Asia Global Institute's Distinguished Fellow Andrew Sheng says that the US is playing hardball with other economies now, but without cooperation it can’t devalue its dollar. It will need other countries’ help when the good times come to an end.
On Wednesday, the US Federal Reserve Chairman Jerome Powell announced a cut in the federal funds rate by 25 basis points, citing “global developments” and “muted inflation”. This was evidently insufficient to appease either markets or President Donald Trump, who asked for a “large cut” just before the Federal Open Market Committee (FOMC) meeting.
After the announcement, Trump tweeted, “as usual, Powell let us down”. On Thursday, Trump announced 10 per cent more tariffs on US$300 billion of Chinese imports. US markets fell by 1 per cent and the dollar strengthened slightly against other currencies.
How do we make sense of what is happening to the dollar, the world’s most important reserve currency?
The dollar accounts for 44 per cent of daily global foreign exchange trading and accounts for roughly 60 per cent of total official foreign exchange reserves. Because the dollar has a very liquid market both onshore and offshore, companies and governments like to borrow in dollars, especially when interest rates are low.
As the Bank for International Settlements reported, there is now US$14 trillion in US dollar debt booked offshore. The US also has a negative net international investment position of US$9.5 trillion, or 47.4 per cent of gross domestic product as of the end of 2018.
With the US federal budget deficit now topping US$1 trillion, bringing gross debt to an estimated 113.2 per cent of GDP and net investment deficit of 51.4 per cent of GDP by 2024, the IMF has warned that “the US public debt is on an unsustainable path”.
The same June 2019 IMF report card on the US economy also says: “The US economy is in the longest expansion in recorded history. Unemployment is at levels not seen since the 1960s, real wages are rising, and inflationary pressures remain subdued.”
We all know what worries Trump. If the economy, and especially the stock market, tanks in the run-up to the November 2020 elections, his re-election is in trouble. But why should financial markets worry?
The answer is that there is a very close relationship between the stock market and central bank balance sheets. Since 2015, when the Fed started to “normalise” interest rates (by raising them) and reversing quantitative easing (expanding its balance sheets), the S&P 500 stock market index has roughly topped and moved sideways.
During this period, both the European Central Bank and Bank of Japan have been easing, concerned about their slow growth. The People’s Bank of China has eased to relieve liquidity during a period of deleveraging. Hence, if the world is slowing faster than expected, monetary policy cannot be so tight as to push the economies into recession.
But the US has now begun to politicise the dollar and weaponised tariffs by increasing the rhetoric on currency manipulation, excessive surpluses and threats of tariffs and sanctions to try and contain its unsustainable trade deficits and debt trajectory.
Trump and some in his administration think the dollar is overvalued, and want lower interest rates to alleviate the upwards valuation pressure. But the US administration may be boxed in by its own asymmetric dollar trap.
The Fed is in charge of monetary policy (the main tool that affects the external price of the dollar), but responsibility for the exchange rate lies with the US Treasury. If the Treasury ramps up sanctions, threats of currency manipulation and/or tariff increases, major trading partners could either ease monetary policy or allow their exchange rates to depreciate.
Given the massive size of global foreign exchange markets, the US cannot unilaterally depreciate the US dollar without the cooperation of major reserve currency central banks, who may not cooperate since the US has threatened them on “unfair trade”, currency manipulation and the like.
The last time the dollar successfully depreciated through intervention was through the Plaza Accord of 1985, when Japan, Germany, France, the United Kingdom and the United States jointly intervened in the foreign exchange markets to depreciate the dollar.
This time the US cannot convene another Plaza Accord because Europe, Japan and China may not cooperate. Indeed, fundamental disagreements over sanctions using the dollar on trading with Iran and other countries have caused Europe, China, India, Russia and others to consider non-dollar alternative payment mechanisms.
Furthermore, growing trade surplus countries are more in Europe (particularly Germany and Netherlands) than in Japan or China, as the IMF External Sector Report 2019 showed.
Much will depend on whether Germany and the Netherlands are willing to reflate fiscally, but based on the bad experience of the Chinese reflation in 2009, these fiscally conservative countries are likely to push the deficit countries (mainly the US) to address their structural imbalances rather let their own economies get out of whack.
The US enjoys the benefits of the dominant reserve currency, but this is not sustainable unless the US takes tough steps to correct its structural savings deficit. Trump may want “America first”, but other players will play the long game and wait for the US to plead for cooperation. No one wins a trade war, but the long game is who is hurt most by global recession.
There is no free lunch. The US must work within the global financial system through cooperation, not coercion. Going it alone, as happened with protectionist moves in the 1930s, risks another global recession. In this highly interconnected world, not even the US can go it alone for long.
This article first appeared in the South China Morning Post on August 3, 2019. The views expressed in the reports featured are the author's own and do not necessarily reflect Asia Global Institute's editorial policy.