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Forex debate: Does the US deficit matter?


SINGAPORE—Dollar bears have long argued a yawning current account deficit would send the dollar tumbling.

But as each month passes and the US deficit grows, analysts are debating if the current account really matters for the dollar.

Conventional wisdom among economists is that the dollar needs to fall sharply to put a brake on US overconsumption and head off a potentially painful adjustment when Asian central banks stop offering cheap funding of the current account deficit.

But some economists say obsessing about the current account gap, now around 6 percent of US GDP, is misplaced. They say Asia could keep its currencies undervalued for two more decades without creating major market instability as it follows a well-worn path of export-led industrialization.

J.P. Morgan currency strategist Claudio Piron said the theory that the US deficit will not guide the dollar tends to gain popularity whenever the US currency rallies.

“People talk about it. It’s out there as some kind of structural view and explanation for the dollar’s extended shelf-life,” he said.

The United States ran a record $166.2-billion deficit in the second quarter, or $1.8 billion a day. Much of Asia has a surplus that is used to buy US assets, mostly debt.

Economist Mieczyslaw Karczmar said the shortfall should not be seen necessarily as a problem for the United States.

“The deficit is a reflection of US strength, not weakness,” he wrote in a paper for Deutsche Bank Research. “The primary cause of US trade deficits is disparity of growth, with the US growing faster than most other industrial nations due to demographic and productivity factors.”

The dollar has weakened since 2002, notably against the euro, sterling and the Canadian and Australian dollars. The Federal Reserve’s trade-weighted index shows the dollar has fallen around 13 percent since early 2002.

Karczmar says that dollar decline was due mostly to low US interest rates, terrorism fears and signs the US government was not unhappy with a weaker currency.

But dollar moves against Asian currencies have been limited. Asian central bank buying of US assets to keep regional currencies undervalued and exports competitive has been blamed for preventing a dollar adjustment.

Asian central banks hold about $2.25 trillion of foreign reserves, almost double what they held at end-2001. To buy US assets, they sell their currencies, helping to prevent the dollar from falling.

New Bretton Woods?

Michael Dooley, David Folkerts-Landau and Peter Garber have argued in a series of papers published by the US-based National Bureau of Economic Research that Asia can fund the US deficit for many years.

Their case is that history shows that currencies can stay undervalued for long periods and they say Asia is merely replicating what Europe and Japan did after World War Two. Under the Bretton Woods system—named after the New Hampshire town in which it was formed in 1944—currencies were pegged to the dollar, which was pegged to gold. The currencies of Europe and Japan were undervalued to help promote growth.

The financial community is still skeptical.

Economists from banks such as Goldman Sachs and UBS have called the similarities with Bretton Woods superficial.

“In particular, the US now has a large and widening current account deficit rather than the surplus it ran during Bretton Woods,” wrote Goldman’s Michael Buchanan, a senior global economist.

Capital was flowing into the United States, he said. Before it was flowing out to help rebuild the war-torn countries.

In other words, the only thing holding the dollar up, these economists argue, is other countries’ readiness to buy US assets. And as there is no compulsion for Asia to invest in the dollar bloc, self-interest could make the system unsustainable.

Deficit drives growth

But Dooley and his colleagues see a structural US current account deficit as important if large developing countries are to grow out of poverty and create jobs.

In their model, it is to everyone’s advantage that less developed economies with lots of cheap labor have weak currencies to ensure they can export their way to prosperity and attract direct investment.

For example, they estimate China has about 200 million underemployed or unemployed workers. They calculate it could take between 12 and 20 years to create jobs for these people.

Until then, it is in Asia’s interests to fund the US deficit to fuel its own growth and develop its financial markets. “Even if governments weigh the same risks of financing net deficits as do private investors, governments also see benefits of accelerating their development strategies,” they wrote.

By John Mair, Reuters

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Today’s Front Page February 21, 2020

Today’s Front Page February 21, 2020