Globalization and Financial Globalization and Financial Stability:Stability:

The US DollarThe US Dollar

Assaf Razin, Tel-Aviv UniversityAssaf Razin, Tel-Aviv University

Summer 2008Summer 2008

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Variety of Crises

2

Asia

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An Historical Perspective

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Sovereign Debt Default Through Inflation

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Currency Crises and Inflation Crises Travel Hand in Hand

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Housing, the Sub-prime Mortgage Market, and the Financial Turmoil

The U.S. economy experienced a mild recession in 2001. During the ensuing recovery, above-trend growth was accompanied by

rising rates of resource utilization, particularly after the expansion picked up steam in mid-2003. Unemployment rate declined from a

high of 6.3 percent in June 2003 to 4.4 percent in March 2007

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Residential Property Prices

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US Economy in 2007

The economy continued to perform well into 2007, with solid growth through the third quarter and

unemployment remaining near recent lows. Indicators of the underlying inflation trend, such as core

inflation, showed signs of moderating.

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US Housing Market

A sharp and protracted correction in the U.S. housing market followed a multiyear boom in housing construction

and house prices. Indicating the depth of the decline in housing, according to the most recent available data,

housing starts and new home sales have both fallen by about 50 percent from their respective peaks.

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Although sub-prime borrowers and the investors who hold these mortgages are the parties most

directly affected by the collapse of this market, the consequences have been felt much more broadly.

On the way up, expansive sub-prime lending increased the effective demand for housing,

pushing up prices and stimulating construction activity. On the way down, the withdrawal of this

source of demand for housing has exacerbated the downturn, adding to the sharp decline in new

homebuilding and putting downward pressure on house prices. The addition of foreclosed properties

to the inventories of unsold homes is further weakening the market.

The Action of the Fed

To help address the significant strains in short-term money markets, the Federal Reserve has taken a range of steps. Notably, on August 17, the Federal Reserve Board cut the discount rate--the rate at which it lends directly to banks--by 50 basis points, or 1/2 percentage point, and it has since maintained the spread

between the federal funds rate and the discount rate at 50 basis points, rather than the customary 100 basis points.2 The Fed also adjusted its usual practices

to facilitate the provision of discount window financing for as long as thirty days, renewable at the request of the borrower

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Two Shocks

•In essence, the global economy has received two shocks in the past 12 months—the credit crunch and higher commodity prices.

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Monetary tightening?

•After the Fed's rapid, pre-emptive loosening to a federal funds rate of 2%, is it going to ?tighten

If the ECB tightens and the Fed does not, the

Will weaken against the Euro Dollar

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The euro zone has a stronger economy but much tighter

monetary conditions

•Falling odds of a financial-market catastrophe and inflation uncomfortably high (and set to rise higher) the balance of shocks is shifting

(the ECB has kept short-term rates unchanged at 4% throughout the credit crisis)

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Oil Price

The developed economies consume a disproportionate share of the world's energy, with North America and Europe accounting for about half of the total

oil use in 2006. However, it is the newly industrialized countries and oil producers that account for the recent rapid growth in demand, with Asia and the Middle East accounting for 60% of the increase in petroleum use between 2003 and 2006. North America and Europe contributed only 1/5 of the growth.

In June 2008 the oil price reached $ 138 per barrel

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Oil Price Surge

Oil price surged after Iraq’s invasion to Kuwait, this has largely reversed a

year later after the Iraq’s defeat in the first Gulf war

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China’s Oil Consumption

Particularly dramatic in this growth in oil consumption has been China, whose petroleum consumption between 1990 and 2006

increased at a 7.2% annual compound rate. It's always amusing to project these impressive exponential growth rates. If that rate of growth were to continue, China would be using 20 million barrels a day by 2020, about as much as the U.S. is today. By 2030, China

would be up to 40 mb/d, twice the current U.S. consumption.

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China’s Growth Rates

•For the past twenty years China has achieved a growth rate averaging nearly 10 percent a

ear. China’s today ranks the fourth largest

economy in the world in terms of GDP.

Factors contributing to growth are: 1. increasing openness in trade

2.High rate of capital investment.

3 .A strengthening of the educational system

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Three historical precedents

•The Japanese Deflation(Mid -90s)•The US recessions of 1990-91 and 2000-02•Three exogenous shocks played a role in each: 1)an oil

price surge (disrupting production and taxing consumption)

•2 )An asset price correction, in real estate and equities (reducing consumption through a “wealth

effect”)•Impairmaint of financial institutions’ balance sheets

(reducing credit)21

Assets’ Price Correction: Japan vs. the US

Asset price correction in Japan has been several order of magnitude

larger than the current shock in the US

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The saving and Loan Crisis of the Late 1980s—the macro economic

effects are hinged on the extent to which financial institutions need to

reduce balance sheets ant recapitalize their assets.

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The Dollar Decline

Optimists see the dollar's fall as part of a necessary rebalancing of the world

economy. Without a change in exchange rates, the US current account deficit is on an explosive path. It could widen from its current 5-6 per cent of US gross domestic product to 8 per cent in 2008 and 12 per

cent in 2010 .

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AdjustmentsAs the dollar falls, there is an

upward pressure on US import prices and more inflationary

pressure generally. In response, the Federal Reserve will have to raise

interest rates faster than currently expected. Higher interest rates will make borrowing more expensive

and slow investment growth .

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They is a negative impact on asset valuations, including house prices. US

households, no longer living off capital gains, will have to start saving again. With

investment down and saving up, the current account deficit will narrow. A significant

decline in both consumption and investment will mean a recession in the US.

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Can Dollar loses its status as a Reserve Currency? At present,

foreigners’ desire to hold dollar cash and bonds as a store of value allows

the US to finance its debt at low cost. A loss of that status would mean a

permanent loss of wealth for the US.

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Oil Producers’ currency pegs stick

Gulf states’ Policymakers – barring Kuwait, which revalued its currency last year – have struggled to defend their currencies’ pegs to

the dollar. Rising inflation has stoked expectations of revaluation, encouraging

speculative inflows. These, added to huge oil revenues for many states, have fed domestic

liquidity .28

•As a result bank lending to the private sector, where demand for credit is already high

thanks to negative real interest rates, is up. Booming credit growth has fuelled domestic

demand, and thus inflation. The vicious circle has been reinforced by rate cuts in the US,

which have forced GCC central banks to reduce domestic rates.

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US Twin Deficits

deficits of this magnitude are not something that foreigners would willingly

finance, especially in so far as they reflected chronic budget deficits rather

than high levels of private investment .30

Why the US saving rate is so low?

•The federal government is consuming at roughly twice the rate it did a decade ago, as a

share of national income .

•Among households the group whose consumption has increased the most rapidly is

the elderly. Since 1960 average consumption•per oldster roughly doubled relative to

average consumption per youngster.

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Who is paying for the growth of the consumption of oldsters?

•Answer, in part, is US government.

•Medicare and medic aid(majority of it goes to elderly)

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U.S. Current Account Deficit (% of GDP)

1.5

4.2 3.9

4.95.7

0

1

2

3

4

5

6

mid-90's 2000 2001 2003 2004

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The US current account deficit was a record$666 billion in 2004;fully two-thirds of

global net foreign lending:

Global imbalances

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US net external Assets turn negative:Short term liabilities exceed corporate stock and direct Investment on the assets side.

• The current account deficit is The current account deficit is bridged by bridged by foreign lendingforeign lending of two of two sources:sources:

• FirstFirst, European investors: attracted , European investors: attracted to the US higher producivity to the US higher producivity business. Despite low levels of business. Despite low levels of interest rate, the Dollar depreciation interest rate, the Dollar depreciation against the Euro created against the Euro created expectations for a subsequent expectations for a subsequent appreciation ( remember Rudi appreciation ( remember Rudi Dornbusch’s overshooting theory?):Dornbusch’s overshooting theory?):

The Turning Point: The Price of US Dollar in

Euros

1.2

0.8

0

0.2

0.4

0.6

0.8

1

1.2

1.4

spring-01' winter-03'36

• SecondSecond, Asian countries’ fixed and , Asian countries’ fixed and managed exchange rate regimes, managed exchange rate regimes, resulted in a massive US Dollar resulted in a massive US Dollar purchase:purchase:

• Japan’s Japan’s foreign-exchangeforeign-exchange intervention policy intervention policy in currency trade, to avoid the in currency trade, to avoid the appreciation of the Yen, yielded appreciation of the Yen, yielded accumulation of $450B between 2000-accumulation of $450B between 2000-2004.2004.

• ChinaChina’s formal rigid exchange rate (8.28 ’s formal rigid exchange rate (8.28 RenminbiRenminbi to the to the DollarDollar) required the ) required the purchase of $275B at the relevant purchase of $275B at the relevant period.period.

• In 2003 alone, the combined official In 2003 alone, the combined official reserves’ purchased of China and Japan reserves’ purchased of China and Japan amounted to $350B, equal to 64% of the amounted to $350B, equal to 64% of the entire U.S. current account deficit!entire U.S. current account deficit!

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• What is the Asian motivation for What is the Asian motivation for accumulating so many Dollars?accumulating so many Dollars?

• First, the credit dry up in the Asian First, the credit dry up in the Asian Financial crisis of 1997-1998, induced Financial crisis of 1997-1998, induced government will to rebuild a government will to rebuild a precautionary “war chest” of precautionary “war chest” of liquid liquid international funds.international funds.

• Second, and more importantly, the Second, and more importantly, the purchase of Dollars to avert local purchase of Dollars to avert local currencies appreciation, kept their currencies appreciation, kept their domestic prices relatively lowdomestic prices relatively low. Thus, the . Thus, the funding of the U.S. current account deficit funding of the U.S. current account deficit was motivated by the desire to subsidize was motivated by the desire to subsidize these countries’ these countries’ export to the U.Sexport to the U.S..

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• Narrowing the US current account deficit Narrowing the US current account deficit requires some combination of requires some combination of increased increased savingssavings and and lower investmentlower investment. .

• Excess World Savings:Excess World Savings: Nevertheless, Ben Bernanke suggests Nevertheless, Ben Bernanke suggests

that the world suffers from too much that the world suffers from too much rather than too little saving (clue: the rather than too little saving (clue: the long-term interest rates are extremely long-term interest rates are extremely low across the globe). He attributes low across the globe). He attributes thisto high saving by Asian thisto high saving by Asian economies.Currently, also increase OPEC economies.Currently, also increase OPEC countries’ saving as a result of the rise in countries’ saving as a result of the rise in the the price of oilprice of oil. .

• If this “savings glut” argument is correct, If this “savings glut” argument is correct, then presumably there is little need to then presumably there is little need to worry about falling thrift in the U.S. worry about falling thrift in the U.S.

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• As the Dollar falls, normally, there is As the Dollar falls, normally, there is an upward pressure on the U.S. an upward pressure on the U.S. import prices which induces import prices which induces inflationary pressureinflationary pressure. .

• In response, the In response, the Federal Reserve is to Federal Reserve is to raise interestraise interest rates faster than rates faster than expected. Higher interest rates makes expected. Higher interest rates makes borrowing more expensive, which borrowing more expensive, which slows down investments.slows down investments.

• The inevitable implication is that the The inevitable implication is that the U.S. economy will slow; or possibly U.S. economy will slow; or possibly succumb to succumb to recessionrecession??

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• Due to the US huge Due to the US huge domestic market, domestic market, the US Dollar would need to fall the US Dollar would need to fall dramatically to reduce world demand for dramatically to reduce world demand for US exportsUS exports and to reduce US demand for and to reduce US demand for importsimports from the rest of the world, to from the rest of the world, to narrow down the US current account narrow down the US current account deficit significantly.deficit significantly.

• Moreover, the Moreover, the Asian central banksAsian central banks exchange rate policy exchange rate policy stalls this process stalls this process by by acquiring sack-loads of Dollars, slowing acquiring sack-loads of Dollars, slowing the decline of the US Dollar, which the decline of the US Dollar, which enables America to enables America to borrowborrow more. more.

• Thus, the Thus, the natural adjustment process of a natural adjustment process of a furtherdecline of the US Dollarfurtherdecline of the US Dollar, when it , when it will come, is bound to be sharper. will come, is bound to be sharper.

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• Moreover, in order to keep their Moreover, in order to keep their exchange-rate operations from causing exchange-rate operations from causing inflation in China, the Chineseinflation in China, the Chinese central central bank would keep on bank would keep on selling bonds on selling bonds on the China’s domestic marketthe China’s domestic market, in order to , in order to mop up excess money supply.mop up excess money supply.

• However, this absorption (China central However, this absorption (China central bank buying US treasuries and bank buying US treasuries and simultaneously selling domestic bonds) is simultaneously selling domestic bonds) is expensive to China’s authoritiesexpensive to China’s authorities: In many : In many cases the interest rates on domestic cases the interest rates on domestic bonds are significantly higher than on bonds are significantly higher than on the treasuries the central banks are the treasuries the central banks are buying. The World Bank estimates that buying. The World Bank estimates that this differential this differential cost the emerging-cost the emerging-market central banks $250M a year for market central banks $250M a year for every $10B they hold in reservesevery $10B they hold in reserves..

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• Obstfeld and Rogoff also suggest that the rise in relative U.S. savings, required to close up the current account deficit, implies a negative aggregate demand shock for U.S-produced non-traded goods. The same forces, however, imply a positive demand shock for foreign non-traded goods.—thus more US real exchange rate depreciation.

• This general equilibrium effect turns out to imply an even larger change - more than 50% larger - in the real dollar exchange rate than in a partial equilibrium calculation.

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• A relative pickup in A relative pickup in Europe’s Europe’s productivity growth rates productivity growth rates (as in thec (as in thec last quarter), would lead to closing of last quarter), would lead to closing of global imbalances only if the global imbalances only if the relative relative productivity jump were in non-productivity jump were in non-tradable goods production, rather tradable goods production, rather than tradable goods productionthan tradable goods production..

• Contrary to conventional wisdom, Contrary to conventional wisdom, as as the global recovery rebalances the global recovery rebalances towards growth in Europe and Japan, towards growth in Europe and Japan, the U.S. current account deficit could the U.S. current account deficit could actually become larger rather than actually become larger rather than smallersmaller, at least initially., at least initially.

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• The trade adjustment channel: current shortfall in net savings and future trade surpluses, are linked. if total returns on the net foreign assets are expected to be constant, today’s current account deficits must be compensated by future trade surpluses. That is, the inter-temporal approach to the current account suggests that he inter-temporal approach to the current account suggests that the U.S. will need to run trade surpluses to reduce this imbalance.the U.S. will need to run trade surpluses to reduce this imbalance.

• The financial adjustment channel: in the presence of stochastic asset returns, which differ across asset classes, expected capital gains and losses on gross external positions significantly alter the need to run future trade surpluses or deficits. That is, part of the part of the current account balancing adjustment proces can take place current account balancing adjustment proces can take place through through a change in the returns on U.S. assets held by foreignersa change in the returns on U.S. assets held by foreigners, , relative to the return on foreign assets held by the U.Srelative to the return on foreign assets held by the U.S..

• For the United States, capital gains and losses on external assets and liabilities are driven by stock price fluctuations and currency fluctuations. Since most of the foreign-currency denominated assets held by U.S. residents are in the form of equity (direct investment and portfolio equity instruments), capital gains and losses are primarily determined by the difference in foreign and domestic stock market performance, measured in U.S. dollars.

The favorable return differential for the USA is associated with the ‘equity premium’, together with the higher weight of equities in total assets than in total liabilities.

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Balance of Payments’ Adjustment

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During 2002-2004 the weakening dollar and stronger stock market performance overseas with respect to the United States generated capital gains for theU.S. amounting to over 10 percent of GDP.

• Importantly, this wealth transfer may Importantly, this wealth transfer may occur via a occur via a depreciation of the Dollardepreciation of the Dollar. .

• Almost Almost all of U.S. foreign liabilities are all of U.S. foreign liabilities are in Dollars wheras 70% of U.S. foreign in Dollars wheras 70% of U.S. foreign assets are in foreign currenciesassets are in foreign currencies..

• Gian Maria Milesi-Ferretti, calculates that between 2002 and 2004 more than 75% of the increase in America's net foreign indebtedness caused by the current-account deficit was offset by changes in the value of external assets and liabilities as a result of the dollar's fall. Thus a big external deficit does not necessarily imply a commensurate rise in net indebtedness to foreigners.

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• With large gross asset and liability With large gross asset and liability positions, positions, a change in the Dollar exchange a change in the Dollar exchange rate can transfer large amounts of wealth rate can transfer large amounts of wealth across countries: across countries: A back of the envelope A back of the envelope calculation indicates that calculation indicates that a 10% a 10% depreciation of the Dollar, represents, depreciation of the Dollar, represents, ceteris paribusceteris paribus, a transfer of 5% of U.S. , a transfer of 5% of U.S. GDP from the rest of the world to the U.S. GDP from the rest of the world to the U.S.

• For comparison, the For comparison, the U.S. trade deficit on U.S. trade deficit on goods and services 6 percent of GDP in goods and services 6 percent of GDP in 20052005. .

• This means the through the trade channel This means the through the trade channel the annual transfer of spending from the the annual transfer of spending from the US to the rest of the world is similar to US to the rest of the world is similar to the transfer of wealth through annual 10 the transfer of wealth through annual 10 percent depreciation of the US dollar.percent depreciation of the US dollar.

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• Historically, 31% of the international istorically, 31% of the international adjustment of the U.S. current adjustment of the U.S. current account deficit is account deficit is realizedrealized through through valuation effects (valuation effects (The financial adjustment channel) on average.) on average.

• These considerations tend to These considerations tend to lengthen the period of lengthen the period of unprecedented levels of U.S. current unprecedented levels of U.S. current account deficits; but not to prevent a account deficits; but not to prevent a large adjustment (through the large adjustment (through the The trade adjustment channel) ) in the future.in the future.

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• Tentative ConclusionsTentative Conclusions•During the past few years the United States have relied on sizable capital gains to stabilize its external

position. looking forward, exploiting this channel again would require.•Notwithstanding the importance of valuation effects, the current level of U.S. trade deficits

•cannot be permanently sustained and global adjustment requires the rebalancing of savings and investment flows between the U.S. and the rest of the world.

•If the trends in imports and exports of the past 15 years were to continue, US net liabilities could jump from •Roughly a quarter of gross domestic product at the end of 2003 to 120 per cent of GDP by 2014.

• Even if the current account deficit were to stabilize as a share of GDP, the ratio would reach 80 per cent of GDP. It is hard to believe that the foreign private sector would willingly hold such huge claims, denominated in the dollar, at current US asset prices.

•Is the US current account deficit sustainable in its •present magnitudes?

•Economic analysis would say NO. Timing of a reversal?• A continued sizable differential in rates of return between U.S. external assets and liabilities.

•Logic would suggest that this channel cannot be exploited systematically for a prolonged•period of time—it would likely require persistent dollar depreciation, which would

•eventually be incorporated in inflation expectations and ex-ante interest rate differentials.

•Not likelyNot likely!!

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