Trumping the global monetary system
It is difficult to know exactly what US president-elect Donald Trump will do when he takes office in January. But thanks to his vow to pursue tax cuts and increase infrastructure spending, financial markets expect faster growth in the United States — a perception that is boosting the dollar’s exchange rate against most currencies, including the renminbi, and triggering capital flight from emerging economies.
Notwithstanding Trump’s vow to impose tariffs of up to 45 percent on Chinese goods, a resurgent dollar will hurt the US’ trade competitiveness, as according to the International Monetary Fund, the dollar was already about 10-20 percent overvalued in June.
And while trade is supposed to be the primary driver of exchange rates, capital flows have grown to the point that their role in guiding exchange rates is now much larger. In this context, market optimism about US growth could lead to ever-larger imbalances and possibly disrupt the international monetary system.
Besides, from 1997 to 2007, the US net investment deficit widened by only $0.3 trillion, while the net investment surpluses of China, Japan and Germany rose by $1.2 trillion, $1.1 trillion, and $0.8 trillion. The major investment-deficit players were the eurozone minus Germany, with a deficit of $2.4 trillion during that decade, and the UK, with a deficit of $0.5 trillion.
Over the next seven years, until 2014, the US’ net investment position declined by $5.7 trillion, leading to a liability of 40.2 percent of GDP. Germany’s net investment surplus increased by $0.8 trillion, Japan’s rose by $1.2 trillion, and China’s was up by $0.7 trillion. The rest of the world’s net investment position strengthened by $3 trillion during this period, owing mainly to the commodity boom, which faded as China’s economy slowed.
The rapid growth in the US’ gross liabilities to the rest of the world is apparent in the US Treasury data on foreign holdings of US securities, which rose from $9.8 trillion in 2007 to $17.1 trillion in June 2015, of which $10.5 trillion was debt and $6.6 trillion equity. Foreign holdings of US securities were equivalent to 95 percent of the country’s GDP in June 2015.
Against this background, policies that will strengthen the dollar considerably could prove highly problematic. As the dollar strengthens, the value of US holdings of foreign assets will decline in dollar terms, while the country’s liabilities will continue to grow, owing to sustained fiscal and current account deficits (now around 3-4 percent of GDP annually). The result will be further deterioration of the US’ net investment position, which the IMF has projected will reach minus 63 percent of GDP by 2021.
The truth is that it is unlikely that the dollar-induced imbalances will be sustainable. The other reserve-currency countries will probably continue to allow their currencies to depreciate, in order to reflate their economies, and emerging economies will probably continue to use exchange rates to cope with capital-flow volatility. If this continues, the strain on the international monetary system will only intensify.
There is something that can be done to ease the pressure. During the global economic crisis, the Fed eased global liquidity shocks by undertaking currency swaps with other major central banks. It could undertake similar swaps today, but with countries facing large capital outflows, thereby slowing the dollar’s appreciation. The question is whether the US under Trump would be willing to develop currency-swap arrangements and other coordination mechanisms for emerging economies such as Russia and China.
At a time of far-reaching economic and geopolitical risks, investors view the US dollar as a safe haven. But, in time, they may find that a new Plaza Accord — the 1985 agreement to devalue the dollar and push the Japanese yen and the Deutsche mark sharply upward — will become necessary. Trump bought the Plaza Hotel three years later, but sold it in 1995. So, this time, it might be called the “Trump Tower Accord”.
In this context, market optimism about US growth could lead to ever-larger imbalances and possibly disrupt the international monetary system.