Investment Strategies VI – The Dollar Will Get Stronger (?)

Introduction

In my recent investment postings, e.g., http://www.morssglobalfinance.com/investment-strategies-v-the-global-recession-and-financial-management/, I have recommended betting against the US dollar, arguing that with all the debt financing the US government will have to do in coming years, the dollar will fall in value. The issue is definitely important. If the dollar increases in value, you want to hold dollar investments; if it loses value, you want to buy commodities or invest via other currencies.

A good friend of mine suggested I try to argue just the opposite – that the dollar will strengthen in coming years. An interesting challenge, so here goes.

Inflation, Deflation, and The Value of the Dollar

There is considerable misunderstanding on the meaning of the terms “inflation” and “deflation”, and how they relate to the dollar. Here are the key points:

1. In common parlance, inflation/deflation relates to the buying power of a currency (we will focus on the dollar) – deflation (prices go down) means the dollar can buy more; inflation (prices go up) means the dollar can buy less;

2. There are two elements that affect the dollar’s value, one domestic and one international:

  • Domestic – if an economy (we focus on the US economy) is operating at full employment/full capacity utilization, increasing aggregate demand cannot increase production; instead, prices will be bid up – inflation.
  • International – Some of that excess demand will increase imports. And more dollars on international currency markets will weaken the dollar further.

The Case for a Weaker Dollar

Today, and for the next couple of years, excess aggregate demand in the US will not be a problem. Prices will not be bid up because of excess aggregate demand. The following table provides estimates from the Congressional Budget Office of both capacity under-utilization (GDP Gap – the percent below full capacity production at which the economy is operating) and the unemployment rate for the next few years.

Table 1. – Capacity Utilization Estimates

 CBO Estimates

2009

2010

2011

 GDP Gap (Percent)

-7.4

-6.3

-4.1

 Unemployment Rate (Percent)

9.3

10.2

9.1

Source: US Congressional Budget Office

In these circumstances, increasing aggregate demand should result in higher production and lower unemployment; it should not result in domestic inflation (the value of the dollar falling relative to the goods it is used to purchase). Incidentally, at the end of July, the US unemployment rate was 9.4% (15.2 million out of work). And unemployment will get worse before better.

But global inflation must also be considered: the dollar could also weaken relative to other currencies. Consider the following:

  • The Congressional Budget Office is now projecting Federal government deficits of  $1.6 trillion and $1.4 trillion for 2009 and 2010, respectively. The absolute size of these deficits is unprecedented. As a percent of GDP, they are 11.2% and 9.6% in 2009 and 2010, respectively. These percentages have only been exceeded during the Second World War. As I have indicated in an earlier posting (http://www.morssglobalfinance.com/the-us-bailoutstimulus-plans-are-they-affordable-are-they-needed/), it is unlikely the public and private market for US securities is large enough to absorb these amounts. As a result, the Federal Reserve will have to buy up a considerable portion of these deficits. The Fed will buy this debt with US dollars, thereby putting more dollars in circulation.
  • Larry Summers has said: “The US current account deficit is currently running in excess of $600 billion at annual rate, in the range of 5.5% of GDP. It represents well over 1% of global GDP and absorbs close to two-thirds of all the world’s current account surpluses. All of these figures are without precedent. The US has never run such a large deficit and no other nation’s deficit has ever been as large relative to the global economy.” In addition to this international deficit, the U.S. Government is running a budget deficit in excess of $300 billion.

How can such imbalances exist with a strong dollar, little inflation, and low interest rates? The answer is the U.S. borrowing from foreigners. In 2003, 2004, 2004, Asian governments (China, Japan) have bought $274 billion, $354 billion, and $53 billion in US debt, respectively. The rest of the world now holds over $1.9 trillion in US debt. At 5% annually, that is $95 billion in interest payments.

The US trade deficit has come down somewhat this year, but it is still running near $700 billion annually. This means Americans are increasing the global dollar supply by that amount every year. In past years, this increase in dollars supplied to the global market has been absorbed by foreigners buying US equities and governments (most notably the Chinese and Japanese) buying US government debt. After the stock market collapses, foreigners are less likely to be eager purchase US stocks. And the Chinese government has warned it is increasingly uneasy about its large holdings of US Treasury securities.

Since the global financial panic started, US dollars and other forms of US government debt have been extremely popular worldwide. The world does not believe the US government will renege on its debt. But as the panic subsides, the demand for US government debt should also fall, and this should mean a weaker dollar.

In the past, I have agued that all of this should mean an expanded supply of dollars globally with no corresponding increase in demand. This should make the price of the dollar fall relative to other currencies and commodities – a dollar inflation. And if this happens, it is better to be invested in commodities or financial assets via other currencies.

More Relevant Information

Let’s look at the US trade balance on goods and services. In the ’60s and ’70s, the US ran trade surpluses. No longer. And between 2000 and 2005, the trade deficit increased by $335 billion.

Table 2. – US Trade Balance on Goods and Services (in millions US$)

1960

1970

1980

1990

2000

2005

2008

3,508

2,254

-19,407

-80,864

-379,835

-715,268

-695,936

Is this sustainable? With such a large trade deficit, the only way to avoid a catastrophic collapse in the value of the dollar is to have the excess dollars absorbed by international capital inflows into the United States. That means that every year, foreign direct investment, foreign purchases of stocks, bonds, and U.S. government securities have to approximate the trade deficit. Up to now, this has happened. But recognize that part of the adjustment took the form of a weakening dollar as portrayed in Table 3. Today, it takes only 94 yen or 1.07 Swiss France to buy a US$ while in 1950 it took 361 yen and 4.37 Swiss Francs. The Chinese Yuan used to be pegged to the US$ at 8 to 1. Today, it takes only 6.8 Yuan to buy a dollar.

Table 3. – The US Dollar Exchange Rate
Currency

1950

1960

1970

1980

1990

2000

2009

Japanese Yen

361.1

360

360

226.7

144.8

107.8

93.75

Swiss Franc

4.37

4.37

4.37

1.68

1.39

1.69

1.07

In short, the value of the dollar has already fallen by a very large amount. A Japanese investor who used 1,000 yen to buy dollars in 1950 would get only 260 yen back today; a Swiss investor who used 1,000 Swiss Francs to buy dollars in 1950 would get back only 245 Swiss Francs today.

The Federal government debt is $5 trillion. Foreigners are owed 53% of that amount, or approximately $2.3 trillion. The Chinese and Japanese governments own approximately $500 billion each. They have bought this debt to absorb dollars resulting from the annual US trade deficit of approximately $700 billion annually.The Federal debt is expected to increase by an unprecedented $1.9 trillion in 2009, and the hope is that the Chinese and Japanese will continue buying.

The Case for a Stronger Dollar

With this as background, let us return to the issue at hand. There are two reasons the dollar could strengthen or at least not lose value:

1. The stimulus packages are not enough;

2. Other countries support the dollar.

The Stimulus Packages Are Not Enough

I am not alone in having earlier argued that the stimulus packages are not enough to get the world out of the global recession (http://www.morssglobalfinance.com/the-global-recession-what-stimulus-is-needed-for-recovery/). And today, I view what little good economic news there is (we are near the bottom) as being the direct result of government stimulus activities. A number of the economic writers I respect the most, e.g., John Mauldin, are talking about a double-dip recession (http://frontlinethoughts.com/gateway.asp). If that does happen, there could be another global panic, and people could return to dollars as a “safe haven”. The global demand for dollars would increase and so would its value.

Other Countries Support the Dollar

Countries that export to the US do not want the dollar to weaken. Natural resource exporters don’t care much, but countries that export high value added products, like China and Japan, care a lot. Why? Because a weaker dollar means they will lose jobs to the US. We hear a lot about the decline in US manufacturing and the loss of jobs to low-cost producers. What most people don’t realize is that a significant portion of the US job loss resulted from exporters to the US propping up the US dollar.

Companies like to produce in the US. Foreign direct investment in the US in 2007 was $232.8 billion, more than any other country. Consider Toyota. Table 4 provides data for the 12-month period 4/08-3/09. As the dollar weakens, the United States becomes a more attractive production locale.

Table 4. – Toyota Production and Sales

Production (in thousands)

North America

919

Japan

4,255

Total

7,051

Sales (in thousands)

North America

2,212

Japan

1,945

Total

7,567

Siemens, a large German firm, ran an ad a few years back in the US. It talked about exporting $5 billion of goods, from the US. China, Japan and other exporters do not want to lose jobs to the US. A weaker dollar makes producing in the US more attractive. What can these countries do to keep the dollar strong?

They can continue to do what they have been doing – buying US government securities.

At the end of June 2009, the US Treasury reported that total foreign holdings of US securities was $3.382 trillion, with China and Japan holding $776 and $712 billion, respectively.

Table 5. – Treasury Securities – Total Holdings (in billions US$)

Country

2000

2001

2002

2003

2004

2005

2006

2007

2008

Jun-09

China

60

79

118

159

223

310

397

581

727

776

Japan

318

318

378

551

690

670

623

478

626

712

Total

1,015

1,040

1,236

1,523

1,849

2,034

2,103

2,353

3,077

3,382

In Table 6, the total holdings data of Table 5 are converted to net new purchases. The table also includes US government surplus and deficit data. It is notable that in recent years, the highest government deficit as a percent of GDP occurred in 1983 when it was 6%. During World War II, it got to 30% in 1943, but at that time, the US had price controls and rationing.

Table 6. – Net New Purchases of Treasury Securities (in billions US$)

 Item

2001

2002

2003

2004

2005

2006

2007

2008

2009

(est.)

2010

(est.)

US Govt. Surplus/Deficit (-)

128

-158

-378

-413

-318

-248

-161

-455

(1,587)

(1,381)

US Govt. Surplus/Deficit(-) as % GDP

1.27

(1.52)

(3.49)

(3.59)

(2.60)

(1.91)

(1.18)

(3.20)

(11.2)

(9.6)

Foreign Purchases US Treasury Securities

 

 

 

 

 

 

 

 

China

19

39

41

64

87

87

184

146

?

?

Japan

0

60

173

139

-20

-47

-145

148

?

?

Total

25

196

287

326

185

69

250

724

?

?

Source: US Treasury and Congressional Budget Office

The estimated US government deficits in 2009 and 2010 do appear formidable. Let us ask what China and Japan can afford to do? Table 7 provides data on China and Japan’s international reserves.

Table 7. – International Reserves

(billions of US$)

International Reserves

China

Japan

Total

1,945

1,023

US Government Securities

776

712

US Government Securities %

40%

70%

Source: IMF, US Treasury

With 70% of its reserves already in US securities, it is unlikely Japan can do much to absorb the growing US government deficits. China has more latitude, but it has already expressed public concern about the growing US government deficit. Beyond the question of what these countries can afford to do to support the dollar, there is the matter of what the central banks want to do. Rest assured, they do not want to buy more US government debt. They see the dollar as in investment that will lose value: they want to sell and not buy.

Conclusion

A double-dip recession is the only plausible argument for a stronger dollar. Neither China nor Japan has the will or resources to absorb the growing US debt in a way that will significantly strengthen the dollar.

The double-dip recession is a very plausible scenario. But when we come out of it, next year or five years hence, bet against the dollar.

The content above was saved on the old Morss Global Finance website, just in case anyone was looking for it (with the help of archive.org):
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