The U.S. Dollar has been holding up quite nicely during this credit crisis. In fact, it rallied significantly from deeply oversold levels against the Euro and British Pound (remember Dollar-Euro at 1.60 and Dollar-Pound at 2.10?). However, America has a number of structural problems which will inhibit further appreciation. Moreover, former buyers of U.S. Treasuries in the Middle East and Asia are going to have domestic economic worries of their own very shortly and will not be supporting U.S. assets. This means that the Dollar will be a weak currency in the not too distant future.
Let’s address the structural weaknesses of the United States. The first issue is savings. As the Anglo-Saxon countries of Australia, Canada, New Zealand, the U.K. and the U.S. prospered in the 1990s and earlier this decade, their savings rates dropped precipitously. In the U.S., we saw a drop from 7% at the beginning of the 1990s to near zero before the credit crunch hit in earnest.
As a result, the U.S. has run a massive current account deficit, borrowing money from abroad in order to maintain adequate levels of investment at home. In essence, Americans were selling off pieces of the country to finance their spending. This is akin to an addict selling furniture to fuel his habit. In 2005 and 2006, this deficit was as high as 7.5% of GDP.
In the meantime, all of this deficit spending was financed by debt. Debt to GDP levels have reached unprecedented levels: 341% Total U.S. Debt to GDP, 98% Household Debt to GDP, 133% Household Debt to Annual Disposable Personal Income, 115% Financial Sector Debt to GDP — all as of Q2 2008.
While debt levels could continue to rise during good times, the present financial crisis has caused massive credit writedowns at U.S. financial institutions, restricting their capital and ability to lend. Debt levels will contract.
Now, the U.S. could try to shift the burden of borrowing onto the federal government to cushion the downturn this deleveraging will cause. And it will do so in part as Federal Government deficits are expected to reach into the trillions in the coming years. However,the U.S. will be greatly constrained by events in the Middle East and China in particular — major U.S. creditors. Both China and Middle Eastern countries will have large domestic economic concerns with which to contend. I anticipate they will pull back on their purchases of U.S> assets, as a result.
In the Middle East, the economy boomed as oil rose from $10 a barrel to $147. However, oil has recently come crashing down to $50 a barrel. This is happening in the midst of an enormous property crash in places like Dubai (see source articles below). Most oil-exporting Middle Eastern nations have a experienced a population explosion of late and this puts enormous pressure on government to create jobs and economic growth. With oil prices and property prices falling, there will be a hard landing in these countries. They will not spend their money buying U.S. Treasuries or agency paper in such a predicament.
Then, you have China, America’s largest creditor. China is seeing its manufacturing sector implode and a very serious stock market and housing crash. The situation there is much worse than we are led to believe as the Chinese have recently lowered interest rates considerably, have started large domestic stimulus packages and have even tried to depreciate their currency. Again, one should anticipate a much lower appetite for U.S. assets going forward.
Where does that leave the U.S.? To my mind, it leaves the U.S. in a situation where inflation will be the preferred mechanism to reduce the real burden of its mountain-like debt load. This is dollar bearish. Moreover, even if the U.S. cannot or does not inflate, the structural problems I have already run down will inhibit growth over the medium-term in the U.S. This too is dollar bearish.
The U.S. Dollar is riding high right now in part due to weakness abroad. However, as recessionary events start to play out, it will become more evident that the U.S. is structurally weak and that is when the Dollar will lose favor.
Other Charts
Sources
Dubai: Has the bubble burst? – The Economist
Dubai shares hit despite promises – BBC News
Heavily in Debt, Dubai Calls in the Bankers – Deal Book
Could China be depreciating? – FT Alphaville
Economic nationalism and the USD – FT Alphaville
China factory output down sharply – BBC News
China’s $586bn boost for own economy may have done the whole world a favour – Independent Ireland
China tops U.S. govt foreign creditor list – Sydney Morning Herald
China Property Slump Threatens Global Economy as Growth Slows – Bloomberg
Flow of Funds Data – Federal Reserve Board