A soaring US dollar poses risks for the world economy
Trump's presidency could make for troubling outcomes
In 1988, Donald Trump paid US$407 million (A$545 million) for New York’s elegant Plaza Hotel, which he boasted was the “Mona Lisa” of hotels. As a New Yorker, Trump would have known that over the years the Plaza had featured stars such as Lisa Minnelli and Peggy Lee and was the venue for Truman Capote’s renowned Black and White Ball in 1966. Given his business background, he was no doubt aware that three years before his purchase the luxury hotel had hosted a meeting that temporarily suspended the free-float of the US dollar.
Another way of looking at the so-called Plaza Accord that came from the gathering of the finance ministers of France, Japan, the UK, the US and West Germany in New York in 1985 is that it’s still the biggest attempt to massage the US dollar since it was floated in 1973. (There have been other efforts, most recently in 2011.) In 1985, the currency was considered overvalued after it soared 44% over the preceding five years and global policymakers were worried that the resultant widening of the US trade deficit could force Washington to hinder imports. The G-5, as the countries were known, agreed for their central banks to intervene in forex markets to lower the US dollar against their currencies over the next two years.
A similar challenge confronts policymakers today though there is no uniform consensus on what should be done. The greenback has rallied more than 27% from its 2013 lows on a trade-weighted basis to a 14-year high and many countries appear content to let the US dollar rise because it helps their exporters. For Trump, however, the higher US dollar may undermine his core political promises. These are his pledges to reduce the US trade deficit, restore manufacturing, create millions of jobs and double economic growth to 4%. If, as expected, a higher US dollar widens the US trade shortfall, which widened to a four-year high of US$502 billion in 2016, and trims US economic growth, pressure will mount on Trump to subvert the free trade that he says rips off Americans and sucks jobs out of the US. Thus, a high US dollar could conceivably trigger radical US policy changes that could damage the world economy and cause upheaval in investment markets.
To be sure, the US dollar is rising for fundamental reasons and, unlike in 1985, is not considered overvalued. As with any currency, it could weaken at any time. (A widening trade deficit, for starters, places downward pressure on a currency.) Even if the US dollar stays strong, a burlier greenback carries advantages for the US, which is why US officials have favoured a strong currency since the mid-1990s. A rising currency, for example, trims inflation and allows the Federal Reserve to keep the cash rate lower than otherwise. (Lower inflation, though, makes it harder for Janet Yellen to ‘normalise’ interest rates so as to have ammunition to fight the next downturn.) A rising US dollar encourages foreigners to buy US Treasuries, which helps lower long-term US interest rates, because they are confident of avoiding currency losses. The lower US interest rates go, the more chance any Trump stimulus has to work. An elevated US dollar means US living standards are rising because imports are cheaper. A sturdier currency can bolster a country’s morale, which can ease domestic political tensions and aid the economy. Trade effects from currency movements happen slowly so any threats from a higher US dollar aren’t necessarily immediate. But, politically, consequences can move swiftly. The US-based losers from a higher US dollar will project more voice than the silent majority of winners. A regular release of US trade numbers that shows widening trade deficits, especially with China, could prove politically volatile because they would reveal the limitations of Trump’s economic policies. The political, economic and investment implications could be vast.
Strength to strength
The US dollar, over the four years to February 1, has climbed 27% against the euro, 25% against the UK pound, 24% against the yen and 38% against the Australian dollar for numerous reasons. Overarching these causes is the fact that the currency is free to respond to market forces – whereas most currencies aren’t. It’s worth pondering that nothing says Washington must leave the value of the US dollar at the mercy of supply and demand.
The foremost driver of the US dollar in recent years has been the US economy’s better performance, which has interest-rate differentials widen in favour of the US. Another fillip for the US dollar is the drop in the US current-account deficit to about 2.5% of gross domestic product from a peak of 5.8% in 2006 due to the shale revolution and the export success of companies such as Apple. The current account is the widest measure of a country’s trade in goods, services and money, and any reduction in the deficit releases a brake on a currency.
Another boost for the currency comes from the alluring investment status of the US and its currency. When investors are upbeat they seek US stocks (even though a strong US dollar reduces the US-dollar-value of foreign earnings of US companies). When investors are jittery, they turn to US bonds for their haven status. Other reasons for the strength of the US dollar relate to weakness of other currencies. This year, for instance, the US currency has touched a 31-year high against the pound due to the uncertainty about the UK’s divorce from the EU.
The outlook hints at a higher US dollar, if investors think that under Trump the US will run a looser fiscal policy and a tighter monetary policy, essentially the ingredients of the US dollar’s strength in the mid-1980s.
A stronger US dollar poses problems for the world economy. First, it hampers the trade performance of emerging countries because they mostly link their currencies to the US dollar. It does this by making their exports less competitive and by reducing the price of their commodity exports that are quoted in US dollars (generally all of them). Commodity prices slide as the US dollar rises because they are less affordable in other currencies.
Second, a higher US dollar worsens the creditworthiness of those emerging countries whose banks and companies borrow in US dollars but are repaid by their borrowers in local currency. This currency mismatch, which sees bank liabilities increase as the US dollar rises, could jolt financial systems in the emerging world. The Bank of International Settlements estimates that cross-border claims in the emerging world stood at US$3.6 trillion at 30 June 2016. On the brighter side, a higher US dollar, via steeper import prices, helps the eurozone and Japan escape deflation.
The paramount issue of the rising US dollar, however, is how Trump will respond if his core pledges threaten to unravel. His first option is to do nothing. This might be Trump’s best path if the strong US dollar reflects a thriving US economy and wages are rising, because voters won’t care too much about trade deficits. This option has the advantage of no unintended consequences. But if the economy is struggling as the trade deficit widens, Trump might be forced to act given his statements that trade deals “rape” the US.
A second possibility for Trump is to break with protocol and talk down the US dollar. Trump certainly tried this option in January when he said that “our dollar is too strong” and it’s “killing us”. The trouble with such remarks is that they can have minimal or only fleeting or even perverse results. They are only effective if forex dealers think they herald massive government intervention. That leads to the option of another Plaza Accord. But this requires international co-operation from probably the G20 countries that could be hard to marshall. Even if such a co-ordinated effort were achievable, it could be ineffective or, to the other extreme, its outcome could be difficult to control. The Plaza Accord of 1985, for instance, was followed by the Louvre Accord two years later to arrest a slide in the greenback that was hurting Japanese exporters in particular.
Then there are radical options that spring from the unpredictable nature of Trump’s presidency. Some people worry that he could pressure the Fed hold back on rate increases to curtail the US dollar’s ascent. Another course would be for the US to unilaterally intervene in forex markets to lower the US dollar, a de facto suspension of the currency’s free float. While Trump could claim past G7 communiqués allow this, the danger is that he could start a currency war that could morph into a trade war – when protectionist measures are explicit rather than implicit via currency movements. Given that forex turnover is estimated to be 10 times what it was in 1985, it wouldn’t be easy for the US Treasury to lower the US dollar unilaterally to a targeted level, especially if the Fed were to take action to reduce the extra amount of US dollars in circulation after Washington sold US dollars. Trump, of course, could hassle the Fed if it were to conduct such ‘sterilisation’.
Trump’s most effective way to ensure better growth and trade outcomes for the US might be to take protectionist steps under the legal authority a US president already possesses. While a trade war with China (and others such as Germany and Mexico) would probably be one of the most unwanted outcomes of a Trump presidency, it might reduce Trump’s trade problem for a time. There would be no Plaza-like elegance in the longer-term aftershocks.
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