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| Unhappy Euro |
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4th
Quarter 2007 |
In the summer of 2003, after the Euro/dollar exchange rate had appreciated to 1.15 from its 2001 low, a Lettre du CEPII untitled “The Happy dollar” argued that (i) the dollar would likely continue on its way down, (ii) adjusting the US current account through the exchange rate alone would yield a very large dollar depreciation, (iii) the Euro could reach unreasonable levels should some Asian countries not accept a revaluation of their currencies, and (iv) this would result in a tough test for the cohesion of the Euro area, given unequal vulnerability of countries and sectors to the dollar weakness.
At the end of 2007, the Euro/dollar exchange rate is approaching 1.50, and none of our 2003 thoughts has proven ill designed. The question now is whether the dollar fall will come soon to an end.
There is no definite answer to this question. Every day, the amount of foreign exchange transactions represents about one hundred times the amount of goods and services traded around the world. Needless to say, failing confidence on the dollar will result in new downs for this currency. However, it should be remembered that each fall in the dollar depreciates all US items, from Californian wine and lawyer services to Treasury bonds and IT stocks. Such depreciation of goods, services and especially assets acts as a powerful brake on dollar depreciation: when US assets get cheaper, why not buy more of them? Why not bet on a dollar re-appreciation? Hence, there is an end to the dollar depreciation, just because when it is cheap enough, the US debt finds more investors to buy it. In addition, some investors, such as the People’s Bank of China or sovereign funds are still buying dollars massively, even though they are also diversifying their portfolios towards other currencies. This is also stabilising.
In the longer run, a weak dollar should help reducing or even inverting the US current account deficit. If the deficit is reduced, then less US securities will need to be purchased by non-US residents, which should lead to a higher dollar. However, not too much hope should be put on the ability of the weak dollar to raise the US current account. Price elasticities of exports and imports are generally found to be limited. On the import side, foreign suppliers are likely to reduce their prices in their own currencies to keep their market shares on the US market; as for those suppliers located in countries with a quasi-fixed exchange rate against the USD – notably China – they could substitute for other suppliers in US imports. On the export side, the specialization of the United States on service exports is unlikely to yield much sensitivity to price competitiveness.
Still, it is difficult to guess what will be the dollar’s low, just because it is difficult to guess what benchmark world markets have in mind. In fact, there are two ways of reasoning.
According to the first one, the present stock of US debt held by the rest of the world is huge, but there are also huge savings around the world that would be happy to come back to a safe, liquid market. The present weakness of the dollar can then be viewed as temporary: it is related to the subprime crisis, to the US downturn and to the quick reaction of the Federal Reserve. Lower interest rates will unlikely convince foreign investors to buy more dollars. Nevertheless, when the downturn has hit more countries, or when the Fed has succeeded in stopping it, the dollar will come back as the preferred currency of international capital markets, and the US debt spiral will start again.
A second line of reasoning considers the US net debt as undoubtedly non-sustainable. In order to reduce it, there is no other choice but save. For national net savings to increase, all agents would need to save more: households, firms, and the government, which would mean selling more domestic goods and services to non-residents, and less to residents, thanks to a weak dollar. In this view, the dollar weakness is not temporary. It will last until the net foreign asset position of the United States is back to sustainability. The dollar could even be weaker in order to make the balance-of-payment adjustment faster.
In between those two polar scenarios, there is a soft-landing scenario where the dollar appreciates a little bit while staying under-valued compared to its purchasing power parity level, and where the balance-of-payments adjustment is achieved more through a change in behaviours (more savings), and less from currency depreciation. This soft-landing scenario has become more likely now that a new growth engine exists in Asia. Indeed, slowing consumption in the United-States is now less depressing for the world economy than it used to be. However this soft-landing scenario relies on virtuous behaviours of households and authorities – the government and the Fed – and perhaps also on international policy co-ordination, which has not really been active since Le Louvre agreements, twenty years ago. |
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BÉNASSY-QUÉRÉ, A., BÉREAU, S. & MIGNON, V. Equilibrium exchange rates: a guidebook for the Euro/dollar, CEPII working paper, forthcoming.
BÉNASSY-QUÉRÉ, A., FONTAGNÉ, L. & FOUQUIN, M., The Happy Dollar, La Lettre du CEPII N ° 225, 2003.
BÉNASSY-QUÉRÉ, A., LAHRÈCHE-RÉVIL, A., MIGNON, V. & DURAN-VIGNERON, P., Burden sharing and exchange rate misalignments within the Group of Twenty, within C.F. Bergsten and J. Williamson eds., Dollar Adjustment: How Far? Against What?, Institute for International Economics special report 17, Washington D.C., November 2004.
BÉNASSY-QUÉRÉ, A., LAHRÈCHE-RÉVIL, A. & MIGNON, V., The dollar in the G20, La Lettre du CEPII N ° 238, 2004.
BÉNASSY-QUÉRÉ, A., LAHRÈCHE-RÉVIL, A. & MIGNON, V., World Consistent Equilibrium Exchange Rates, CEPII working paper N ° 2006-20.
GAULIER, G., LAHRÈCHE-RÉVIL, A. & MÉJEAN, I., Structural Determinants of the Exchange-Rate Pass-Through, CEPII working paper N° 2006-03
GAULIER, G., LAHRÈCHE-RÉVIL, A. & MÉJEAN, I., Exchange-Rate Pass-Through at the Product Level, CEPII working paper N ° 2006-02.
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