The dollar hit a new low against the euro yesterday, and at around $2.05 to sterling it is pretty weak here too. So how far will it go? And does it matter if the dollar decline really gets going?
At an individual level, the fall has resulted in a strange reversal of the relationship between Britons and Americans. We go to the US and feel rich; they come here and feel poor. I was talking to some young American bankers last week who said their London colleagues were really hurting: though their salaries were paid in sterling, their bonuses were calculated in dollars. I nearly said "poor dears", but thought better of it.
But the impact on US bankers in London, or UK holidaymakers in Florida, is less important than that on the world economy. The dollar is already at a level low enough to start to correct the chronic US current account deficit, with exports rising faster than imports – but that may not stop it falling further.
Currencies usually overshoot their long-term sustainable levels, and if the dollar does fall a bit further, it may be no bad thing. It would force a faster adjustment in the US, with consumption being held down and exports driven up. But the deeper the decline, the greater the danger of global disruption and damage to the world economy.
So what, on the balance of probability, is going to happen? The best starting point is the familiar one: US indebtedness. This is already on such a scale, the surprise is not that the dollar is weak but rather that it hadn't weakened sooner. You can see what has been happening to the dollar and the current account in the two charts. From 2000 to 2003, the current account was in pretty poor shape (though not quite as bad as last year) but the dollar was still strong. The attractions of the US as a place to invest brought in enough funds to offset the deficit. That has now changed for, I think, four main reasons.
The first is that prospects for the US economy have deteriorated. There is a great debate about the risks of recession next year, the action the Federal Reserve will take to reduce this risk, and the consequences of that. Given what has been happening to the US housing market, it is surprising demand has held up as well as it has, but it does take a lot to stop Americans shopping. Whether or not there is an actual recession, there is no doubt there will be somewhat slower growth. That would not be a disaster and the Fed is expected to cut interest rates soon to check the downturn. But obviously an actual recession would hit company profits and undermine the support they have given to shares.
The second reason is the scale of the disruption in financial markets caused by the sub-prime mortgage scandal. Foreign investors had assumed a reasonable level of competence in their US advisers – that these people knew what they were doing. Their faith has been seriously dented and, as a result, other potential investments are being scrutinised with greater scepticism. Those who have lost money on exotic bets are going to be more careful in the future.
The third reason foreigners are downgrading the US as a place to invest is that the alternatives seem much more attractive. I was at an investment conference in Bahrain last week and much of the interest there was in Asia. One obvious spur is the calculation by the IMF that this year will be the first in which China adds more demand to the world economy than the US does. America still has advantages in the scale and transparency of its markets, and on some measures, US shares offer better value than Chinese or Indian ones. But money will seek to chase growth and growth is in Asia.
Finally, there is a shift in official attitudes to US investment, as well as the private sector ones noted above. Many countries in Asia and the Middle East either have or are setting up sovereign investment funds, which aim to invest a country's cash in a wider range of assets. In addition, official reserves are being diversified out of US Treasury bills and bonds and into other currencies and investments. That is one of the reasons why the pound has been so strong: diversification out of the dollar. The sovereign funds take this to a further level.
I don't think Americans understand quite how vulnerable they have allowed themselves to become. The capital inflows have been so large for so long that what to the rest of us looks like a problem does not seem to to matter to them. That is understandable. If money keeps coming in, why should it suddenly stop? Well, there has been a good example in recent weeks of just such a change in sentiment – in the gumming-up of the money markets. Northern Rock relied on the premise that it could keep borrowing from the markets to maintain faster growth than would be possible if it had to get most of its money over the counter at its branches. I am not saying the US is in a Northern Rock situation yet; just that markets are fickle creatures and I don't think the US financial model – borrow 6 per cent of your GDP from the rest of the world each year – is any more sustainable than the Northern Rock one.
So what will happen? On the balance of probability, the dollar will be pretty weak for the next three years, maybe longer. And there is a chance, which I would put at evens, of a sharp further decline in the coming months. If that were to happen, there would be a string of consequences. The headline price of oil, and other commodities denominated in the dollar, would shoot up. Many of the countries that still keep a dollar peg, such as those in the Gulf, would move the peg to a basket of currencies – Kuwait has already done so. Central bank reserves would be further diversified, particularly into euros. Indeed, the dollar would stop being a special currency, losing much of its international role.
Maybe we won't quite reach that point. But if we do, well, it would be a shock for which the United States would be completely unprepared.Reuse content