The Future of the Dollar: What International Transactions Tell Us

Introduction

Since March 22, 2009, I have recommended betting against the dollar, i.e., invest to make money as the dollar weakens. It is useful to look again at this issue as I do below by examining international transactions data.

The Current Account

One hears a lot in the press about the US trade balance. The trade balance is part of the current account (presented in Table 1). It is the difference between imports and exports of goods and services. The Table shows the US had a positive balance on both goods and services in 1960. Since then, the goods trade has gone negative while the services have stayed positive. The income balance has stayed positive, largely because US foreign direct investments have exceeded foreign direct investments in the US. Unilateral transfers include US military grants and individual income remittances, and these have continued to grow.

Table 1. – The US Current Account (in bil. US$)

Source: US Bureau of Economic Analysis

The Goods Trading Deficit

What initially caused the large goods trading deficit to develop? In the ‘70s and ‘80s, foreigners were attracted to US stocks and bonds. In addition to serving as a “safe haven”, such investments made good returns.

And this additional demand for dollars kept it strong and made US goods increasingly non-competitive. The situation was analogous to oil exporters – the so-called “Dutch Disease” – where a decrease in the price competitiveness, and thus the export, of the affected country’s manufactured goods. But while the international demand for U.S. securities strengthened the dollar, they the purchase of securities is not like the export of goods and services. Why? Because unlike goods and services, securities can be sold and such actions weaken the dollar.

The Financial Account

To see how this all fits together, it is important to introduce a second account – The US Financial Account (formerly called the Capital Account). Data in my version of this account (Table 2) show how current account deficits or surpluses are balanced out.

Table 2. – The U.S. Financial Account (in bil. US$)

Source: US Bureau of Economic Analysis and author’s adjustments

The table has two sections: Americans investments abroad, and foreigners’ investments in the US. Under each of these major headings, data are provided on investments by type for governments and the private sector. A negative number means a dollar outflow (increasing the global supply of dollars, thereby causing its value to fall) while a positive number means a dollar inflow (dollar strengthening). US investments abroad, like imports, increase the global supply of dollars, just as foreign investments in the US, like exports, reduce the global supply of dollars.

Now, back to the point I made above about capital inflows strengthening the dollar. Table 1 indicates a trade deficit of $81 and $379 billion in 1990 and 2000, respectively. In those same years, you can see from Table 2 that foreign private investments in the US were $105 and $995 billion, respectively. The Financial Account data can be simplified further by reducing it to the net government and private sector flows and this is done in Table 3.

Table 3. – US Capital Flows (in bil. US$)

Table 3 highlights several important points:

• the strong net inflow of dollars from the government sector – this reflects foreign governments’ purchases of US dollars (more on this below);
• while the direct investment in the US by foreigners is higher than in any other nation, the US makes more direct investments overseas – hence the negative numbers shown for the last three years;
• with the global financial panic in late 2008, the strong inflow of dollars into US securities has been reversed (more on this later).

With this information as background, we return to the question posed at the outset.

What Will Happen to the Dollar?

Let’s start with what we know. If the dollar remains at its current value relative to other currencies, the trade balance will again climb to the $600 – $700 billion range as the US pulls out of the global recession resulting from the near collapse of the US banking system.

What will absorb this outpouring of dollars into the global marketplace? Two options:

• foreign governments will buy up dollars, or
• private investors will buy US securities.

Let us examine each of these possibilities.

2. Governments buying dollars

Table 4 provides US Treasury estimates of foreign government holdings of US government debt.

Table 4. – Leading Foreign Government Purchasers of US Debtend-June (in bil. US$)

Source: US Treasury

Overall, many countries bought US debt in late 2008 and all of 2009 as part of the panic reaction to the financial collapse. But in looking at the numbers through time, we see several different patterns. The list includes the small country tax havens (Luxembourg, Bermuda, and the Cayman Islands). There are then countries such as the UK, Switzerland, the Netherlands, and Germany that hold dollars as part of their overall portfolios. For all of these countries, exports are important, but unlike the next group, they have not purchased US securities “for their exporters”.

The third group includes China, Hong Kong, Japan, Taiwan, and most recently, Brazil. These countries are buying dollars in hopes of keeping its value up to support their exporters. Japan was the first “prop-up-the-dollar” country, and it started buying dollars in the late ‘eighties. China started its purchases in the ‘nineties and it has carried on. Brazil started its significant buying in 2005. The central bankers of these countries are not pleased in having to accumulate dollars: they know that they are purchasing assets that will lose value.

Overall, the Treasury estimates that foreign governments hold more than $4 trillion of US government debt. Will they continue buying to offset the US trade deficit? The China Daily has reported China foreign currency reserves at $2.5 trillion, of which two-thirds are already invested in US government debt. Is it willing to buy more?

2. Private Investors Purchasing US Securities

As I have indicated above, foreign private investors in the past have been attracted to US securities, both equity and debt. But will this continue, and equally important, will Americans increasingly invest abroad? Recent data are presented in Table 5.

Table 5. – Private Investors’ International Transactions

(in bil. US$)

Source: US Bureau of Economic Analysis

It is notable that after the panic period where everyone liquidated their overseas assets, US investors, heeding articles such as I have been writing, have gone back to investing overseas. In the first 3 quarters of 2010, foreign investors started again buying US government debt and private securities. But while the net is positive, will it continue, and will be enough along with foreign government of US government debt to neutralize the again-growing US trade deficit? And will foreigners keep believing in US investments?

And there is one other factor to consider here. Aside from international transactions, one has to believe the value of the dollar will be influenced at some point by the tremendous amount of liquidity being injected into the US system by the Fed ($2 trillion) and the US Treasury – the Congressional Budget office reports the deficit in 2009 was $1.4 trillion. It projects the deficit for 2010 at $1.3 trillion and in August, projected the 2011 budget at $1.1 trillion – but that was before the new stimulus bill of $917 billion.

Investment Implications

From what has been said above, it is extremely difficult to believe the dollar will increase in value over the next decade. Is it worth investing outside of the US for this reason and because emerging market countries are virtually debt free and growing rapidly?

I will offer my views on these questions in my next article.