Why the U.S. Dollar Will Remain Strong

The president is irked by the dollar’s persistent strength, but he shouldn’t blame China or the Fed.

This month the Trump administration officially declared China a currency manipulator. This declaration, the latest salvo in the ongoing U.S.–China trade war, came after the Chinese government allowed its currency, the yuan, to fall to its lowest value in a decade. It is now trading at just over 7 yuan to a dollar.

The currency-manipulation designation is one of the most unwarranted charges volleyed against China by the Trump administration. The depreciation of the yuan was largely caused by market forces and, by most accounts, China has not been a currency manipulator since about 2012.

But the Trump administration’s concern over currency values is linked to a more general irritation lurking beneath the surface of this trade fight: the strength of the dollar over the past few decades. As seen in Figure 1, the dollar has tended to be overvalued more often than not, a key reason for the persistent U.S. trade deficits:

Some of the dollar’s strength during this time can be attributed to past mischief in currency markets by China, but more can be ascribed to the unique role the U.S. financial system plays in the global financial system. It is important, then, that we understand the relative importance of these two backstories if we want to make sense of why the dollar tends to be overvalued.

China and the Dollar
Consider first the role of China. Starting in the early 2000s, the opening up of the Chinese economy contributed to a doubling of the global labor force and turned the country into an export powerhouse for goods requiring cheap labor. But China decided that it needed more than its low labor costs to keep its economy fully employed. As a result, it began efforts to keep down the value of its currency as a way to make its goods cheaper on the global marketplace and further boost its exports to the world. It did so by buying up dollars and selling yuan on a large scale.

It is this past currency mischief by China that gave the country a reputation as a currency manipulator. Most observers, however, believe that China engaged in such mischief only between 2003 and 2012. Even the U.S. Treasury Department concurred with this consensus — up until this month.

The fruits of this currency manipulation are most evident in China’s current-account (CA) balance, which combines all its foreign transactions, including trade activity, into one measure. A positive CA balance means first that China is running a trade surplus with the world and second that it is lending funds to foreigners so they can pay for the Chinese goods. A negative CA balance would mean the opposite.

Figure 2 shows that China’s CA balance surged between 2003 and 2012. A CA balance of 3 percent or less is considered normal, so this bulge is generally understood to be evidence that China was undervaluing its currency during this time to boost exports. The CA balance surge, however, is now long gone. Along with other indicators, such as China’s declining stash of foreign assets, this declining CA balance corroborates the standard view that China is no longer a currency manipulator.

What, then, are we to make of the yuan’s depreciation this month? It is the largely the result of China’s weakened economy pulling the yuan down. The Chinese government had been fighting the downward pressures on the yuan, but it finally buckled. The timing of the depreciation was surely influenced by the trade war, but at its core, the yuan’s decline was the consequence of downward market pressure on the yuan.

In short, China has contributed to the dollar’s strength in the past, but that time is long gone. The Trump administration is therefore barking up the wrong tree by labeling China a currency manipulator today.

The U.S. Financial System and the Dollar
If China isn’t responsible for the strong dollar that continues to flummox the president, what is? A better explanation is the unique role the U.S. financial system plays in the global economy: It acts like a banker to the world.

Charles Kindleberger first noticed this in 1965, when he observed that the United States tended to borrow for the short term at low interest rates from the rest of the world while investing abroad in riskier, long-term assets that earn a higher return. Put differently, the United States was issuing a lot of highly safe and liquid assets like treasury bills and commercial paper to foreigners while acquiring claims to riskier assets like stocks and physical capital in other countries. As a result, the United States’ balance sheet with the rest of the world looked a lot like a bank’s balance sheet. Kindleberger observed that the U.S. financial system was providing an important financial intermediation service to the world.

Fast-forward to the present, and Kindleberger’s insight holds true. Globalization has led to an even greater need for the United States to act as a banker to the world, as the financial integration of the world economy has not led to a proportional deepening of financial markets. China, India, and other emerging markets, for example, saw their economies grow rapidly, but they were unable to adequately expand their capacity to produce safe stores of value.

This disconnect created a void that was largely met by the U.S. financial system. The United States had the deep financial markets and relatively stable governance that gave it, unlike other countries, the capacity to produce large-scale amounts of safe assets for the rest of the world. The Great Recession, weak recovery, and subsequent post-crisis financial reforms have only increased this heightened demand for safe U.S. assets since 2008.

Figures 3 and 4 document this banker-to-the-world role. Using data from the U.S. Financial Accounts, the figures show the U.S. balance sheet with the rest of the world since 1975. Figure 3 shows the liability side of the balance sheet: the assets we have issued to foreigners. The blue and gray areas show the safer assets provided to the rest of the world, while the pink areas show the risker assets. During the financial crisis, safe assets made up 77 percent of total liabilities to the world, and while the the safe asset share has shrunk more recently, it remains a majority of U.S. liabilities at 60 percent.

Figure 4 shows that assets owned abroad by the United States and reveals that riskier assets make up just over 70 percent of the total:

These numbers resemble those of a bank’s balance sheet, and this banker-to-the-world role explains why the dollar tends to be overvalued. The world needs dollars to buy safe assets from the United States. This, combined with the reserve-currency role held by the dollar, raises demand for the dollar, making it more expensive. As long as the U.S. remains the main supplier of safe assets to the world, the dollar will continue to be relatively pricey, and the U.S. will probably continue to run trade deficits.

The Cross We Have to Bear
Ultimately, then, the real source of President Trump’s angst is not China or any other “currency manipulator” but the special role played by the U.S. financial system in the global economy. Some advanced economies like Germany could help by providing more safe assets, but none has the ability to produce at the scale of the U.S. economy. The United States is currently the only game in town for the mass production of safe assets.

This banker-to-the-world role does have costs. But just as one can view the cost of NATO as an investment in global peace, so can one view the cost of the banker-to-the-world role as an investment in the stability of the global financial system. Any attempt to undermine this role, such as recent proposals to tax it, are likely to intensify the demand for safe assets and further drive down already-low interest rates. That outcome would probably be even worse for the country, so for now, the banker-to-the-world role is the cross we have to bear.

[A strong dollar may not be great for trade, but it’s essential to the economic survival of the US and the world. Zimbabwe and Venezuela can suffer hyper-inflation and the world barely notices, but if the dollar collapses we will enter a new Dark Ages globally.]

The alternative to an overvalued dollar is not hyperinflation. It’s a fairly valued dollar. Zimbabwe’s and Venezuela’s problems aren’t caused by their currency exchange rates. Their currency exchange rates are caused by their economic problems, which in turn are caused by nutty economic policies. Every other country (including Singapore and Switzerland*) has a strategy to punish speculators and foreign countries that try to push their currency’s value to the point of overvaluation. The US is the exception.

The principal problem is that so many countries use the US dollar as their reserve currency. That, and the fact that so many also use the dollar for trade, help to inflate the dollar’s value, which imposes real economic costs on the nation’s manufacturers and workers, by making them less competitive in world markets. This is a problem that can only be solved using capital controls**. But capital controls are also problematic in that they feed domestic asset bubbles***.

Excerpt from the Financial Times:

https://ftalphaville.ft.com/2018/09/19/1537329600000/China-s-currency-will-not-replace-the-US-dollar/
[The size of the US economy and the level of trade are not the only reasons the US dollar is the principal foreign reserve currency. The transparency of the US financial markets as well as the predictability and credibility of monetary policy reinforce the safe-haven status that the dollar holds. Unlike many other economies, the current structure of the US economy also makes it reasonably tolerant to running continuous trade deficits, which also supports our view that the US dollar is to remain the dominant foreign currency reserve for some time. The convenience and cost advantage of trading in US dollars mean that central banks would have to weigh up the outlay of shifting a sizable dollar portion into alternative currencies. In addition, the extensive proportion of US dollars in foreign reserves means that although shifts in reserve holdings do occur, it could take decades for them to accumulate into a notable shift in the US dollar’s position as the key global reserve currency.

China may have the economic heft, but its currency does not float freely, its local financial markets are not fully accessible to foreign investors and its monetary policy is far from predictable. The Party can throw up capital controls whenever it sees fit — a tactic it used between 2015 and 2016 after it stunned financial markets with an surprise 2 per cent devaluation of its currency.

Allowing market forces to play a larger role in determining the renminbi’s value and opening up the capital account would require a complete overhaul of the country’s financial system. If there was ever a good time to take on this monumental task, now does not appear to be it: Chinese officials are fending off a financial crisis as they scramble to manage an enormous domestic debt bubble.]

* https://www.moneyandbanking.com/commentary/2015/1/18/a-swiss-lesson-in-time-consistency

** https://en.wikipedia.org/wiki/Capital_control

*** https://asia.nikkei.com/Economy/China-s-capital-controls-give-bubbles-fresh-fuel

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