WORLD ECONOMY

A depreciating dollar

Will America stagnate if Asia recovers?

C.P. CHANDRASEKHAR

AN unusual question haunts the world's financial analysts. Can the United States sustain its robust growth if the rest of the world is buoyant as well?

This question arises in a context in which many economies which were experiencing stagnation or contraction appear poised to return to a situation of growth. The Japanese government's repeated efforts to pump-prime the system with deficit-financed govern ment expenditures finally appear to be yielding results. Real GDP grew by a pleasantly surprising 2 per cent in the first quarter of 1999, after five consecutive quarters of decline. There is evidence of expansion in Europe as well, after the period of c ontraction induced by the fiscal austerity adopted as a run-up to the euro. Finally, not only has the recession bottomed out across East Asia, but there is evidence of robust growth in South Korea during the first two quarters of this calendar year. Sinc e the United States and the United Kingdom have already been experiencing strong expansion, the world seems poised to return to a bygone era of "synchronised growth" in all major economies or regions.

But, as even the International Monetary Fund (IMF) makes clear in its recently released World Economic Outlook, that prospect is still uncertain. This is because developments during the decade of globalisation seem to have rendered synchronised gr owth (or recession) across the world's economies an unlikely occurrence.

The world economy in the 1990s has been characterised by two much-noted features. First, slow growth in Japan and across much of the world. According to World Economic Outlook, the average rate of world economic growth during the 1990s was only 3 per cent, which is below the 3.5 per cent average of the 1980s and 4.5 per cent in the 1970s. The second feature has been remarkable instability. Not only have there been two phases of sharp slowdown in economic growth (in 1991-93 and 1998-99) over the d ecade, but it has been characterised by periodic crises in Mexico, countries of East Asia, Russia and Brazil.

Yet the 1990s represented one of the best decades for the U.S.. Not only was the U.S. recession of 1990-91 unusually mild, but the country went on to record almost continuous and, more recently, particularly robust growth. If this process is sustained th rough early next year, as some expect it to, then this would be the longest episode of continuous growth on record for the country.

Till recently, this unusually splendid growth record of the U.S. was attributed to specific features of its economy or economic policy. The U.S., it was initially argued, had more flexible labour markets than Europe, as did the U.K. which was also perfor ming better. This helped companies downsize and restructure, and kept wages down, enhancing U.S. competitiveness and growth.

More recently, better growth has been ascribed to U.S. policy. To quote from World Economic Outlook: "The recent impressive performance of the U.S. economy is, in large part, testimony to laudable policies. These include the turnaround in the fisc al balance from deficit to surplus (a structural improvement equivalent to roughly 3.5 per cent of GDP since 1993); the agile management of monetary conditions by the Federal Reserve in achieving and maintaining low inflation, in helping to maintain stab le growth and also in helping to calm global financial turbulence; and structural policies that have continued to foster the flexible working of markets."

KORJI SASAHARA/AP
Currency traders at a Tokyo brokerage on September 24.

WHAT is left unexplored in that summary assessment is the role that 'external factors' played in reviving growth in the U.S.. Exports were clearly not a contributory factor. Export volumes grew at just 1.5 per cent in 1998 while import volumes grew by 10 .5 per cent. As a result, the value of the current account deficit on the U.S. balance of payments has risen almost continuously from $43 billion in the first quarter of 1998 to almost double that value in the second quarter of 1999. Despite this worseni ng current account deficit, the dollar remained strong and even gained in strength. This, as has been widely reported, was only because of large financial flows into the U.S. from abroad. Not only did money flow into U.S. equity, but outstanding amounts of international debt securities originating in the U.S. rose sharply from $552.8 billion at the end of 1997 to $946 billion at the end of the first quarter of 1999.

The willingness of foreign investors to hold dollar-denominated assets is thus the key to the rise of the dollar. And so also to robust growth in the U.S. Given the large direct and indirect (through pension funds, for example) investments of personal sa vings in equity in the U.S., the stock market boom enhanced the wealth of American citizens, reducing incentives to save. The net result has been a collapse of private savings in the U.S. Personal savings as a percentage of disposable personal income in the U.S. fell from 1.2 per cent in 1997 to 0.5 per cent in 1998, turned negative in the first quarter of 1999 and touched a remarkably high negative level of 1.3 per cent in the second quarter ending June 1999. The other side of the fall in savings was a rise in private consumption expenditure, which was crucial to sustaining growth in the U.S. economy.

Thus, growth in the U.S. was dependent on a consumption boom fuelled by the willingness of foreign investors to bet on the dollar, irrespective of the state of the U.S. balance of payments. That willingness stemmed from a range of sources, many of which were related to the dollar's still-unchallenged role as the world's reserve currency. Higher interest rates in the U.S. at a time when the Japanese economy was performing poorly is indeed one such factor. This triggered the infamous "yen-carry trades" in which investors borrowed yen funds, converted them into dollars and invested them in higher yielding dollar-denominated assets. When the occasion arose to unravel these trades, they gained not merely because of the differential in interest rates between Japan and the U.S. but also because of the depreciation of the yen in the interim period.

The other element contributing to investment in U.S. assets was the "flight to safety" from a stagnant Japan and an East Asia struck by crisis. In fact, till mid-1998 those flows virtually insulated the U.S. economy from the effects of that crisis. Final ly, inflows into the U.S. fed upon themselves. To start with, investments in American financial assets helped sustain what was a completely unexpected boom in stock markets. High returns in the stock market obviously makes investment in American stocks a n attractive proposition, drawing in more funds from the international economy.

In the circumstances, growth has been robust in 1997 and 1998 and remained at acceptable levels even in the first half of 1999. Overall, for much of the recent past, the U.S. economy has been characterised by a strong currency, a conservative budgetary s tance, a buoyant stock market, a creditable rate of growth and low inflation. In the world of macroeconomic indicators, something must give to ensure this otherwise peculiarly favourable scenario from the American point of view. And that has been the def icit in the trade in goods and services. That deficit rose almost continuously and nearly doubled, from $33.3 billion in the first quarter of 1998 to $65 billion in the second quarter of 1999. This magnitude of increase in the trade deficit accounts for almost 85 per cent of the increase in the current account deficit in the U.S. balance of payments during this period.

What is worrying financial analysts is that as the recovery begins outside the U.S., this situation may change. The most telling sign of this has been the weakening of the dollar in recent times. Towards the middle of September the dollar touched a three -and-a-half year low of yen 103.3 to the dollar. Not only was the value of the U.S. currency that day at a new low, but underlying its day-to-day fluctuations was an acceleration of the depreciation of the currency from a value as high as yen 122 to the dollar just two months earlier. Even if we consider monthly average figures of the value of the yen vis-a-vis the dollar, the trend of a sharp appreciation of the dollar vis-a-vis the yen between August 1998 and January 1999, which was stal led thereafter, has revived from May this year. The weakness of the dollar has also resulted in a reversal of the "unexpected" appreciation in its value vis-a-vis the euro since its creation in January.

The current weakening of the dollar indicates that America's ability to borrow itself into growth when the rest of the world languishes seems to be under challenge. Observers are clear that the dollar sank sharply in mid-September because investors were no longer ready to bet on an overheated U.S. economy. The signs of reversal of capital flows into the U.S. have appeared despite the fact that the Federal Reserve Board has raised interest rates twice in recent months. The consequent widening of interest rate differentials between the U.S. and elsewhere is obviously proving inadequate to attract the foreign investor.

A number of factors could explain this tendency. The fall in the dollar occurred in the wake of the news of a record current account deficit in the second quarter and of a surge in retail sales of 1.2 per cent in August, which took its value to a level c lose to 11 per cent higher than in the corresponding month of the previous year. Clearly, private consumption was still buoyant and was still widening the gap between America's imports and exports. But now international investors have begun to pull out i n the wake of these developments. All of a sudden what has been true all along - that U.S. fundamentals are indeed weak and that the economy is vulnerable - seems to matter to the investor.

This loss of confidence is related to a number of other developments. The incipient recovery in Japan and the rest of Asia is reversing the flight to safety into U.S. bonds and reducing the "autonomous" demand for dollar-denominated assets. Operators wan ting to unwind positions financed through yen carry trades could be increasing their demand for the Japanese currency, resulting in a strengthening of the yen. Above all, the possibility that as Japan recovers and the U.S. current account deficit widens, the yen would appreciate vis-a-vis the dollar, and more than neutralise any gains from investments in higher yielding U.S. bonds, would make investors turn dollar-shy and yen-friendly. And the more they turn away from the dollar and towards the y en, the more would their expectations of an appreciation of the yen be realised. All this is now happening with greater intensity because the biggest investors in U.S. Treasuries are Japanese investors, who are reportedly selling out in the U.S. and taki ng their money back to where it came from.

While this decision may be reasonable from the point of view of the individual Japanese investor, it is creating much discomfort among governments. A depreciating dollar is obviously bad news for the U.S. Underlying that depreciation must be a loss of co nfidence in U.S. equity, which could trigger an abrupt fall in U.S. equity prices. As the public information notification issued by the IMF after its executive board concluded the Article IV consultation with the U.S. noted: IMF directors believed that i n the U.S. "the strength of demand, including corporate investment as well as household consumption, had been underpinned by the high level of stock prices - a level that was difficult to explain". This would mean that a sharp market decline could wipe o ut illusory wealth, lead to an abrupt adjustment in the household savings rate from its current historic low, and massively squeeze consumption demand. The era of high growth and large current account deficits appears to be near its end.

But the lessons from this episode go further. In the era of financial globalisation, it appears, synchronised growth in different parts of the world is impossible. The boom in America appears to depend on slow growth and crises elsewhere. And a recovery elsewhere appears to threaten America's economic health. Interestingly, World Economic Outlook does recognise this new conjuncture in the world economy. To quote the Outlook:

"Economic and financial linkages and policy transmission mechanisms across countries have become more complex in the 1990s, warranting a further reassessment of key relationships. Historically, the developing countries' economic cycle was mostly positive ly correlated with that of the industrial countries due to the impulses transmitted through trade and commodity prices. In the early 1990s, however, when the industrial countries went through successive episodes of cyclical weakness, growth actually acce lerated in many emerging market economies, fuelled by the rapid growth of trade among them (especially in Asia) as well as by substantial capital inflows.

"More recently, in the wake of the Asian crisis, all industrial countries with significant trade links with Asia would have been expected to experience adverse effects on growth. In fact, however, while Japan and, to a lesser extent, Europe were negative ly affected, the United States' economic expansion appears to have gained further momentum. A flight to dollar-denominated assets helped to sustain the U.S. expansion by boosting domestic demand through lower interest rates and the dampening effect on pr ices of an appreciating dollar, notwithstanding the negative impact on U.S. exports.

"In both examples, the integration of financial markets appears to have contributed to a tendency for global financial resources to move to whichever countries and regions are relatively dynamic at the time. In principle, such reallocations of financial resources are beneficial for the recipient countries and also for global growth and efficiency. However, as experience shows, large net capital flows into strongly expanding economies may exacerbate risks of overheating and asset market bubbles, while ra pid reversals of such flows can severely strain weak financial systems and lead to destabilising currency movements."

Behind this elaborate reasoning is one striking judgment. In a globalised world dominated by financial as opposed to real flows, growth at one pole has come to depend on stagnation or contraction at the other. Whatever other virtue the IMF may find in ma rket-driven globalisation, it has been forced to admit that its downside is that autonomous tendencies in the current conjuncture militate against the synchronised growth needed for a global consensus.