The US Dollar, being the reserve country of the world has enjoyed a benefit which no other country with a huge current account deficit has enjoyed. Over the last 15 years the Fiscal Position of the US has also deteriorated with the Fiscal Surpluses of the late 1990’s now being converted into a huge deficit. I remember there was a time when I started off my career in 1995 and in the following years when there used to be talk of there being no US Government Bonds to invest into after the next 10 years given the fact that the US Government was in surplus and all the Long Term government bonds will be exhausted in the first decade of the new millennium. Look at where we are today. The Debt to GDP of the United States has crossed 100% and is expected to continue to grow over the next few years. Fights over raising the US Government Debt limit have become an annual feature between Democrats and Republicans. The process of Fiscal Adjustment in the US has just started and has a long way to go.
The huge and growing surplus of Emerging Markets, especially Russia and China have flown into US Dollar Reserves over the last several decades. The surpluses generated by countries like China by their sale to other parts of the world also continued to flow into US Treasuries. This has kept the US Dollar strong despite fundamental logic being for the USD to actually decline. The Foreign Exchange Reserves of other developed countries like Japan also are to a great extent into US Government securities.
The other developed country that has seen a long term currency appreciation has been Japan. However this has been due to the fact that Japan continued to have a trade surplus despite a continuously rising currency for decades. Although the Japanese Government has continued to run a Fiscal Deficit it has been largely internally funded.
Till the mid 1990’s the Current Account Deficit of the US was in the range of around $ 100 billion with some variation up and down over the year. However with the emergence of China and the low cost manufacturing that China offered manufacturing started shifting out of the US into China largely and also to other Emerging Markets. As a result the CAD ballooned from $ 120 bn to $ 850 bn plus in the year 2006. This was a bump up from 2% of GDP to 9% of GDP. However most of the surpluses that were being generated by the exporters continued to be ploughed back into the US in the form of Capital flows i.e. Buying of US Government Bonds. China today holds nearly $ 1.28 trillion and Japan $ 1.13 trillion of US Government Securities. The more shocking piece of statistics is that the total outstanding debt of the US has moved up from $ 8.8 trillion 2007 to 16.7 trillion today. Out of this the US Federal Reserve is holding $ 2.1 trillion via its Quantitative Easing Operations.
US had a perennially growing CAD till the shale gas boom hit the US economy. This has led to a huge growth in Oil and Gas production in the US. It is now expected that US will become the biggest producer of Oil outside the OPEC by next year. This has also combined with a slowdown in the economy. This has given some relief to the Current Account Deficit and has also made manufacturing of some products viable in the US. As a result the CAD has come down to a run rate of $ 400 billion per year. However still the CAD plus the Fiscal Deficit continue to be at 10% of GDP. This essentially implies that USA needs a funding of nearly $ 1.5 trillion incrementally every year.
I believe that the direction of the US Dollar has changed for the worse and we will now see a continuous decline in the US Dollar over the next several years. The reasons for this will be as follows
Decline of Fear – A large part of the US Dollar strength since the year 2008 has been due to various fears in the markets, starting from the Financial Crisis to the Euro Zone crisis, expected hard landing in China and lastly the run on the currencies of high CAD Emerging Economies. However the worse of these fears are now behind us. Euro zone has stabilized, there is unlikely to be a severe slowdown in China, at least over the next few years and the run on EM currencies also seems to have peaked.
Periodic fights over the US Debt Limit – This is by far the biggest reason why I believe that the US Dollar will decline going forward. The US Dollar as the reserve currency and US Government Debt as the risk free benchmark have been established for several decades now. However the rapid decline in the US Fiscal position and the huge growth in US Government Debt over the last 5 years have made the US a highly indebted country. The Fiscal Deficit was over 7% of GDP last year. The CAD is still over 3% of GDP. High CAD’s have been sustained only due to the reserve currency status. Although there is no major alternative today, there is likely to be a shift in the Asset Holding of currencies going forward. The current level of Debt has become unsustainable for a country having a nominal GDP growth of 3-5%.
The fight over the Debt Limit increases in such circumstances creates a situation where the Debtor countries are becoming jittery now. As such the probability is high now that as the confidence on Europe grows there will be more flows into Euro Country bonds given that they offer a higher yield too.
No Idea of how FED Exits – The US FED has expanded its balance sheet to a level where it is now holding $ 2.1 trillion of US Government Bonds and $ 1 trillion plus of MBS. These bond buys have had an impact of keeping the cost of borrowing of the US Government low, mortgage rates low and general interest rates in the economy. Just a whiff of an exit in the FED Bond buying resulted in the yields on US Government bonds move up from 1.5% to near 3%. Given the level of US Government borrowing a 1% increase in overall borrowing costs will increase Fiscal Deficit by over 1%. As such, first stoppage of balance sheet expansion and then contraction will create upward pressure on borrowing costs. This will be counter balanced by attempts to cut the Fiscal Deficit, high unemployment and low inflation. However all combined interest rates should edge up.
However contrary to popular logic this does not mean increasing interest rates in other countries. The difference in Indian and US 10 yr bond yields has been 0.5% to 7% plus over the last 10 years. As such if our CAD and Fiscal Deficit improve this gap with US bond yields will also reduce.
As such overall the direction of the move of the US Dollar will be a declining trend over the next several years. The fears of Emerging Currency declines post FED Tapering are vastly exaggerated. Post the panic phase the USD will decline long term.
The last wave of US Dollar decline resulted in the US Dollar Index falling from 120 in the year 2002 to 70 in 2008. The subsequent bounce back saw a rise back to the 90 levels. The next level of decline should see the USD Index move much below the 70 levels.
