Sunday, April 29, 2007

Dollars and sense

Seven dollar myths

By Axel Merk

Without shying away from controversy, we do away with a number of myths of why the US dollar ought to move up or down.

Myth I: The dollar is safe because the
US has ample assets
Some say the US current-account deficit that requires foreigners to arrange for more than $3 billion of capital inflows every business day just to keep the dollar from falling does not matter. These pundits say a deficit of 6.5% of gross domestic product(GDP) is sustainable because the deficit is only about 1% of all private assets held in the United States; as a result, deficits could be carried a long, long time.

This argument is one about the dollar going to zero, an extreme case of the dollar losing relative to other currencies. However, the current-account deficit and its affect on the dollar are about cash flow: putting it in the context of GDP is reasonable, as GDP is a cash-flow measure of production. Comparing it to private savings is mixing apples with oranges.

Myth II: The dollar is doomed because
of the large US budget deficit
Just as dollar optimists are wrong to say the dollar is safe because of the United States' tremendous wealth, dollar pessimists are mistaken by putting too much emphasis on the budget deficit. By issuing debt, the direct impact of the budget deficit can be mitigated to the burden of interest payments. Of course, as interest payments become excessively large, they will weigh on the dollar eventually. However, the linkage to the dollar is indirect. While it is correct that large budget deficits structurally weaken the US in the long run, it is not appropriate to link short-term dollar movements to the budget deficit.

Myth III: A lower dollar will cure the trade deficit
All too often we hear how much more competitive the US would be if it only allowed the dollar to fall. While a weaker dollar may be a short-term boost to earnings and make exports a tad more competitive, it will not bring back industries that have been outsourced. It is most unlikely that the US will thrive on exporting shoes to China, no matter how low the dollar will fall.

What a weaker dollar may do is provide temporary relief. But unless the US turns into a society of savers and investors, a weaker dollar will only be a pause to an even weaker dollar as imbalances are built up yet again.

Myth IV: A lower trade deficit will save the dollar
Odds are that the current-account deficit may be close to its peak. However, that does not mean the dollar is out of the woods: if an abatement in the rate at which the current-account deficit deepens were due to a sustained improvement in savings and investments, it might have long-term positive implications for the dollar.

But it looks as if the driver behind any "improvement" (if one can talk of such as the deficit continues to widen) will be due to a drop in domestic consumption due to a slowing economy. Rather than being good news for the dollar, this discourages foreign investors to invest in the US. American chief executive officers focus their investments abroad, so why should foreigners invest in the US?

As the US economy slows and consumers can no longer extract equity from their homes, the savings rate ought to go up. Famous for having dipped into negative territory, consumers have to pare back their spending as access to easy money dries up.

Myth V: A weak economy causes a currency to falter
We agree that the US economy is heavily dependent on growth to keep the dollar stable. But it is a US-specific problem: in the current environment, it may not apply to the European Union. The key difference is that, in recent years, the EU has focused on structural reform rather than growth; as a result, it does not have the severe current-account deficit the US has. Should the world economy slow down, many markets may suffer, but the euro might still do comparatively well. Europe has plenty of issues, but as far as the euro is concerned, the region is in a very strong position.

In contrast, a reduction of foreign-money inflows into the US is the single biggest threat to the greenback. As a result, the dollar has been reacting negatively to any news signaling a slowdown of US consumer spending. And as consumer spending is closely linked to the fate of the housing market, negative data on housing may reflect negatively on the dollar. As the housing market is not very liquid, any adjustment process is likely to be long and grinding.

Myth VI: China is the problem
In our assessment, China is the most responsible player in Asia. We believe other Asian countries, including Japan, are willing to risk a destruction of their currencies to continue to export to American consumers. The Chinese are taking their imbalances very seriously and are working hard at addressing many issues facing a nation governing 1.4 billion people. Having invited Western investment banks to invest billions in their local banks has provided an encouragement for reform from within.

If there is one thing that spooks the currency markets more than a slowdown in US real estate, it is the flaring-up of a protectionist-talking US Congress. When presidential candidate Hillary Clinton recently expressed concern about the Chinese buying up the majority of US debt, the dollar fell sharply. If protectionist measures increase, foreigners will have fewer incentives to purchase dollar-denominated assets, providing pressure on both the dollar and interest rates.

Interestingly, nobody seems to focus on the fact that there is an unconventional solution to foreigners holding too much of America's debt: live within your means and do not issue debt. Such an old-fashioned concept would indeed strengthen the dollar. Unfortunately, none of the presidential candidates at either side of the aisle seem to have heard of this notion.

Myth VII: Higher interest rates help the dollar
It seems that ever since academics developed a theory of how interest-rate differentials move currencies, the theory has not worked. Yet just about every textbook continues to teach it. Aside from the fact that expectations on future interest rates and inflation are more relevant than actual interest rates, there are simply too many factors influencing currencies to be able to focus on interest rates. Why do some low-yielding currencies, such as the Swiss franc, perform reasonably well, whereas many developing countries have weak currencies despite high interest rates?

A good year ago, the US joined the ranks of developing nations in paying more in interest to overseas creditors than it receives in interest from its own investments. As a result, higher US interest rates mean higher payments abroad, further weakening the foundations of the US dollar.

There are many more myths about the dollar, but the selection above may provide some food for thought.

Axel Merk is the portfolio manager of the Merk Hard Currency Fund.

Original article posted here.


Ducky's here said...

"putting it in the context of GDP is reasonable, as GDP is a cash-flow measure of production. Comparing it to private savings is mixing apples with oranges."

I think there is meaning in looking at our savings rate. It is rather poor and if there were any slowdown in foreign purchases of dollars we are so heavily in debt that we don't have the savings to ride out the problem.

Da Weaz said...

I agree with you. This article is posted more to spur thought than a reflection of my own views regarding these "myths."