Global growth would benefit from a weaker US dollar, but a weaker US dollar requires a sustainable pickup in global growth. This paradox is one of the central challenges facing the global economy and the strength of the dollar last year was one of the factors behind the current economic slowdown.
Since 1980 the US share of global growth has fallen from 22% to 15%. However, the dollar remains as important as at any time since the end of Bretton Woods in 1971. While the US only accounts for 10% of world trade, the dollar accounts for around two-thirds of global security issuance, foreign exchange reserves and emerging market external debt. Furthermore, one-third of countries explicitly peg their currency to the dollar and 70% use the dollar as their anchor currency.
The world is on a dollar standard and a stronger dollar causes pain in a number of ways. Around 50% of global trade is invoiced in dollars, so when the dollar appreciates this creates a headwind for world trade. The financial crisis provided an important example; dollar strength and a squeeze on trade financing meant that trade declined significantly, even in regions with little exposure to the troubled US housing market, such as Asia.
The rise of dollar-denominated debt outside the US means that dollar strength tightens global financial conditions. For countries or companies with dollar debt but local currency cash flows, a stronger dollar can be equivalent to a rate rise, which can be painful if it coincides with slower growth or weaker revenues. After the Asian financial crisis many countries built up their reserves, but dollar exposure can still cause stress via private sector balance sheets.
As the world’s reserve currency, the US provides the most flexible, deep and open capital markets in the world, which allows countries to build reserves. The conventional thinking is that this gives the US an exorbitant privilege because they import goods using their own currency.
However, economist Michael Pettis has argued persuasively that the cost associated with providing the reserve currency is a factor in the current trade war. His argument is that these inflows create distortions and as long as the US absorbs these foreign flows they need to respond with either more debt or face higher unemployment. This quickly becomes complicated, but President Trump is aware of the potential benefits of a weaker dollar and has turned his attention to the currency. Since 1995, the US has had a strong dollar policy, but under the current administration this is now uncertain.
The most obvious channel to weaken the dollar is pressuring the Federal Reserve (Fed) to cut rates. While rates have indeed fallen, weaker growth outside the US has kept the dollar strong. Many expected this year to be a rerun of 2016, when a combination of easier US monetary policy and stimulus in China boosted growth. However, the China stimulus has been much more measured this time.
Returning to trade, a key issue is that the basic assumptions underlying the benefits of global trade have been undermined: Firstly, that the countries benefitting most from global trade see currency appreciation, and secondly, that the winners spend their “winnings”. While Trump focusses on China’s competitive devaluation, his accusation was only valid between 2003 and 2014. Today, Germany is a big beneficiary of trade, yet it is not seeing currency appreciation, due to euro membership, and it is also not spending enough.
The positive news is that there are good reasons for the dollar to fall. The currency is expensive, the budget deficit is almost $1 trillion and the Fed is cutting rates while also launching a form of quantitative easing. Furthermore, pressure is increasing on Germany to increase spending, which would increase imports and allow rates to rise back above zero. While growth in China is structurally slowing, recent measures should also help to stabilise growth.
A longer-term solution to dollar dominance was recently suggested by Bank of England Governor Mark Carney and involves a Synthetic Hegemonic Currency. Carney mentioned Facebook’s Libra, but this has a host of problems and Jamie Dimon has since described it as “a neat idea that will never happen”. So, Libra is not the answer, but Carney’s wider point does help to advance the conversation.
In the short term, global manufacturing is showing tentative signs of stabilising, thanks in part to responsive central banks. However, if growth continues to weaken then the dollar is likely to remain strong with the rest of the world continuing to export stagnation to the US. In this case, we are likely to end up with more of the same – negative rates in Europe and increasingly radical fiscal and trade policy in the US.
Nicholas Rilley, is an Investment Manager/Strategy Analyst, Butterfield Asset Management.
Sources: Bank of England, TS Lombard, Carnegie Endowment for International Peace, Council on Foreign Relations, Gavekal.
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.