The G-7 should promptly join the effort to convince China to let the renminbi appreciate; the countries of Euroland in particular have a huge incentive to do so because only a much greater appreciation of East Asian currencies, which will occur only if the renminbi is allowed to rise, will take the pressure off the euro to continue its disproportionate climb against the dollar.
The first phase of the inevitable and essential correction of the exchange rate of the dollar has occurred smoothly and effectively over the past seventeen months. As a result, we can expect the US current account to improve over the next couple of years by $100 billion or so from where it would otherwise be. This is especially good news for the American manufacturing sector, which has been hit over the past three years by the "triple whammy" of weak domestic growth, weak growth in its foreign markets (where it sells about one third of its output) and an overvalued dollar.9
We now need a second phase of the dollar correction of roughly equal magnitude but significantly different composition. Much of the essential further fall of the dollar should occur against the currencies of China, Japan, Korea and other countries in East Asia rather than against the euro (though some further adjustment will be needed there too). Those countries, especially China and Japan, must change their policies of competitive undervaluation to permit such realignment to occur. The United States and the G-7 should attach the highest priority to achieving this change over the coming months.
1. This statement draws on C. Fred Bergsten and John Williamson, editors, Dollar Overvaluation and the World Economy, Washington: Institute for International Economics, February 2003, a compendium of thirteen papers by leading experts on the topic and an overview by the co-editors drawn from a conference hosted by the Institute in September 2002.
3. Media and market discussion of the so-called "strong dollar policy" is substantively irrelevant. No administration has ever defined the term nor taken steps to implement the concept. The dollar is in fact still quite strong against its historical averages while of course weaker than in the recent past.
4. This estimate was suggested during a recent discussion in Washington by former Japanese Vice Minister of Finance Eisuke Sakakibara, known as "Mr. Yen" while in office, and conforms with my own judgment.
5. Some analysts of Japan believe that a weaker yen is now appropriate in light of the weakness of the Japanese economy. This view underemphasizes the importance of the fact that Japan, despite all its problems, continues to run by far the world's largest trade surpluses (and that the surpluses are again rising, due in part to the fact that the yen is quite weak by historical standards). Moreover, exports account for less than 10 percent of Japan's GDP so Japan can only recuperate economically by addressing its wide range of severe domestic problems.
6. It would be desirable for this counter-intervention to take place by the other major financial powers as well as the United Sates, with approval from the International Monetary Fund in furtherance of the prohibition in its Articles of Agreement of manipulation of currencies "to gain an unfair competitive advantage."
7. A similar situation arose in the late 1980s, after the dollar had come down sharply against the other G-7 currencies after the Plaza Agreement, when the Asian NICs (Hong Kong, Korea, Singapore, Taiwan) also "rode the dollar down" and began to run huge external surpluses. The United States and G-7 then persuaded them to let their currencies appreciate and the second leg of that adjustment was successfully completed, cutting the US current account deficit to very low levels by 1990-91.
8. China stresses the importance of maintaining "a stable exchange rate" but in fact its peg to the dollar, which gyrates so sharply against all other currencies, assures it of an unstable trade-weighted rate. China would achieve greater currency stability by denominating the renminbi in a basket of currencies rather than the dollar (or any other single currency) and then letting the rate respond to market forces.