What Happened to the U.S. Dollar

1. What Happened to the U.S. Dollar Andrew Hickey, Brian Marcin, Eugene Gutsalo, Tony Lau

2. The 90’s • Dollar is Strong • Technology Boom • Strong Dollar Policy - Paul O'Neill, treasury secretary in 2001 statement, “…So I'll make it very clear: I believe in a strong dollar, and if I decide to shift that stance I will hire out the Yankee Stadium and some rousing brass bands, and announce that change in policy to the whole world." - Strong Dollar means US Bonds favored by foreign governments, because it is accompanied by high interest rates. US Government wanted this to increase investments, and growth in the economy.

3. Recession of 2001 • The Bush administration abandons strong dollar policy • Federal Funds Rate Decreases to record lows; 1.13 in 2003

4. Depreciation of the Dollar Price-adjusted Major Currencies Dollar Index February’s http://www.federalreserve.gov/releases/h10/summary/indexnc_m.txt

5. The Euro € The Euro has appreciated from 1.1 euros/dollar to roughly .80 euros/dollar

6. The British Pound £ The Pound has appreciated from .7 pounds/dollar to roughly .53 pounds/dollar.

7. The Japanese ¥en Japanese Yen has appreciated from 123 yen/dollar to roughly 119 yen/dollar

8. Possible Reasons

9. Inflation worries • Increasing Oil Prices 90’s: $10 a barrel 00’s: $70 a barrel • Terrorism and Market Uncertainty

10. Return on Dollar Deposits Drops

11. Government and Citizens • Government has expanded greatly under the Bush administration. • Increased borrowing…more military spending. • Baby Boomers are retiring. Puts great strain on our social security system. This means more social security and medical expenditures. • Elderly are important voters.

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14. Where is Money Going? • Interest rates have gone up, and the Euro and Yen are weak, yet the U.S. dollar is still depreciating! Why? • Better Returns • U.S. Economy

15. Better Returns • Foreign Currencies might offer better short term rewards. • Commodities, falling dollar has historically meant higher gold prices. • Further depreciation…makes bonds unattractive for foreigners.

16. Our Economy Bush Administration and Congress • Low approval rating. • Structural budget deficits. • Lack of productive capacity. The Future • Barrier to entry for services field low. • No traditional manufacturing; we are not a low cost provider.

17. Stock Market • In the United States investments are relatively productive, hence the current account deficit. • NYSE (Dow Jones Industrial Index) is over 12,000 points

18. China • The Yuen, a “Phony” currency • Pegged to the U.S. dollar, many argue highly undervalued. • Maintain rate due to: • Large foreign reserves. • Current Account Surplus • Low-wage workers, no share of profits and benefits. • Therefore, can keep prices low.

19. Yield Curve • Inverted • Investors not getting a better return for long run t-bill securities investments. Therefore, long term bonds are unfavorable. • Low growth. Possible recession in 12 months. Merrill Lynch's North American Economist David Rosenberg observes that: "Our recession-risk indicator puts the probability that there will be an economic downturn in the coming year at 51%. That's the highest level since the 2001 recession."

20. http://usmarket.seekingalpha.com/article/20452

21. Twin Deficit • Public and Trade deficits (US Financial and Current Accounts) • Financial Account, peaked at -$800 billion in 2005. Current account hit -$705 billion in in 2005. • Recent estimates showed that they have decreased to roughly -$200 billion.

22. Result of Twin Deficit • USA now biggest debtor in the world • USA population has a negative savings rate. • No real economic return or value, as a result of this borrowing. • Investors concerned.

23. Depreciation, over time, improves the Current Account Deficit

24. Current Account Components • The current account of the balance of payments is the sum of the balance of trade, net factor income, and net transfer payments. • A current account surplus increases a country's net foreign assets by the corresponding amount, and a current account deficit does the reverse. • Both government and private payments are included in the calculation.

25. Account Surplus Turns to Deficit • Since 1991 U.S. residents collectively spent increasingly more than their income • Current-account imbalances demand financing, requiring borrowing from foreigners • Gradual erosion of America’s industrial base resulting from re-location of manufacturing to Asia to maximize the advantage of lower labor costs • Increase in the U.S. demand for foreign goods due to weakened dollar which entices consumers to pursue least cost goods and services • America begins decline from creditor to debtor focusing attention on current accounts importance

26. The 90’s Era of Increasing Deficit • Surge in foreign demand for dollar assets in the late 1990s contributed to a higher dollar exchange rate and lower U.S. interest rates • In the late 1990s, the rapid pace of financial globalization – spurred by technological advance, financial deregulation, and further liberalization of capital controls worldwide enhanced the appeal of the United States to foreign investors

27. The 90’s Era of Increasing Deficit • Rise in demand for dollars pushes up the exchange value of the dollar, making U.S. goods more expensive to foreigners and foreign products cheaper for Americans to buy • Emerging Asian countries, especially China, boosted their exchange reserves thereby raising the demand for dollars

28. Recession and Savings • Recession in 2001 and the weak recovery thereafter • After 2000 the national saving rate fell again and was below its 1993 value by early 2003 • By 2003, cumulative net borrowing from abroad raised the nation's net obligations to the rest of the world by $2.1 trillion, to a record $2.4 trillion, or 22 percent of gross domestic product (GDP)

29. Current Trends • Interest rates paid to foreign holders of securities are also expected to increase, facilitating foreigners attempt to influence economic policy • Rapid rise in oil prices increasing deficit concerns • In 2005 U.S. trade deficits increased with every major area of the world • Many researchers believe trade imbalance is unsustainable

30. 2006 Account Deficit Statistics • Deficit on goods increased to $210.6 billion in 2nd quarter from $208.0 billion in the 1st quarter • Services payments increased to $86.3 billion from $83.1 billion • Foreign direct investment in the United States increased $48.4 billion in the second quarter • Deficits on goods and on income increased to 218.4 billion

31. Importance • With the current account deficit at it present level, foreign investors are beginning to worry about the United States ability to continue the status quo. The future growth of the economy and the ability to maintain or improve our standard of living is dependent on importing about $2.5 billion per day in foreign capital to finance the deficit.

32. Affects of Overvalued Dollar on Account Deficit

33. How to Fix the Deficit • Develop alternative energies • Encourage development of renewable fuels • Continue and increase solar tax credits • Eliminate legislative roadblocks to offshore wind power sites • Speed up the approval process for nuclear power generation

34. How to Fix the Deficit • Encourage increase in domestic savings • Increase productivity to lower export prices • Government credits for education and research and development • Insist on honest valuation of currencies

35. Under Consideration • Business as usual • Protectionism • Fair trade • Communication

36. Sustainability

37. What is sustainability? • Sustainability of Current Account can be defined in two ways: National & Global Models. • National models: From the standpoint of the US economy, sustainability is about how much the US economy can afford to borrow from the rest of the world by running a CA deficit and building up a negative net international investment position which it ultimately must pay back with interest.

38. What is sustainability? • Global Model (from the standpoint of the rest of the world) -is about how much those investors are willing to buy and hold US assets in their portfolios, considering issues of risk, return, and diversification.

39. Definition of sustainability? • Sustainable debt-the level of debt which allows a debtor country to meet its current and future debt service obligations in full, without recourse to further debt relief or rescheduling, avoiding accumulation of arrears, while allowing an acceptable level of economic growth. • World Bank and IMF hold that “a country can be said to achieve external debt sustainability if it can meet its current and future external debt service obligations in full, without recourse to debt rescheduling or the accumulation of arrears and without compromising growth.”

40. Why do people care about sustainability? • When countries run large current-account deficits for a number of years, concerns often arise around the sustainability of those deficits. • The U.S. current account deficit, driven by the United States' widening trade deficit, is the largest it has ever been, both as a share of the U.S. economy and in dollar terms. • How much longer can the United States continue to spend more than it earns and support the resumption of global growth?

41. External Crises • A cursory look at historical episodes suggests that a number of countries (Australia, Ireland, Malaysia and South Korea) have been able to sustain large current account deficits for several years. Nevertheless, others such as Chile and Mexico have not been able to do so and have suffered severe external crises.

42. External Crises • Example: • Mexico • Investors realized that Mexico cannot repay the national debts. So they quickly withdrew all the Mexico assets.

43. What does sustainability depend on ? • The sustainability of the U.S. current account deficit ultimately depends on the willingness of foreigners to continue to lend to the U.S. (or more broadly to continue to accumulate U.S. assets). • That willingness depends on the amount of lending that already is outstanding, which relates to the solvency of the country, and the income payments that are needed to service past borrowing, which relates to the liquidity of the country.

44. Sustainable? • Do • - borrow money to invest, earn more money • Not Do • -borrow money and just consume

45. Indicators of External Debt Sustainability • There are various indicators for determining a sustainable level of external debt, there is no unanimous opinion amongst economists as to one sole indicator. • These indicators can be thought of as measures of the country’s “solvency” in that they consider the stock of debt at certain time in relation to the country’s ability to generate resources to repay the outstanding balance.

46. Measures of a Country’s External Debt Burden • There are two major ways to measure a country’s external debt burden. • 1.) Stock measure - the net foreign asset position. This is simply the size of a country’s total foreign assets relative to its total foreign debts. • The US net foreign debt has rising from 4% of GDP in 1995 to 22% of GDP in 2004.

47. Measures of a Country’s External Debt Burden • 2.) Flow measure - the net foreign income. This is the net income earned from owning foreign assets. • The US earned a net foreign income of $30 billion, despite the fact that it was a net foreign debtor.

48. More Indictors of External Debt Sustainability • Debt/GDP ratio -The most commonly used ratio is the National debt divided by the GDP - US has a Debt/GDP ratio of 66%, placing it in 35th place (out of 113) on the ranking of the Debtor Nations http://www.optimist123.com/optimist/2006/04/the_best_debt_c.html

50. Is US large deficit sustainable? • A large CA deficit is not sustainable in the long run because it increases US net debt to foreigners, which cannot rise without limit. A larger debt can be serviced only through higher borrowing or higher next exports. • For net exports to rise, all else equal, the value of the dollar must fall. This explains why many economists believe that both the dollar and the CA deficit will fall at some point in the future.