Wednesday, July 18, 2012

A Contrarian Viewpoint: How About a Strong Dollar Policy?

Turning our attention to currency markets, the most recent iteration of the Eurozone crisis has seen the common currency slip 9% off its 2012 high against the U.S. Dollar to $1.23. The Euro is down 17% from its August 2011 level, just before the continent’s most recent date with economic disaster. Measuring the strength of the dollar by comparing it to such a beleaguered currency is clearly not the best gauge, but even when using the Dollar Index..a weighted basket of liquid, major currencies… to offset the Euro’s glaring weakness, the greenback is still a healthy 6.4% above its year-to-date low. As illustrated in the chart below, over the past several years the USD has had a strong inverse relationship with equities as measured by the S&P 500. This is a consequence of the annoying binary risk-on / risk-off trade, in which entire markets move in lock-step to developments in the macro crisis du jour.  When sentiment improves, investors leave (often USD-denominated) safe assets such as Treasuries and add to riskier positions like equities, commodities and international instruments. The other big story knocking around markets is concern of a slowdown in China. This too has rattled currency markets.  Since the Chinese Renminbi is rigged, we cannot use it as a gauge of investor sentiment, but the Australian Dollar has acted as a proxy for the China trade, and vis-à-vis the USD, the Aussie currency has slipped 5.4% off its recent high.

Since the 2008 financial crisis, periods of elevated risk aversion have seen advances in the USD, but absent an apocalyptic catalyst (there have been many of late), these moves are blips in a longer-term trend of gradual dollar weakening. In fact, despite Europe’s bungling efforts in combating its crisis, one can argue that it is surprising that the USD has only gained 18% versus the EUR since last summer.  But this entry is not about trading currencies. Instead…and forgive the possible overstatement….it concerns a concept central to the United States’ future economic prospects and confidence in itself; it is about adopting (and maintaining) a strong Dollar policy.

A  Cold, Drizzly Lesson in Economics

It was nearly two decades ago that I arrived in Munich on a foggy and frigid late-autumn evening. After a long trip, getting warm nourishment was of primary import. Hence I was crushed to see the exorbitant prices for a couple of Weisswurst and bowl of Goulash Suppe. I expected that such bucolic Bavarian fare would have run me a few pfennigs (this was well before the Euro). Instead I was forced to shell out nearly 10 Deutsche Marks for a couple of glorified hot dogs. Perplexed by how little my travel funds bought, I commenced reading financial periodicals to find an explanation. There I came across utterances from the U.S. Department of Treasury proclaiming America’s commitment to a strong dollar policy, which in Washington Speak, meant just the opposite.
Why, one may ask, would the U.S. want to debase its currency? As stated in previous entries, the United States is the world’s largest debtor nation and much of those obligations are held by foreign creditors such as China. With debt denominated in dollars, the U.S. can effectively inflate way these liabilities by increasing the money supply. Of course officials cannot pronounce that sticking it to the Chinese (as well as Japanese and major oil exporters) is U.S. policy, so instead they champion other less-cynical benefits like the boost in exports that purportedly accompanies a weakening USD along with the juicing of profits by foreign operations of U.S.-domiciled multinationals once earnings are converted back into the relatively weaker dollar. And these are indeed attractive benefits given that approximately half of S&P 500 revenues are generated abroad.
But what causes a currency to weaken and what are the potential negative consequences? Well, if there was a playbook on how to debase one’s currency, U.S. officials are following it line by line.  Lenders don’t like risky credit profiles. During the Clinton years…covering the time I learned my cruel economics lesson on the drizzly streets of Munich…the U.S. famously ran a short-lived budget surplus. In 2011, the budget deficit was 9.6% of GDP. Total government debt is 1995 was 71% of GDP. Currently it is over 100%. The current account deficit back then was 1.5%/GDP. Presently it is double that level.  Another factor in determining the attractiveness of a currency is the growth prospects of the country.  From 1981 to 2006 U.S. quarterly GDP grew on average by 3.1% (annualized). Since the nadir of the crisis in 2009, growth has hovered at 1.5%. If we don’t grow, there is less foreign demand for U.S. assets, and thus there is less demand for dollars needed to purchase these instruments physical assets. And we cannot forget rates. A common driver in currency trading is to take advantage of interest rate variations in different countries. Investors seeking returns more attractive than available in their home market can borrow locally and invest in countries where interest rate yields are higher (the so-called carry trade). With the Federal Reserve wedded to 0.25% interest rates well into next year and 10-Year Treasuries at 1.5%, the USD is well positioned to become the funding currency of the carry trade rather than the investment destination. These hindrances to stronger dollar demand are partially offset by the fact that the USD remains the world’s reserve currency, the main unit of international transactions (especially in the commodities space) and the country remains the world’s largest economy with the most liquid and transparent financial markets, thus making it a safe harbor in tumultuous time.

And What of a Strong Dollar?
Most Americans are (or should be) aware of the country’s chronic current accounts deficit, simply meaning we consume more than we produce. Venturing deeper into the arcane realm of national accounting, a current account deficit is (almost) equally offset by a capital account surplus. So what is a capital account? It is the flow of capital into and out of a country, mainly in the form of portfolio investment (stocks & bonds) or foreign direct investment, or FDI, (e.g. foreign firms opening up shop in the U.S. via acquisitions or building factories). Having foreign investors (individuals or corporations) choose to ship their excess savings to the United States is incredibly important considering the fact that Americans don’t save. We spend. We spend so much that we must rely upon these foreign funds to maintain the nation’s capital stock. In addition to liquidity, size and safety, U.S. financial markets have historically offered the best risk-adjusted returns for investors. Being that these investments help improve productivity by allocating capital to the most-promising enterprises, which in turn increases GDP, the U.S. needs to ensure it continues to remain a favored investment destination, especially in light of its paltry savings rate.

The good news is that the U.S. is consistently the world’s leading destination for FDI, with its tally over the past decade nearly equaling the much-ballyhooed BRIC economies combined (see chart below). This may be a shocker to all those whining about the outsourcing of U.S. jobs, but the reality is America is one of the greatest beneficiaries of multinationals expanding abroad. In 2009, majority foreign-owned firms in the U.S. generated $2.9 trillion in sales, employed nearly 5.3 million workers and paid them over $400 billion in compensation. Evidence of the benefits of FDI is everywhere. In the Southeast alone both Volkswagen and Kia have dropped around $1 billion each to open assembly plants, and BMW’s South Carolina facility paradoxically exports its X6 model back to Europe. Ugly car, but a feel-good story for the American worker.

These investments have occurred despite the gradual weakening of the dollar, which adversely impacts foreign firms’ profits when converted back to Euros, the Korean Won, etc. The lucrative size of the American market makes the conversion risk one worth taking, but at some time in the future, a tipping point could be reached.
The Right Kind of Exports
But a weaker dollar helps exports, right? So the story goes, but here too, the U.S. is in a unique situation. Advanced economies like America, Japan and Germany manufacture the complex capital goods and high technology components that drive productivity higher and are thus in demand by developed and emerging economies alike. Given their sophistication, these are not fungible wares that are sensitive to prices fluctuations brought on my currency moves. Buyers of such complex products are willing to pay a premium to gain the benefit of the added-value of these goods. In short, currency levels matter less to our mix of exports. Let us also not forget that foreign trade only comprises 15% of U.S. GDP. The benefit of a strong dollar attracting FDI likely offsets any potential lost sales via trade. These facts put the Chinese-made Olympic uniform kerfuffle in perspective, don’t they? And what of corporations that benefit from half their revenues coming from abroad? Not only are our goods price inelastic, but also simple arithmetic tells us the other half of revenues is domestically generated, right? A strong dollar will boost local buying power too, thus aiding personal consumption (70% of GDP).

So much more than Bratwurst and Hefeweizen
Speaking of Germany, that country’s much vaunted Mittelstand (small and mid-sized manufacturers), along with global powerhouses like Siemens, Daimler and BASF, churn out an array of exports perhaps even more sophisticated than those of the U.S. As shown below, exports rose dramatically over the past decade despite the rapidly appreciating Euro. This illustrates that with the right export mix, a stronger currency does not necessarily torpedo the nation’s industry.

Can the inflows dry up? Let’s hope not.
Thanks to its position as the world’s largest economy, its deep financial markets and business-friendly legal framework, the U.S. has been a preferred destination for foreign investors.  Given the country’s meager savings rate, this productivity-enhancing investment is necessary tonic. But continuation of this flow is not guaranteed. Government deficits and the nation’s debt (both public and private) remain elevated. Tough but practical solutions such as ones favored by the Bowles-Simpson Commission have been resolutely ignored. Now the country faces the 2013 fiscal cliff, which although may address chronic deficits, would do so in a manner that would likely shift the economy from tepid growth back into recession.  High debt, low growth countries are not favored destinations for investment flows. Coupled with the acute problems in the U.S. is the reality that higher growth regions are getting their acts together with regard to establishing liquid and transparent financial markets and freeing their currencies-controls to attract investors. America may not have serious competition today as the dominant investment destination and especially as a safe-haven, but in the future, other markets will incrementally attract a greater share of international funds.
The current de-facto weak dollar policy only make’s the country’s position more tenuous. Cynically allowing a depreciating dollar to inflate away foreign obligations will shake investors’ confidence in the U.S.  Internally it hurts domestic consumers by fueling imported inflation via dollar-denominated raw materials, especially energy products. Aside from getting its fiscal house in order, a strong dollar policy is another key step in maintaining the confidence of the global investment community. Both FDI and portfolio inflows provide much-needed fuel to build a future economy based on high value-added manufacturing, strengthen the country’s infrastructure and keep its financial markets functioning as an efficient channel in allocating capital to cutting edge enterprises.  
Shifting gears to a strong dollar policy cannot happen instantaneously. Tough budgetary decisions continue to be proverbially kicked down the road. The raising of interest rates would not only crimp already weak lending markets and thus curtail growth, but also would further blow out the federal deficit by jacking up payments on the country’s massive debt load. The darker alternative to a strong greenback is the ominously sounding financial repression.  Components of this policy include cajoling (via regulation) banks to favor public debt in their capital structure (thus distorting demand for Treasuries) and maintaining the Fed’s rock-bottom interest rate policy. Such moves not only disincentivize domestic savings….needed to fund investment…but also chase aware foreign investors, who will have a greater assortment of viable investment destinations in coming years.  As stated at the outset, a strong dollar signifies officialdom’s confidence in the prospects of the nation as a growing, innovative, highly-productive, investment destination.  The continuation of current policy will only chase away the foreign investment lifeline and send America further down the path to mediocrity.

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