Thoughts on the Dropping Dollar
Here were my opening (pre-edited) thoughts:
Years from now, history students may wonder why the anxiety the U.S. current account deficit and the dollar’s path once provoked. Or, they might date the beginning of a long slide in the dollar’s value — and resulting macroeconomic turmoil — to late 2006.
I’ve written in other places why a slide in the dollar might be troubling. But to begin with, it might be useful to discuss why the dollar is declining now. In my view, the key reason for the recent decline is a plain-vanilla interest differential story. With the U.S. economy softening considerably in the fourth quarter, money and currency market participants — rightly or wrongly — see the Fed reducing the target federal-funds rate in the coming year. Combine this with an European Central Bank perceived as hawkish on inflation, and the stage is set for a widening real interest differential in favor of the euro. Over the short horizon, interest rates are a key determinant of the attractiveness of a currency, since investor returns expressed in common currency terms typically rise with rates.
About three weeks ago, in the space of a few days, the dollar lost 1.6% of its value against other major currencies. Even now, the dollar is roughly at the same value as it was after the drop. Against a broader basket of currencies, the drop was about half that, but market volatility suggests the dollar is sensitive to revisions in expectations. I think observers are nervous because they are wondering if a dollar decline will trigger a more fundamental set of moves on the part of central banks and other quasi-state entities — in terms of holdings — and on the part of private actors like hedge funds. The importance of hedge funds, combined with the rapid expansion of derivatives markets injects a heightened degree of uncertainty into the current situation.
In other words, while investment bank and professional forecasters are predicting a slow and steady depreciation of the dollar over the next year, a sharp move in the dollar might push the system over a tipping point so that a much more discontinuous decline occurs. If market participants are myopic, that provides yet another scenario for a big drop. On the other hand, this precarious balancing act of the dollar has proven far more durable than many observers had believed possible, and so may survive this challenge.
Here’s an excerpt from Kash:
I think you’re exactly right, Menzie. What is really worrying is the size — in absolute terms — of the adjustment needed to the U.S. current account balance. Still, it’s important to remember that the consequences of a rapid dollar decline could also be severe for the rest of the world, especially in emerging markets.
This may particularly be the case for the 800-pound gorilla in the room: China. If the dollar plummets rapidly, the Chinese central bank (PBOC) would suffer massive capital losses on its more than $1 trillion in reserves. In addition, the real Chinese economy would suffer a dramatic to its massive export sector.
That’s why I’m actually relatively sanguine about the possibility that foreign central banks could trigger a sudden dollar decline simply out of a desire to diversify their porfolios; I think that the PBOC and other central banks around the world, such as the Persian Gulf countries, have too much depending on a stable dollar. Instead, what worries me is the possibility that private investors around the world would decide to dump dollars, presumably because they foresee capital losses due to an incipient decline in the dollar. Perhaps myopically, international investors don’t act like they expect those capital losses right now. But at some point they might.
While not exactly disagreeing strongly, I expand the area of anxiety thus:
China clearly doesn’t have an interest in seeing the dollar decline quickly. So I’m certain that — in part — explains why the PBOC is tightly managing the yuan’s appreciation against the dollar. But even if PBOC and other holders of large dollar reserves don’t want the dollar to depreciate rapidly, they also don’t want to be the last one out the door. That’s why I view the current equilibrium as balanced on a knife’s edge. Any decline in the dollar might be enough to prompt some central banks to try to diversify their holdings. The big question will be how China will respond once the dollar decline takes off.
So, while I used to worry a lot about China, now I worry a lot about China and the oil exporting countries. As Brad Setser points out, the oil exporters of the Persian Gulf maintain a much more rigid peg against the dollar than does China. The pace of reserve accumulation is certainly of a comparable magnitude, and when one adds in Russia, the oil exporters probably weigh more heavily in this dimension.
You can read the whole discussion at the Wall Street Journal’s free link, and add your own thoughts on these issues either in the comments section here or at the Wall Street Journal’s discussion board.