USA Trade Deficit & Dollar Strength

How trade deficits influence exchange rates

By Esther van Luit

Alan Greenspan (former FED Chairman)

“It seems persuasive that, given the size of the U.S. current account deficit, a diminished appetite for adding to dollar balances must occur at some point.“ (2004)

Paul Volcker (Former FED Chairman)

“There is a 75% chance of a currency crisis in the United States within five years.” (2004)

The Dollar: an overview of 2004 & 2010

• The dollar's value: exchange rates, Treasury bonds and the amount of dollars held by foreign countries.

• Top: 144 in 1985.

• Compare to 2010: 77.

Dollar strength measurementsExchange rates Treasury Bonds

• 2002 - 2008 - The dollar fell 40% as the U.S. debt grew 60%. In 2002, a euro was worth $0.87 vs $1.27 in August 2010.

• 2008 - The dollar strengthened 22% as businesses hoarded dollars during the credit crisis.

• 2009 - The dollar fell 20% thanks to fears about the $13 trillion U.S. debt.

• 2010 - The dollar rose 17% against the euro (Jan -June) due to the weakness of the EU's economy. Decline from August.

• High demand= low yield=strong Dollar

• Prior to 2008, the yield stayed in a range of 3.91% - 4.23%, indicating a stable dollar demand.

• 2008 - The yield dropped from 3.57% to 2.93% , indicating strong dollar demand.

• 2009 - The dollar weakened as the 10-year bond yield rose 52.6%, from 2.15% to 3.28%.

• 2010 - The dollar strengthened 22%, as the 10-year Treasury bond yield fell from 3.85% to 2.99%.

Relation Trade Deficit & Dollar Strength

What determines the strength of a currency on the FOREX?

•Interest rates •Inflation•Terms of Trade•Political stability & Economic

performance•Current Accounts Deficit•National Debt

Interest rates• Interest rates, inflation and exchange rates are highly correlated

• High interest rates attract capital, but also curb consumer spending and borrowing.

Inflation

• Low inflation typically goes with a strong currency, since it performs better than high inflation countries.

• The USA has a fairly low interest rate, especially since the last crisis

Terms of Trade, Political stability & Economic Performance

• Terms of trade = ratio comparing export prices to import prices.

• High terms of trade= high demand for country’s export goods…high demand for currency.

• USA: since 1960 deterioration. Terms of trade became stable in 2003. Relatively low.

• Stable countries attract money. The Dollar is the global currency and therefore attractive.

National debt (government)

• Accumulated U.S. National debt: $ 13,7 trillion Dollar

• Americans are adding $ 4.16 billion Dollar per day to the national debt.

• National debt 2010=98% http://www.usdebtclock.org/

http://www.economist.com/blogs/newsbook/2010/08/government_and_private_debt_after_crisis

Total debt Total debt all U.S. sectors:$54.7 trillion, 296% of GDP.

Based on 2010 paper McKinsey Global Institute: Debt & Deleveraging: The global credit bubble and its economic consequences.

The current account is the sum of the exports minus imports, net factor income and net transfer payments.

Over-import = excess demand for foreign currency. This lowers country’s exchange rate untill foreigners buy.

US Trade deficit grows in times of expansion. Recession has caused major shrinkage of the trade deficit. See 2008.

Current Accounts deficit

Current Account deficit

• Per day:Americans spend $1.8 billion more dollars abroad than come into the country (2004)

• Per year (2004):$ 660 billion = China’s total imports 2005!!!

Conclusion 1• Political stability, economic performance, inflation, terms

of trade and interest rates have remained relatively constant over the past years, in regard of the crisis.

• Therefore, the weakness of the Dollar must be due to public debt & current account deficits.

• As they increase, Dollar weakens.

Funding of the debt

•USA is funded by trade-surplussers China, Japan and OPEC, and the UK (negative CA).

• China & Japan invest in Treasury Bonds to remain competitive. Both 20%

• UK = newcomer. x4 Treasury Bonds in 2009. 9%

• OPEC buys bonds to offset dollar devaluation or raise oil-price. 5.5%

What’s to fear? An increase in Current Account deficits by

• Consumer abandons Dollar, switches to Euro▫ Results in low demand for Dollar, USA will no longer be able to finance its imports, FED

raises interest rates to attract capital and Dollar weakens even further.

• Chinese, Japanese, UK, OPEC stop buying Treasury Bonds▫ Money no longer flows back to USA via bond purchases, FED needs to raise interest rates

and Dollar weakens. 2009: China sells 180 billion on bonds. 2009: Japan faces 200% national debt and may stop buying bonds. UK already has negative current account balance.

• OPEC stops raising oil price or switches to Euro▫ Oil is priced in Dollars. As Dollar devaluates, OPEC raises price to stabilize their revenues.

Venezuela and Iran both advocated in 2009 to switch to Euro.

The consequences of a weak Dollar

• Debt value devaluates. Accusation by foreign creditors.

• USA becomes more competitive. Exports up.

• Oil prices up.

• Imports for USA expensive, diminish consumer spending & driving up the trade deficit in case of petroleum.

• Investors move out of Dollar reserves, since value is declining.

• Terms of Trade deteriorate.

• Inflation up, consumers pay the price.

• Ultimately slows USA Economy

Conclusion 2: Dollar collapses?

•NO▫ Slow decline:

Safe harbor currency Global currency Oil currency Holders of US bonds trade with USA. Euro is not at true value

▫ Replacement by Euro? Euros held in reserves increased from $393 billion to

$1.25 trillion in 2008-2010.

Will the Euro replace the Dollar as global currency?

• In 2007, former FED Chairman Alan Greenspan argued that the Euro could replace the Dollar as a global currency.

▫Central banks hold (2009) 27% Euro vs 62% Dollar

▫Cross-border transactions done (2009) 40% in Euro vs 41% in Dollar

▫EU = largest economy in the world (GDP PPP 15 trillion), but 2015/2016 China

Ben Bernanke (current FED Chairman)

Thursday, November 4th 2010:

QE2: The FED will buy Bonds for $ 600 billion to speed up US economy and avoid the fate of Japan: a lost decade of economic progress.

QE1 failed (1.7 trillion, 2008)