The latest currency war may just be a skirmish
To understand why, we have to go back even further – before the global pandemic, before the European debt crisis, before the global financial crisis – to the early 2000s, when global monetary policies were calibrated on real economic fundamentals rather than prevent economies from collapsing. At the time, one of the main drivers of exchange rates was the US current account deficit, and the dollar rose and fell steadily depending on whether the deficit contracted or expanded. Admittedly, this measure is not on par with unemployment or inflation. when it comes to economic importance, but it is essential for the foreign exchange market because by including investment flows in addition to exports and imports, it is the broadest measure of trade. And 20 years ago, the deficit was growing rapidly, from around $50 billion near the end of the last century to over $200 billion in 2005. As a result, the United States needed to attract billions of dollars per day to fund the deficit. Naturally, this had a negative effect on the greenback, with the US dollar index plunging around 33% between July 2001 and the end of 2004.
The current account deficit improved steadily from then on, but the pandemic hit and global trade was disrupted. The shortfall rose from about $100 billion at the end of 2019 to $291.4 billion at the end of the first quarter, the U.S. Commerce Department said Thursday. At 4.8% of gross domestic product in current dollars, the deficit has returned to the level of the period when the dollar was depreciating rapidly.
All of this wouldn’t matter much if the United States were attracting more and more foreign investment to finance the deficit, but that may not be the case anymore. The Treasury Department said last week that foreign holdings of US Treasuries fell nearly $300 billion in the first four months of the year. Although the amount is only a small fraction of the $23.3 trillion in outstanding marketable US government debt, and foreigners still hold some $7.4 trillion of it, it is the direction that matters. Then there are the Federal Reserve’s holdings of treasury bills on behalf of foreign central banks and sovereign wealth funds. This account has grown from $3.13 trillion at the start of 2021 to $2.99 trillion recently. Again, not a huge amount, but the steering is concerning. Perhaps most worrying of all, however, is the erosion of the dollar’s status as the world’s premier reserve currency. Although the International Monetary Fund estimates that the greenback represents 58.8% of global foreign exchange reserves, this is down from a peak of 72.7% in 2001 and the lowest percentage since 1996.
Demand for safe-haven assets amid the pandemic and rising relative interest rates have certainly supported the US currency, with the dollar index up around 17% since the start of 2021. This has exerted enormous pressure on other currencies. For example, the Bloomberg Euro Index fell 10%; the Bloomberg British Pound Index is down more than 7% since May 2021; The Japanese yen plunged 20%; the MSCI EM Currency Index is down 4.61% since the end of February alone.
Certainly, a weaker currency brings certain advantages. On the one hand, it makes a country’s exports more affordable. But that hardly matters when global trade volumes are still incredibly depressed due to supply chain disruptions. Additionally, officials are generally more concerned with the speed of currency movements, which can disrupt an economy as businesses have little time to adjust. As noted by my Bloomberg News colleagues Amelia Pollard and Saleha Mohsin, Isabel Schnabel of the European Central Bank highlighted a chart in February showing how much the euro had weakened against the dollar. The head of the Bank of Canada, Tiff MacKlem, then lamented the decline of the dollar of this country. Swiss National Bank President Thomas Jordan then hinted that he would like to see a stronger franc.
In the case of the United States, a weaker currency could further reduce the incentive for foreign investors to buy dollar-denominated assets, making it difficult to finance record budget and trade deficits. This could mean higher borrowing costs for government, businesses and consumers. It’s been two decades since the US current account deficit boosted global money markets, but that could be about to change, and in a big way.
• Dollar downtrend just beginning: Stephen Roach
• Why the dollar is stronger than it looks: Richard Cookson
• US debt is massive, growing and under control: Gary Shilling
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Robert Burgess is the editor of Bloomberg Opinion. Previously, he was Global Editor of Financial Markets for Bloomberg News.
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