Stephen Roach
Scorn has long been heaped on those daring to question the supremacy of the U.S. dollar as the world’s dominant reserve currency. I certainly received more than my fair share in reaction to a column I recently wrote for Bloomberg Opinion on the likelihood of a sharp decline in the greenback. The counter-arguments were strong and highly political, basically boiling down to the so-called TINA defense – that when it comes to the dollar, “there is no alternative.”
That argument is very important in one critical sense: The dollar, like any foreign-exchange rate, is a relative price. As such, it encapsulates a broad constellation of a nation’s value proposition — economic, financial, social, and political — as viewed against comparable characterizations of other nations. It follows that shifts in foreign-exchange rates capture changes in these relative comparisons — the U.S. versus Europe, the U.S. versus Japan, the U.S. versus China, and so on.
My forecast that a 35% decline in the value of dollar could well be in the offing is couched in terms of the comparison between the U.S. and the currencies of a broad basket of America’s trading partners. Individual components in this basket are weighted by country-specific trade shares with the U.S. and expressed in real terms to capture shifting inflation differentials. As an economist, I care most about currency-related shifts in international competitiveness. The real effective exchange rate, or REER as calculated monthly by the Bank for International Settlements, is particularly well suited for this task.
In dissecting the TINA critique of the weak-dollar forecast, it helps to start with the weighting structure embedded in the REER to get a sense of which of the some 58 country-by-country relative comparisons might matter the most in pushing the BIS construct of the broad dollar index lower. Based on cross-border manufacturing trade flows, the BIS assigns the largest weights to China (23%), the euro area (17%), Mexico (13%), Canada (12%), and Japan (7%). These five countries (region in the case of the euro area) account for 72% of the total trade weights in the broad U.S. dollar index. An additional 13% comes from countries six through 10: South Korea, the U.K., Taiwan, India and Switzerland. Weights of the top 10 account for 85% of America’s cross-border trade.
On this basis, a forecast of a weaker dollar requires some combination of a strengthening in China’s renminbi and the euro. The currencies of America’s USMCA partners (formerly NAFTA) — Mexico and Canada — also matter a good deal in that they account for 25% of U.S. manufacturing trade. The yen is now of little consequence to movements in the broad dollar index, given its sharply reduced trade weight.
The China call is very contentious. From the trade war to the coronavirus war to the distinct possibility of a new Cold War, the negative case for China has never been stronger in the U.S. than it is today. Notwithstanding these concerns, the broad renminbi index constructed by the BIS is up 53% from its December 2004 lows in real effective terms. As long as China stays the course of structural reform — shifting from manufacturing to services, from investment- and export-led growth to consumer-led growth — and embraces a further liberalization of its financial system, the case for further currency appreciation remains compelling, even in the face an increasingly fraught relationship with the U.S.
The call on the euro is also counterintuitive, especially for a broad consensus of congenital euro-skeptics like me. That goes back to my Morgan Stanley days when I argued that an incomplete currency union — especially the lack of a pan-European fiscal transfer mechanism — could not withstand the inevitable stress of asymmetrical shocks.
I now have to concede that reports of the euro’s imminent death have been greatly exaggerated. Time and again, especially over the past 10 years, Europe has risen to the occasion and avoided a catastrophic collapse of its seemingly dysfunctional currency union. From Mario Draghi’s 2012 promise to do “whatever it takes” to save the euro from a sovereign debt crisis to the recent Angela Merkel-Emmanuel Macron commitment to a Next Generation European Union Fund of 750 billion euros ($855 billion) to address the coronavirus crisis, the great European experiment has endured extraordinary adversity. With the trade-weighted euro 15% below its April 2008 high, there is unmistakable upside for the most unloved currency in the world.
With China and the euro zone accounting for 40% of U.S. trade, I would be the first to concede that the math of a dollar crash won't add up unless those two currencies rise significantly, as I expect. Moreover, with both economies plagued by long standing current-account surpluses — albeit sharply reduced in China in recent years — currency appreciation is the classic cure for such imbalances.
Movements in other currencies should reinforce that outcome. That is especially true of yen, which should draw support from Japan’s relatively successful Covid-19 containment strategy. The same can be expected from the U.S.’s USMCA partners, Mexico and Canada, both of whose currencies were hit hard earlier this year by the lethal combination of the coronavirus shock and a stunning collapse in world oil prices.
The plunge in the peso was exaggerated by an unwinding of so-called carry trades during the meltdown of U.S. equities in late March. Barring a double-dip recession in the global economy, haven plays into the dollar should unwind over the balance of 2020 and into 2021, reinforcing the negative case for the dollar. And although cryptocurrencies and gold should benefit from dollar weakness, these markets are too small to absorb major adjustments in world foreign-exchange markets where daily turnover runs around $6.6 trillion.
Alas, the TINA argument doesn't stop there. The counter to my case for dollar weakness also rests on the reserve status of the U.S. currency as the linchpin of world financial markets. All trading nations, goes the argument, have to hold the dollar as the price for doing business in an increasingly integrated dollar-based world economy.
Even so, the dollar’s share of official foreign-exchange reserves has declined from a little over 70% in 2000 to a little less than 60% today, according to the BIS. That downtrend could gather momentum in the years ahead, especially with the U.S. currently leading the charge in de-globalization and decoupling. With America’s share of reserves well in excess of its share in world GDP and trade, such a correction might well be inevitable in an increasingly fragmented, multi-polar world.
If TINA is the dollar’s only hope, look out below. America’s saving and current-account problems are about to come into play with a vengeance. And the rest of the world is starting to look less bad. Yes, a weaker dollar would boost U.S. competitiveness, but only for a while. Notwithstanding the hubris of American exceptionalism, no leading nation has ever devalued its way to sustained prosperity.
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