Financial Daily from THE HINDU group of publications
Monday, Oct 25, 2004
Columns - Global Finance & Overview
Dollar slide and the world economy
V. Anantha Nageswaran
After expressing his relative equanimity over the crude oil price, he dismissed concerns over the state of US household finances and that of the house price surge.
Of course, a small and easily readable research by the Federal Reserve Bank of San Francisco would not have escaped his attention. In its Economic letter No. 2004-27 (October 1), the San Francisco Fed researchers argue that the house price/rent ratio (equivalent of the price/earnings or price/dividend ratio for the stock market) in the US is high compared to its history and that, if history is any guide, such a high ratio usually reverts to the mean through changes in the price rather than through changes in the future stream of rental incomes.
In other words, home price/rent ratio can come down in line with historical averages either through a sharp correction or through a prolonged period of stagnation in home prices. If it does happen, it might just prod the typical American household to think of saving more.
Thus far, they have let the asset markets do their work first, it was the stock market and now the housing market while they splurge on goods that "they do not need with the money they do not have."
However, as long as interest rates remain low and asset markets firm, it is unlikely that US household savings rate would rise. Interest rates are likely to remain low because global economic and political environment is uncertain, the rising cost of energy is a drag on activity and demand rather than a catalyst for higher inflation and capacities in labour and goods are ample, globally.
Therefore, low interest rates would continue to exert a powerful inducement for consumption, setting households up for a very nasty surprise down the road. When that happens, the economy would suffer considerably. That is a different story. For now, it appears to be a risk scenario rather than a likely occurrence in the near future, unless the oil price continues to reach newer heights. It well might. New York Sweet crude oil ended the week on Friday October 22, at over $55 per barrel.
Further gains in oil price: Pre-condition for later lower prices
It appears that there is no reason for oil price to falter at this stage. It would and does come down if there is a severe economic slowdown. For that to happen, it has to rise sharply higher to cause one in the first place, before it falls. Otherwise, consumption shows no signs of faltering. But for the impact of the second oil price shock in the late 1970s, US import of crude oil has steadily risen and so has global consumption.
If not, then there should be some other shock to the global economy to cause a sharp slowdown/recession and drastically reduce demand for crude oil. Otherwise, given the short-term production, and distribution bottlenecks, rising demand would keep the price of crude oil on a rising trend.
American trade deficit climbs and the US dollar falls
With the price of crude oil climbing and the American consumer not tiring of spending, it was not a surprise that the American trade deficit for August was higher than what economists had expected. Indeed, one should expect persistently high (and rising) trade deficit.
This is being funded easily at the moment by foreign purchase of US securities both by official and private buyers overseas.
Standard and Poor's expects the current deficit to rise to 5.7 per cent of GDP next year. The author reckons that it would be 6 per cent. Whether or not such a deficit is easily funded, remains to be seen.
Given that the rest of the world has not flinched from buying US bonds even at lower yields, it is perhaps logical to assume that they would do continue to do so. After all, they do not seem to care for risk or compensating yield.
Either they expect American deflation or that they have other motives to buy. Asian government buyers seem to fall into the category of investors with `other motives'.
They lack the confidence or any rationale to revalue their currencies, as of now. That should continue to transfer the burden of bearing dollar weakness onto global major currencies as it has done in the last few years.
We shall see significant appreciation of global majors against the US dollar next year.
Further, given the weak fundamentals in Europe and elsewhere, their economies would be unable to accept currency strength beyond their own self-imposed tolerance levels.
They would resist through intervention, interest rate and other reflationary policies aimed at weakening their currencies or arresting their appreciation trend.
Consequently, gold will have to climb against all the currencies, including the US dollar.
Hence, in the unfolding US dollar correction, one has to place gold at the top of the list of alternatives that would appreciate against the greenback.
The trigger for a dollar recovery
However, there may be an eventual redemption for the US dollar. Should the oil price rise cause home prices to crash and, thus, eventually bring the American consumer to ponder the cost of their consumption habits, then it would usher in low growth for a few years. Consumption spending has driven the economy in these last few years.
When it slows down, the economy would be hurt. Hence, interest rates would stay low and so would corporate profits. Incidentally, it would also unravel the East Asian economic revival and the fundamental external underpinnings of the Chinese economy would also be exposed.
As equity and fixed income yields in the US stay low, the currency would remain weak. However, the rebuilding of American savings would eventually eliminate the fundamental imbalance in the global economy: American current account deficits and Asian current account surpluses.
Hence, when it is all over, it would offer the best buying opportunity for the US dollar. The example of the Sterling in the 1990s clearly holds out this possibility.
The collapse of the housing bubble in the UK in the late 1980s left many households poorer and caused their savings rate to rise from around 5 per cent of disposable income to around 12 per cent in the following four years.
Sterling collapsed during this period. Of course, the ill-timed and wrongly priced entry into the European exchange rate mechanism too played its part.
However, once the savings rate attained normal levels, Sterling stabilised and began to appreciate. The American dollar might well follow this path.
Profound implications for Asia
Nonetheless, this does not change the outlook for the US dollar for the next year or two. It has to be bearish. This would have profound implications for Asia.
Difficult times lie ahead for East Asia. The economic crisis of the 1990s has not caused a re-think of their economic strategy. They are more externally dependent than before. They would be vulnerable to a slowdown in the US economy.
India, on its part, has a golden opportunity to stamp its resilience on the global economic map. Its growth is not dependent either on FDI or on exports.
It should allow the currency to appreciate steadily and thus cushion the impact of the surge in oil price.
Furthermore, if the government pursues pro-growth economic policies, then India would be taken seriously automatically in the global arena.
(The author is founder-director of Libran Asset Management (PTE) Ltd, based in Singapore. His views are personal. Feedback can be sent to email@example.com)
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