Why the Dollar Rose in 2005 and the Prospect for 2006: Insights into the State of International Asset Markets and the Global Economy
CRS Report for Congress
Why the Dollar Rose in 2005 and the Prospect for
2006: Insights into the State of International Asset
Markets and the Global Economy
May 30, 2006
Craig K. Elwell
Specialist in Macroeconomics
Government and Finance Division
Congressional Research Service ˜ The Library of Congress
Why the Dollar Rose in 2005 and the Prospect for 2006:
Insights into the State of International Asset Markets
and the Global Economy
Summary
The dollar exchange rate rose substantially in 2005, up 7% in the major
currencies index and about 2.3% in the broad index, halting a three-year decline and
moving counter to the expectations of many observers.
The path of the dollar is symptomatic of underlying economic forces that shape
and propel U.S. international transactions. Of singular importance in this regard is
the waxing and waning of the world’s appetite for dollar denominated assets and the
associated flow of funds on international capital markets. A closer look at the several
forces that influence that appetite is revealing of, not only the ups and downs of the
dollar, but also of the forces behind the large current account imbalances in the world
economy (deficits in the United States and surpluses in other major economies).
The confluence of several forces likely explains the dollar’s recent strength.
Most importantly: the fast pace of U.S. economic growth, tax law changes, increases
in short-term interest rates by the Fed, and a large pool of oil export earnings looking
for a safe resting place.
The dollar weakened slightly in late 2005, but during the first four months of
2006, it has not shown any real trend, up or down. The major currencies index has
been flat and the broad index has appreciated slightly. Forecasting the path of the
exchange rate for the rest of the year is highly problematic, as the weight of economic
fundamentals on the dollar can be easily countered in the short-run by sudden shifts
in investor sentiment that are imperfectly understood. Consideration of the probable
forces that have the potential to influence rate of return on dollar assets and the need
to diversify out of dollar assets to minimize the risk of capital losses gives some
overall sense of how the relative probabilities for appreciation versus depreciation
stack up.
Whether the dollar rises or falls in 2006, there will still be reasons for concern
about the underlying health of and impending risks to the United States and global
economies, from the unhealthy combination of deficient domestic saving in the
United States and deficient domestic spending in the rest of the world. The
persistence of these large imbalances into 2006 is very likely only postponing an
inevitable day of reckoning. The delay makes the job of adjustment not only more
difficult but, perhaps, more risky.
For economic policy the task is how to assure an orderly correction of these
imbalances that leaves all the involved economies on sounder macroeconomic
footings. The most favorable economic outcome will result from coordinated policy
actions to raise saving in the United States, boost domestic demand in the Euro area
and Japan, and raise rates of domestic investment in the emerging economies of Asia
and the oil exporting economies.
Contents
In troduction ......................................................1
Possible Reasons for the Dollar’s Appreciation in 2005....................2
Strong Economic Growth.......................................3
Tax Incentives................................................5
Further Tightening of Monetary Policy.............................5
Decreased Personal and Public Saving.............................6
Reform of Japanese Postal Saving System..........................7
Rising Petroleum Export Earning.................................8
Reasons for Having Large Official Holdings....................10
Prospects for the Dollar in 2006.....................................11
Conclusion ......................................................13
The Perils of Current Account and Asset Market Imbalances...........13
A Problem with Asset Markets..............................14
Why the Dollar Rose in 2005 and the
Prospect for 2006: Insights into the State of
International Asset Markets and the Global
Economy
Introduction
The dollar exchange rate rose substantially in 2005, halting a three-year decline
and moving counter to the expectations of many observers. A steady depreciation of
the dollar from early 2002 through 2004 had brought the dollar’s value (on a real,
trade-weighted basis) down about 30% against major currencies and about 15%
against a broader group of currencies.1 It can be argued that such depreciation was
the inevitable consequence of America’s large trade deficit and the associated
accumulation of foreign indebtedness. But it was also a necessary aspect of the
process of correcting those huge imbalances and, as some see it, of mitigating the
looming risk of economic crisis that they carry with them. The growing concern at
that time was not that the dollar would stop falling, but that it might begin to fall too
fast to allow for an orderly correction of those imbalances. And, given the pivotal
role of the dollar and the U.S. market in the global economy, a sharp fall of the dollar
carries the risk of causing a global recession.2
In 2005, however, the dollar changed course and slowly but steadily appreciated
in value, up 7% in the major currencies index and about 2.3% in the broad index. The
appreciation was much more sizable against individual currencies, up about 14%
against the yen and 11% against the euro, but it appreciated little or not at all against
1 The real or inflation-adjusted exchange rate is the relevant measure for gauging effects on
exports and imports. A trade-weighted exchange rate index is a composite of a selected
group of currencies, each’s dollar value weighed by the share of the associated country’s
exports or imports in U.S. trade. The major currencies and the broad index cited here are
constructed and maintained by the Federal Reserve. The major currencies index is
comprised of 7 currencies traded actively outside of their home region. The currencies are
the euro, Canadian dollar, Japanese yen, British pound, Swiss franc, Australian dollar, and
Swedish krona. Because these currencies are traded in liquid financial markets this index
is useful for gauging financial (asset) market pressures on the dollar. The broad index
includes 26 currencies — the 7 in the major currencies index plus that of 19 more important
trading partners. Among the 19 are the currencies of China, Mexico, Korea, Singapore, and
India. The 26 countries account for about 90% of United States trade and, therefore, the
broad index is a good measure of changes in the competitiveness of U. S. goods on world
markets.
2 J. Bradford DeLong, “Divergent Views on the Coming Dollar Crisis,” The Economist’s
Voice, 2005, at [http:\\www.bepress.com].
the currencies of China and several other Asian economies that maintain their
currencies at a fixed rate to the dollar. This appreciation occurred even as the U.S.
trade deficit and foreign debt climbed to record levels.
The path of the dollar is symptomatic of underlying economic forces that shape
and propel U.S. international transactions. Of singular importance in this regard is
the waxing and waning of the world’s appetite for dollar denominated assets and the
associated flow of funds on international capital markets. A closer look at the several
forces that influence that appetite is revealing of, not only the ups and downs of the
dollar, but also the forces behind the large current account imbalances in the world
economy (deficits in the United States and surpluses in other major economies), large
asset market imbalances in the world economy (a large stock of liabilities in the
United States and a large stock of dollar assets in the investment portfolios of
foreigners), and the prospects for an orderly or disorderly correction of those
imbalances.
Possible Reasons for the Dollar’s
Appreciation in 2005
The dollar’s exchange rate is not fixed by U.S. policy; rather, like most other
major currencies, it moves flexibly with the forces of demand and supply in
international foreign exchange markets. These forces are ultimately derived from the
purchase and sale of dollar denominated goods or assets. Goods are, of course, things
like wheat, oil, pharmaceuticals, or aircraft; while assets are things like stocks, bonds,
and real property. An increase in foreign demand for dollar denominated goods or
assets also increases the demand in foreign exchange markets for the dollars needed
to buy those goods or assets, and that tends to bid up the dollar’s foreign currency
price. Conversely, a decrease in demand for dollar denominated goods or assets tends
to push the dollar’s foreign currency price down. For example, the fall of the dollar
over the 2002-2004 period was, in part, the result of a weakening of the demand for
dollar denominated assets by foreigners. 3
The supply of dollars on foreign exchange markets is determined by the
magnitude of the flow of dollars that Americans are exchanging for foreign currency
needed to purchase foreign goods and assets. For example, in the same 2002-2004
period, substantial increases in demand for both foreign goods and assets by U.S.
buyers also contributed to the weakening of the dollar at that time. This also shows
that the pressures on the dollar in the foreign exchange markets can arise from the
investment decisions of both foreign and domestic investors. It is also true that
economic policy, while aimed at other economic goals, can affect the demand and
3 The current account balance responds slowly to a lower dollar. It takes time for the volume
of U.S. exports to rise and the volume of U.S. imports to fall in response to the change in
relative prices caused by the appreciation. Because a depreciating exchange rate’s effect on
the price of imports is more immediate, the actual value of imports will rise for a while.
Therefore there will be a tendency for the trade deficit to get bigger before it gets smaller
after a currency depreciation.
supply of U.S. and foreign goods and assets and, thereby, indirectly affect the
exchange rate.
Asset markets, including the markets for foreign exchange, handle transactions
at a far greater volume and at a much faster speed than the markets for goods and
services. In 2004, just the daily trading on the world’s foreign exchange markets was
estimated to be in excess of $1.9 trillion, with 90% of that trade in U.S. dollars.4
Moreover, this buying and selling of dollars (and other assets) is largely a matter of
near instantaneous electronic transfer with no need for physical handling or transport.
Therefore, asset market events tend to play the dominant role in determining the path
of the exchange rates of the dollar and other major currencies. With assets in the
mix, it is possible to reconcile a rising dollar with a rising trade deficit, because the
upward push of the demand for dollar assets on the demand for dollars is greater than
the downward push of the trade deficit on the supply of dollars in the foreign
exchange market.5
The strength of net capital inflows (the difference between inflows and
outflows) from the rest of the world is a fairly consistent predictor of the general path
of the dollar. For example, during the period from 1996 to 2002, net capital inflows
grew from about $150 billion to $570 billion, and the dollar rose. For the period from
net capital inflows grew strongly again, reaching over $800 billion, and the dollar
appreciated.
The direction and strength of international asset market flows are subject to a
significant degree of uncertainty. Nevertheless, several factors in 2005 could have
contributed to a change in domestic and foreign investors’ calculation of the
acceptable balance between rate of return and risk from holding dollar assets,
triggering an increased capital inflow, and in conjunction bid up of the exchange
value of the dollar. The net effect emerges as the resolution of upward impulses that
happened and potential downward impulses that did not happen.
Strong Economic Growth
The U.S. economy has grown faster than most other industrial economies,
particularly those in the Euro area and Japan. For the 10 years ending in 2004, annual
growth rate of real GDP in the U.S. economy averaged 3.3%. This compares to an
average rate of 2.3% in the Euro area and 1.2% in Japan. For the 2003-2005 sub-
period the U.S. economy’s growth advantage was maintained, but there were some
compositional changes as economic recovery in Japan narrowed its gap with the
United States, while economic weakness in the Euro area economies increased the
U.S. advantage over them. In 2005, the year the dollar began to appreciate, real GDP
4 Triennial Central Bank Survey: Foreign Exchange and Derivatives Market Activity in
5 For a more extensive discussion of the determination of exchange rates see CRS Report
RL31985, Weak Dollar, Strong Dollar: Causes and Consequences, by Craig K. Elwell.
growth in the United States was 3.6% compared to 1.4% and 2.4% in the Euro area
and Japan respectively.6
Generally, a faster growing economy will generate more investment
opportunities that offer higher rates of return than will slower growing economies.
As will be discussed, higher rates of return can be the consequence of vigorous
activity in the private marketplace, but also the result of the configuration of
government policy. Further, rate of return advantages can be arrayed in various ways
between long-term and short-term assets as well as between high risk and low risk
assets.
The most ready measure of a rate of return advantage is the relative levels of
interest rates. In 2005, there was a significant widening of the spread between short-
term interest rates in the United States relative to short-term rates in the Euro area
economies and the Japanese economy. From an average of 1.6% in 2004, U.S. short-
term interest rates increased to around 3.5%, while in the Euro area economies short-
term rates moved up slightly from 2.1% in 2004 to 2.2% in 2005. In Japan, there was
no change with short-term rates staying at 0.0%. The spread on long-term interest
rates in the United States relative to those in the Euro area and Japan also widened.
This was due exclusively to a fall of long-term rates in both the Euro area and Japan
in 2005. In the U.S. long-term rates averaging 4.3% were unchanged from 2004 but
long-term rates in the Euro area economies fell from 4.1% to 3.4% and in Japan from
assets improved in 2005, the change was more significant for short-term assets.
The rate of return advantage in the U.S. economy is likely greater than the
spread between market interest rates would suggest, however. A study by the IMF of
rates of return to capital in the large industrial economies and the developing
economies for the decade 1994-2003 found the rate of return in the United States was
about 8.6% as compared with a G-7 average of about 2.4% and an emerging market
average of about minus 4.7%.7 Given that the U.S. economy’s rate of growth has
accelerated since 2003 (and accelerated faster than other advanced economies), this
large advantage likely still exists. But it is not possible to say that there was
sufficient variation in this rate of return advantage to explain a weakening of foreign
demand for dollar assets in the 2002-2004 period followed by a strengthening of that
demand in 2005.
Data on private (non-government) foreign purchases of U.S. assets in 2005 show
a substantial increase over 2004. Calculated on a net basis (outflows minus inflows)
private capital inflows in 2005 were nearly $570 billion, up from about $186 billion
in 2004. A major portion of the increase in private investment inflows was a $253
6 Data on economic growth rates taken from the OECD Economic Outlook, no. 78, Jan.
7 IMF, World Economic Outlook, “Global Imbalances: In a Saving and Investment
Perspective,” Sept. 2005, pp. 100-104.
billion swing in inflows for direct investment.8 In 2004, this category had a $145
billion net outflow (more out-bound direct investment than in-bound), a pattern that
had been intensifying since 2002. In contrast, in 2005 net direct investment had an
inflow (more in-bound than out-bound) of $108 billion, representing a change of
more than $250 billion.
This shift in direct investment flows is outwardly consistent with the notion that
faster relative growth attracts capital, but as discussed in the next section a special
factor may explain a large part of 2005’s direct investment shift. Other categories of
capital inflows comprising what is usually called portfolio investment ( unaffected
by tax law changes, and more short-term in nature), also increased substantially to
a net inflow of $494 billion, up from $374 billion in 2004. This acceleration of
portfolio investment may certainly have been pulled into the United States by the lure
of higher rates of return, but as discussed in latter sections of the report, there were
also forces that likely pushed foreign investors’ funds towards dollar assets,
regardless of the growth performance and level of rate of return.9
Tax Incentives
A large share of the $250 billion shift in direct investment inflows discussed
above was likely caused by U.S. companies moving reinvested earnings to the United
States from abroad to take advantage of the significant tax incentives provided by the
American Jobs Creation Act of 2004.10 This explanation gains credence when we
observe that nearly all of the net change in direct investment flows was caused by a
reduction of U.S. investors’ direct investment outflows from $252 billion in 2004
down to only $21 billion in 2005. Foreign direct invest inflows to the United States
increased only $27 billion in 2005. If it was only a matter of superior growth
performance prompting the shift of net direct investment flows, the change would
likely be more evenly split between domestic and foreign investor. This tax incentive
was only available in 2005, so its effect on international investment flows will be
limited to that year. Also, because this change is likely to be largely a matter of
shifting accounting entries for most multinational corporations, it would not have
much of an effect on the dollar’s exchange rate.
Further Tightening of Monetary Policy
The Federal Reserve continued to raise short-term interest rates in 2005. By
May 2006, there had been 16 straight rate increases over 19 months, causing the
federal funds rate to rise from 1.0% to 4.75%. As discussed earlier, the average level
8 Direct investment, in the United States and abroad, is defined as: the ownership or control,
directly or indirectly, by one foreign person (individual, branch, partnership, association,
government, etc.) of 10% or more of the voting securities of an incorporated U.S. business
enterprise or an equivalent interest in an unincorporated U.S. business enterprise.
9 Data on asset flows taken from the U.S. Department of Commerce, Bureau of Economic
Analysis, U.S. International Transactions in 2005, Mar. 2006.
10 CRS Report RL32652, The 2004 Corporate Tax and FSC/ETI Bill: The American Jobs
Creation Act of 2004, by David L. Brumbaugh.
of U.S. short-term interest rates increased from 1.6% in 2004 to 3.5% in 2005 and
this was also an increase relative to foreign short-term interest rates. The Federal
Reserve’s intention is to use monetary policy to slowly tighten the reins on aggregate
spending through higher borrowing costs and thereby forestall an acceleration of the
rate of inflation as the economic expansion proceeds.11 However, higher interest
rates will, other things equal, also tend to increase the attractiveness of dollar assets
to foreign investors and bid up the dollar’s exchange rate. This will have its strongest
effect on the foreign purchases of short-term investments, particularly of highly
liquid U.S. Treasury securities. In 2005, foreign purchases of Treasury securities
increased to a record $196 billion, up from $107 billion in 2004.
Decreased Personal and Public Saving
The personal saving rate in the United States has been very low in recent years,
fluctuating narrowly between 1.3% and 1.8% of GDP from 1999 to 2004. The
decline of the personal saving rate since 1999 has been an important reason for the
United States having to attract large inflows of foreign capital (i.e. foreign saving)
to help fund domestic investment, and therefore, a source of upward pressure on the
dollar exchange rate. In 2005, however, the personal saving rate fell even lower,
descending to negative rates through most of 2005. A particularly sharp reduction
in personal saving occurred in the third quarter, with the saving rate falling to -1.3%
of GDP.12 That represented a decrement to national saving of nearly $120 billion
from the second to third quarter of 2005. A negative saving rate means that
households were digging into past saving to pay for their current expenditures. Also
in the second half of 2005, the government saving rate, or more accurately the
government dissaving rate (i.e. a negative saving rate) caused by federal budget
deficits, deteriorated (at a quarterly rate) from -0.4% to -0.8% of GDP. That
translates to a decrement to national saving of about $60 billion in the second half of
Other things equal, a substantial reduction in theses two sources of national
saving would decrease the pool of saving available to the economy for financing
domestic investment, put upward pressure on domestic interest rates, raise the
attractiveness of dollar assets, and exert upward pressure on the exchange rate. Other
things were not equal, however. For at the same time that there was an intensification
of personal and government dissaving, there was an offsetting increase in business
saving. (Business saving is composed of undistributed business profits.) So, despite
two significant negative impulses, the overall national saving rate did not decline in
2005. At 13.5% of GDP, the overall rate of national saving was slightly above the
11 The Federal Reserve Board, Testimony of Chairman Ben S. Bernanke, Before the
Committee on Financial Services, U.S. House of Representatives, Feb. 15, 2006.
12 U.S. Department of Commerce, Bureau of Economic Analysis, Survey of Current
Business, April 2006.
rate was 16% in 1995, rose to a high of 18% in 1999, and has steadily fallen since
then.)13
Therefore, despite some significant negative impulses, it could not be
concluded that a fall of the national saving, itself, contributed to the rise of the dollar
in 2005. What can not be determined is if the fall in the personal and government
saving rates might have changed investor expectations about the future path interest
rates and the dollar itself, causing some speculative capital inflows and upward
pressure on the dollar.
What is known, however, is that the rate of gross national investment increased
to 19.7% of GDP, from 19% in 2004. Meaning that, with the saving rate essentially
unchanged from 2004, bridging the bigger gap between the domestic saving available
to fund investment and the level of investment undertaken required the inflow of
foreign capital to increase to 6.3% of GDP in 2005 from 5.6% of GDP in 2004. A
greater capital inflow puts greater upward pressure on the dollar exchange rate. This
is really just another way of looking at the process discussed in the earlier section on
economic growth.
Reform of Japanese Postal Saving System
Since October 1, 2005, it has been possible for Japanese savers to buy shares of
mutual funds at their post office. The postal saving system is the principal financial
institution for most Japanese households and it has accumulated about $3 trillion in
assets, making it the world’s largest bank. Prior to last year’s reform, Japanese
households were limited to accumulating relatively low-yielding Japanese
government bonds.14
With more lucrative alternatives now available, a large diversification of
perhaps as much as $1 trillion out of the current holdings of largely low-yielding
Japanese government bonds is expected. Even with a significant home-bias, it is
unlikely that Japanese asset markets can offer enough sufficiently profitable
investment options to absorb anything close to the amount of funds likely to flow
from this diversification. Therefore a big share of these funds is expected to flow
toward higher yielding foreign assets. Initial sales are reported to have favored
foreign bond funds. Any such portfolio diversification of foreign investors out of
non-dollar assets can be seen as a force tending to push foreign capital towards the
large, well-functioning dollar asset markets.
Purchases of dollar assets are likely a substantial component of the ongoing
diversification of Japanese households asset portfolio for two reasons. First, as
already discussed above, dollar assets have historically offered a steady high-risk
adjusted return that makes them more attractive than assets denominated in other
easily convertable currencies such as the pound, yen, or euro. Second, the large size
13 CRS Report RS21489, Saving Rates in the United States: Calculation and Comparison,
by Brian W. Cashell.
14 Daniel Engber, “How Japan’s Postal Service Got $3 Trillion”, Slate (www.slate.com),
August 5, 2005.
of the U.S. asset market allows it to easily accommodate large investment inflows as
well as offer a ready market for any future sale of those investments. The precise
magnitude of effect on the dollar exchange rate in 2005 of investment inflows from
Japanese Postal Saving funds is not known, and the time period during which this
flow of Japanese funds could have occurred in 2005 was only three months.
Nevertheless, it seems likely that this was the source of some upward pressure on the
dollar in late 2005.15
Rising Petroleum Export Earning
Because the international oil market does business largely in dollars, rising
prices translate into a rising demand for dollars. This boost in demand was large.
The IMF estimates that the current-account surpluses of oil exporters may have
increased nearly $440 billion in 2005, an outflow of finds more than four times the
size of that in 2002.16 These funds are not being spent immediately on goods and
services, but saved. Therefore, they are being placed in some type of asset, most
likely one denominated in a readily convertible currency that also offers a good
return, low risk, and easy access.17 This is another instance of foreign portfolio
diversification out of non-dollar assets that tends to push foreign capital towards the
large, well functioning dollar asset markets.
As discussed in the previous section, only the large pound, yen, euro, and dollar
asset markets can easily accommodate transactions on this scale and, at the same
time, offer the investor the high degree of liquidity. If these oil exporters chose to
swap their dollar earnings for other hard currencies, it would have exerted substantial
downward pressure on the dollar. But the superior performance of the American
economy means that the dollar market is also offering the investor higher return and
lower risk than in the other hard currencies. Because these purchases are often made
through third parties, the flow of earnings into dollar assets is difficult to measure,
but most experts believe the bulk of theses flows are into dollar assets. This is
consistent with the increase of private foreign purchases of U.S. Treasury securities
and non-Treasury securities assets in 2005 cited above. Given that high energy prices
are most likely going to continue for some, upward pressure on the dollar exchange
rate can be expected to continue as well.
Foreign Central Banks Slow Accumulation of Dollar Assets
A telling aspect of international transactions for dollar assets in 2002, 2003, and
2004 was unusually large and accelerating purchases of dollar assets, primarily of
liquid U.S. Treasury securities, by foreign central banks. Foreign central bank
official holdings of U.S. securities increased by about $673 billion over that three-
year period. The total accumulation of official holdings in this period across the
major hard currency assets (yen, dollar, euro, pound) was $1.6 trillion. For the
15 John Makin, “Japan Moves toward Sustainable Recovery,” Economic Outlook: AEI
Online, Oct. 27, 2005, at [http:\\www.aei.org].
16 IMF, World Economic Outlook (chapter 2), Apr. 2006.
17 “Recycling the Petrodollars,” The Economist, Nov.10, 2005.
United States, the scale of the foreign central bank accumulation of dollar reserves,
concurrent with greatly reduced private foreign purchases of U.S. assets, led to the
unusual condition of official purchases exceeding private purchases by more than
$200 billion on a net basis. Such substantial official purchases certainly countered
the forces pushing the dollar exchange rate down in this period — not stopping that
process, but doubtless slowing it.18
For many observers in 2005, the unprecedented scale of the build up over the
previous three years of official holdings by foreign central banks was unlikely to
continue for much longer. Several factors suggested a sizeable and imminent sell-off
of dollar assets by foreign central banks. One, the prospect of further dollar
depreciation would mean a large loss of earnings on these holdings. Two, central
banks would move to forestall the rising risk of inflation associated with such
massive accumulations of official holdings.19 Three, in response to mounting
political pressure, many thought China would let its currency appreciate relative to
the dollar. Therefore, there was concern that sizable movement out of dollars by
central banks coming on top of the ongoing weakening of demand by private buyers
could trigger a dollar collapse that could send recessionary ripples across the world
economy.
During 2005, however, foreign central banks did not undertake a large scale sell-
off of dollar assets. Japan’s central bank, after several years of large scale purchases,
stopped accumulating dollar reserves in 2005, but it did not selloff its existing
holdings. Other Asian central banks, particularly China’s, continued to amass dollar
reserves in 2005, however, the pace of accumulation on a net basis by all sources
slowed. The increase in 2005 totaled $235 billion as compared with a $399 billion
gain in 2004. This brought the total worldwide official holdings of dollar assets to
about $900 billion. One would conclude, then, that earlier upward pressure on the
dollar from these central bank activities abated in 2005, but there was not the overt
downward pressure from a mass central bank selloff that many had anticipated.
As discussed in a later section, a sizable share of the accumulation of dollar
assets by foreign central banks since 2002 has been the result of some countries
trying to stabilize or fix the value of their currency relative to a falling dollar. This
introduces a degree of interdependence between the dollar’s path and the rate of
accumulation of dollar reserves, for, with the dollar rising for other reasons in 2005,
fewer reserves needed to be accumulated to achieve the currency stabilization goal.
Some diversification of foreign official holdings did occur, but it is interesting
to observe that a significant portion of it was across classes of dollar assets rather
18 See CRS Report RL33274, Financing the U.S. Trade Deficit, by James K. Jackson.
19 Any increase in the central banks holdings of assets increases the money supply, which
in some circumstances might cause an acceleration of inflation. To nullify this potential
inflationary effect of asset purchases, central banks sometimes carry out equal sized but
offsetting transactions in domestic assets that leave the central banks total asset holding
unchanged. This is called a sterilized foreign exchange intervention. The capacity for
successful sterilization is limited by the stock of domestic assets and the tendency in less
developed financial systems for reserve inflows to leak into the economy.
than across assets in other currencies. Federal Reserve data on changes in custodial
holdings for other central banks at the New York Fed show a large shift in purchases
from Treasury securities into government sponsored enterprises (GSEs) and agency
bonds. Out of a recorded increase of foreign official holdings in 2005 of about $184
billion, $38 billion was of Treasury securities and $146 billion was of GSEs and
federal agency bonds. This is in sharp contrast to 2004, when foreign central banks
purchased $205 billion in Treasury securities and $66 billion in federal agency
bonds.20 Presumably, the higher yield on federal agency bonds offsets some of the
risk of holding dollar assets.
Reasons for Having Large Official Holdings. Official holdings are used
for two purposes: one, to afford a country sufficient international liquidity to finance
short-run trade deficits and weather periodic currency crises; and two, to stabilize a
country’s exchange rate. The liquidity function is usually only important to emerging
economies that do not have a readily convertible currency or ready access to
international capital markets on favorable terms. The Asian financial crisis of the
late 1990s showed emerging economies that enormous liquidity balances are
necessary to weather a currency crisis and since then they have accumulated21
enormous official holdings of foreign exchange reserves.
The currency stabilization function has been a particularly important motive for
the accumulation of foreign exchange reserves during the 2002-2004 period by the
central banks of Japan, China, Taiwan, Korea, and India. The central banks of Japan
and China undertook particularly enormous accumulations of foreign exchange
reserves in this period($373 billion and $323 billion respectively). The individual
accumulations of Taiwan, Korea, and India were far smaller; nonetheless, their
collective reserve growth was more than $200 billion. For comparison, in 2004, the
far larger U.S. economy’s official reserves increased less than $3 billion, bringing its22
total stock official reserves to only $190 billion.
There are no data to gauge what portion of these total reserve accumulations of
the central banks are of dollar assets. However, since in each instance the focus was
primarily to fix or control their currency’s value relative to the dollar so as to
maintain a competitive price of their exports in the American market, a very large
share of these official holdings was likely of dollar assets, most often U.S. Treasury
securities. Worldwide official holdings of dollar assets increased $415 billion
between 2002 and 2004.
20 Federal Reserve Board, H.4.1 statistical release, various issues (www.federalreserve.gov)
21 International Monetary Fund, Revised IMF Annual Report: Data on Official foreign
Exchange Reserves, November 2005.
22 U.S. Department of Commerce, Bureau of Analysis, International Transactions in 2004,
Survey of Current Business (www.bea.gov), April 2005.
Prospects for the Dollar in 2006
The dollar weakened slightly in late 2005, but through April 2006, it did not
show any true trend, up or down. The major currencies index has been flat and the
broad index has appreciated slightly. Forecasting the path of the exchange rate for
the rest of the year is highly problematic, as the weight of economic fundamentals on
the dollar can be easily countered in the short-run by sudden shifts in investor
sentiment that are imperfectly understood. What will be done here is to lay out the
probable disposition of forces that will have the potential to influence the two key
investor motives for holding dollar assets: the incentive to earn a high rate of return,
and the need to diversify to minimize the risk of capital losses from holding too many
assets in any particular currency. Considering this array of potential forces will at
least give some overall sense of how the relative probabilities for appreciation versus
depreciation stack up.
In 2006, the prospect of a high risk-adjusted return will likely continue to make
dollar assets attractive to foreign investors. Economic growth in the United States
accelerated to 5.3% in the first quarter of 2006 and is generally projected to outpace
of other major economies this year. Faster growth usually translates into higher
corporate earnings and higher investment returns, that attract foreign capital inflows
and tends to push up the dollar exchange rate. Telling evidence in this regard is that
long-term interest rates have risen in late 2005 and early 2006. The yield on inflation
adjusted 10-year Treasury securities has risen nearly a half a percentage point during
the six-month period ending in March 2006.
One important uncertainty about relative economic performance of other hard
currency economies is whether Japan, after a long period of feeble growth, will
continue the improvement in economic performance evident in 2005. Japan’s growth
is still likely to fall well short of that in the United States, but the ability to have
strung together two years of reasonable growth and the common forecast of healthy
growth in 2006 may persuade some Japanese investors that Japan’s economic
performance will continue to be good and persuade Japanese investors to move into
domestic assets rather than into dollar assets. Also, the Euro area economies are
expected to pick up the pace of growth in 2006, which is an improvement relative to
a lackluster performance in 2005, and will likely still lag well behind the pace of
growth in the United States.
The one-time tax incentives that put upward pressure on the dollar in 2005 will
be absent in 2006. However, probable continuation of U.S. monetary and fiscal
policies that combine large Federal budget deficits with a steady tightening of
monetary policy would tend to push up U.S. interest rates and add to the
attractiveness of dollar assets in 2006. In late April, however, comments by the Fed
Chairman, Ben Bernake, suggested that the Fed’s policy of monetary tightening
might be ending. The importance of monetary policy for the near-term behavior of
the dollar was made clear by some investors quickly selling dollar assets and causing
a fall of the dollar in some markets, apparently in response to the mere suggestion of
a policy change.
Outsized portfolio diversification from some sources toward dollar assets in
2006 seems probable. First, it is likely in 2006 that a goodly share of portfolio
diversification out of yen assets held by the Japanese postal saving system will be
toward dollar assets. This is apt to occur on a greater scale in 2006 than in 2005.
Second, the prospect of further increases in petroleum prices will likely lead to
further large portfolio diversification towards dollar assets by oil exporting nations.
As discussed above, both the great size and efficiency of U.S. asset markets as well
as advantages in rate of return will tend to draw in these funds.
Yet the incentive for private investors in general to diversify out of dollar assets
seems also very big. Many experts argue that the U.S. current account deficit is too
large to be sustainable and that the dollar’s exchange rate would have to fall by at
least 30% to shrink the trade deficit from its current level of 7% of GDP to a
sustainable level near 3% of GDP. Dollar depreciation of that magnitude would
easily swamp the interest rate differences that currently favor dollar assets, meaning
that holders of those assets would see the potential earnings from those investments
quickly wither away, while the attractiveness of assets denominated in appreciating
currencies increase. This prospect would seem to be a compelling reason for profit
sensitive investors to move out of dollar assets and into euro or yen assets. (This is
all the more compelling if growth in these economies seems to be closing the gap
with that in the United States.) The investor sensitivity to this prospect is evidenced
by the short-term weakening of the dollar that often follows release of official
statistics showing the U.S. trade deficit continuing to grow.
Whether the central banks of countries actively using foreign exchange reserves
to fix or stabilize their currencies relative to the dollar will continue to amass dollar
reserves probably hinges on the direction of the several market forces just discussed
and on whether China remains committed to maintaining its fixed parity with the
dollar. It may be that China sees the fixed parity as a critical anchor that contributes
to the economic stability needed to attract long-term foreign investment, and sustain
the rapid pace of economic growth needed to continue the still formidable task of
absorbing China’s huge labor force into the industrial sector. If it does, it will
accumulate dollar assets as necessary to counter downward pressure on the dollar
relative to the yuan. On the other hand, if the dollar is subject to upward pressure,
maintaining the fixed parity would call for the sale of dollar assets. Other Asian
economies, trying to maintain the dollar competitiveness of their exports relative to
China’s in the U.S. market, will likely buy or sell dollar assets in step with China.
What is difficult to assess is the extent to which liquidity needs, distinct from
that of currency stabilization, will influence the holding of dollar reserves by the
Central Bank of China. While China’s current reserves are large, it is also true that
China is under considerable international political pressure to open up its financial
markets and make the yuan a flexible, convertible currency. A huge stock of foreign
exchange reserves holdings may be seen as necessary to make the passage through
this potentially very stormy transition.
It also seems unlikely that the Bank of Japan, the world’s largest foreign holder
of dollar assets, would undertake any large selling off of those assets at this time.
Japan’s tenuous current economic expansion is very likely tied to the growth of net
exports, and therefore it seems unlikely that Japan’s central bank would dump dollar
assets, causing the yen to appreciate, and, thereby, eroding competitiveness of
Japanese products in the U.S. market.
In a world awash in dollar assets, many offering only a modest rate-of-return
advantage over alternatives in other hard currencies, and with the looming prospect
that at some point a large deprecation of the dollar will be necessary to correct the
United State’s huge current account imbalance, prudent foreign investors might try
to get ahead of impending earnings and capital losses on their dollar investments that
a large dollar depreciation would cause, and diversify out of dollar assets. That this
has not occurred so far may speak to a significant degree of investor myopia and the
risk of an all too abrupt clearing of vision down the road.
Conclusion
Whether the dollar rises or falls in 2006, there will still be reasons for concern
about the underlying health of and impending risks to the U.S. and global economies.
The Perils of Current Account and Asset Market Imbalances
A rising dollar in 2006 would certainly speak to the seeming limitless capacity
of the U.S. economy to attract a still larger inflow of foreign investment (i.e. foreign
saving) despite an already large stock of indebtedness to foreigners. That
attractiveness, however, is relative; contingent, not only on U.S. economic
performance, but also that in the rest of the world.
Maintaining these imbalances at the current scale or larger can occur only
through, what many economists see as, a continuation of the unhealthy combination
of deficient domestic saving in the United States and deficient domestic spending in
much of the rest of the world. The persistence of these large imbalances into 2006
is very likely only postponing the inevitable day of reckoning. This delay arguably
makes the job of adjustment not only more difficult but more risky.
At some point it seems inevitable that international asset markets will force
some correction of these international imbalances. Capital inflows to the United
States will abate and the dollar will depreciate. This adjustment will most likely be
orderly and without crisis. The U.S. experience with adjustment from current
account and financial market imbalances in the 1986-1990 period shows that the
process can be orderly. However, while occurring without crisis, such a correction
happening without policy changes in the United States and abroad will not likely be
on the best terms for deficit and surplus economies alike.
A falling dollar in 2006, that is propelled by an ebbing of foreign capital inflows
to the United States, would act to reduce the nation’s large trade deficit as a
depreciating currency works to boost U.S. exports sales and dampen the purchase of
imports. But, if this is occurring in an economy that has done nothing to boost its
low saving rate, then interest rates will tend to rise, forcing a reduction in domestic
investment spending to a rate consistent with the smaller flow of saving available to
the economy. Less investment would ultimately lead to slower economic growth.
Conversely, if the diminished outflow of saving from foreign economies occurs
without a commensurate increase in domestic demand in those economies, then the
accompanying slowdown in their net exports would dampen near-term economic
growth. Presumably falling interest rates and appreciating exchange rate would
provide an off-setting stimulus to their domestic consumption and investment. But
because the adjustment speeds of net-exports and domestic spending may differ there
is a risk of economic contraction in the short-run. Given that these economies use
increased net exports to the United States as a major engine for economic growth,
this short-run economic shock could be substantial.23
A Problem with Asset Markets. Although asset market trade offers
opportunities to raise overall economic efficiency and improve the economic welfare
of borrower and lender alike, trade in assets is prone to occasional mistakes, the
resolution of which can lead to crisis and collapse. The negative repercussions of
such a collapse could extend beyond the asset market to the wider economy.
The essential weakness of asset markets is that assets are a claim on a stream of
earnings over time — and the future is always uncertain. This can mean that
relatively small changes in investors’ beliefs about that future could have large
effects on the value of the asset. This tends to make these markets much more
volatile than goods markets, where value is far less contingent on the uncertainties
of the future. Add to this the often observed tendency for “herd-like” behavior
among investors, particularly those focused on the short-run, and the volatility in
asset markets can grow larger. Then add in “leveraged purchases,” the inherent
weakness of modern “fractional-reserve banking,” “exchange rate risk,” and the usual
problems of distance (i.e., different language, law, and business practices) and the
potential for volatility and crisis becomes even larger.
In the current context, a disorderly adjustment to the world’s current account
imbalances could be precipitated by a large decline in market preferences for dollar
assets that pushes the dollar down sharply. In the United States, this would cause a
spiking of long-term interest rates and rapidly falling asset prices that would combine
to slow spending by households and business. The weaker dollar does provide a
stimulus to U.S. export sales, but in the pessimistic scenario this is not large enough,
or soon enough to prevent recession In the surplus countries, most of whom rely
heavily on export sales to propel their economies, sharp appreciation of their
currencies would induce recession there as well.
In contrast to the orderly adjustment in the 1986-1990 period, four factors make
a similar achievement more difficult now. One, oil prices were falling sharply in the
late 1980s, but now oil prices are rising sharply. This would add to the inflation
impact of a falling exchange rate and hamper the Federal Reserve’s ability to counter
the interest rate spike. Two, in the 1986-1990 episode other economies’ central
banks, particularly Japan’s, were willing to buy a large volume of dollar assets,
providing a stabilizing counter force to the falling dollar and the rising yen. Given
23 For discussion of the effects of adjusting to a smaller capital inflow and smaller trade
deficit see CRS Report RL33186, Is the U.S. Current Account Deficit Sustainable?, by Marc
Labonte.
the already huge stocks of dollar assets being held abroad this action seems
improbable today. Three, in the 1986-1990 period Europe, the strongest market for
U.S. exports, was booming. Today economic growth in Europe is weak. Four, the
size of the imbalance is twice as large now. Disorderly adjustment and crisis are not
the most probable outcome, but it is a risk that likely grows with the scale of the
international imbalances.
There is no settled opinion about how to best manage asset markets, but it seems
likely that removing any large scale imbalances in asset markets would also limit the
potential for economic harm and, therefore, would be a reasonable policy goal.
Policy Implications
As this report hopefully makes clear, the dollar’s exchange rate is not an
appropriate direct target for U.S. economic policy because it is only a symptom of
more fundamental economic forces, particularly those that influence the demand for
and supply of assets in the international market place. Currently, an examination of
those forces highlights the large and potentially destabilizing imbalance in the global
economy: in the United States persistent large trade deficits and the accumulation of
foreign debt, and in the rest of the world large trade surpluses, weak domestic
demand, and the accumulation of dollar denominated assets. Most economists would
argue that this is a condition that carries more than a negligible risk of generating
financial instability and global recession.
A Program for an Orderly Correction of Global Imbalances. For
economic policy, the task is how to assure an orderly correction of these imbalances
that leaves all the involved economies on sounder macroeconomic footing. A recent
IMF study of current global economic imbalances reached conclusions that are
generally consistent with mainstream economic thinking on this topic. That study
suggested a coordinated international policy response, the essential elements of
which are as follows:
!For the United States to raise its national saving rate. How to
increase the personal saving rate remains problematic, so higher
national saving would likely require an increase in public saving
through a shift of the federal budget from deficit to surplus.
!For Japan and Europe to generate faster economic growth propelled
primarily by domestic demand rather then net exports.
!For Asia (excluding Japan and China) and the oil-exporting
economies a recovery of spending on domestic investment is called
for.
Many would add to this agenda the need for China to allow its currency to
appreciate and for that economy to channel more of its large saving pool into
domestic investment. At present, it can be argued, China, by accumulating short-
term reserves to maintain an undervalued exchange rate, is running a “neo-
mercantilist” policy that allows it to run a large trade surplus to generate demand for
its products and also have a large net inflow of long-term capital to help propel its
economic development. For an economy of China’s size this not likely to be a
sustainable process from the viewpoint of its trading partners. If it needs the inflow
of long term capital it should allow the real transfer of those resources by running a
trade deficit, or be prepared to use more of its own saving to support domestic
investment rather than transfer that saving to the rest or the world.
From the standpoint of mainstream economics this program would, in the end,
provide a better chance of establishing a more healthy macroeconomic foundation for
the United States and the global economies, at once minimizing the prospect for
global economic crisis and promoting sustainable and vigorous long-term growth.