Why the dollar has to decline in the long term
The big joke back in 1995 was that soon there would be no US government bonds available for investment, given the country’s consistent fiscal surplus. The situation is the reverse today. The debt to GDP ratio of the US has crossed 100 per cent and is expected to continue growing.
This has resulted in weakening the fundamentals of the dollar. The greenback is currently afloat mainly with the help of the huge and growing surpluses of emerging markets, especially Russia and China, which have been flowing into US dollar reserves over the last several decades. The surpluses generated by countries such as China from their exports also flow into US Treasuries. The foreign exchange reserves of other developed countries such as Japan also are, to a great extent, invested in US Government securities.
Till the mid-nineties the current account deficit (CAD) of the US was in the range of around $100 billion with minor variations over the years. However, with the emergence of China as a low-cost manufacturing hub, manufacturing shifted out of the US and into China. As a result, the CAD ballooned from $120 billion to over $850 billion by 2006.
CAD as a percentage of GDP increased from 2 to 9 per cent. However, most of the surpluses that were being generated by the exporters also continued to be ploughed back into the US in the form of capital flows for buying its government bonds. As a result, China today holds nearly $1.28 trillion and Japan $1.13 trillion worth of US government securities.
The more shocking piece of statistic is that the total outstanding debt of the US has moved up from $8.8 trillion in 2007 to $16.7 trillion today. Of this the US Federal Reserve holds just $2.1 trillion acquired via its Quantitative Easing operations.
But the CAD and the fiscal deficit together account for 10 per cent of the GDP. This essentially implies that the US needs a funding of nearly $1.5 trillion incrementally every year. It is in this backdrop that I believe that the direction of the US dollar has changed for the worse and we will now see a continuous decline in the dollar over the next several years. The arguments for such a decline are many.
Decline of Fear
A large part of the US dollar strength since the year 2008 has been due to fear among investors caused by various events such as the financial crisis, the Euro Zone crisis, expected hard landing in China and lastly the run on the currencies of high-CAD emerging economies. However, the worst of these crises are now behind us. Euro Zone has stabilised, there is unlikely to be a severe slowdown in China and the run on EM currencies appears to have halted, too.
The position of the dollar as the reserve currency and US government debt as the risk-free benchmark has been established for several decades now. However the rapid deterioration in the US’ fiscal position and the huge growth in government debt over the last five years have made it a highly indebted country.
The US has remained afloat despite a high CAD and deficit only due to the dollar’s reserve currency status. Although there is no alternative today, there is likely to be a shift in the asset holding in currencies in the coming years. The current level of debt has become unsustainable for a country with a nominal GDP growth of 3-5 per cent. The tussle over the debt limit in such circumstances makes the debtor countries jittery. There is now a probability that as the confidence in Europe grows, there could be higher flows into Euro country bonds, given that they offer a higher yield, too.
No idea of Fed exit
The US Fed has expanded its balance sheet to a level where it is now holding $2.1 trillion of government bonds and over $1 trillion of mortgage-backed securities. These bond purchases have had the effect of keeping the cost of borrowing of the US government low and mortgage and general interest rates subdued.
A hint of an exit by the Fed from its bond-buying programme has already resulted in the yields on US gilts shooting up from 1.5 per cent to nearly 3 per cent. Given the level of US government borrowing, a 1 per cent increase in borrowing costs will increase fiscal deficit by over 1 per cent. A halt in balance sheet expansion and then contraction will create upward pressure on borrowing costs.
All these factors suggest that the dollar could be on a declining trend for the next several years. The fears of emerging currency declines post Fed tapering are vastly exaggerated. After the panic phase, I believe, the dollar will decline on a sustainable basis. The last wave of dollar decline resulted in the US Dollar Index falling from 120 in 2002 to 70 in 2008. The subsequent bounce-back saw it rise back to the 90 levels. The next level of decline should see the index move much below 70 levels.