In focus

Are the US dollar’s days of dominance done?


After rising sharply at the beginning of the Covid-19 crisis, the US dollar has weakened in the second half of 2020. Investors are now wondering if this could be the beginning of a major trend that could see the dollar weaken substantially, after a long period of strength.

A broad set of drivers can explain the movements in the dollar. But importantly, all these drivers can be better understood if viewed through the lens of the balance of payments. The balance of payments is the record of all international trade and financial transactions made by a country's residents with the rest of the world. 

Here we look at the key developments in the US balance of payments and some of the headwinds that could lead to a further weakening of the dollar.

The relationship between the current account and the dollar

The current account - one of the two major components of the balance of payments - is often used to forecast the fortunes of currencies.

Historically, the relationship between the US current account and the dollar has not been clear cut. The US has run a persistent current account deficit, on average around 2.5% of GDP, since 1980, but this has not been an obstacle to the dollar going through periods of very strong growth.

What is clear is that periods of significant dollar weakening have been associated with a widening current account deficit. For example, in the mid-1980s and again in the early 2000s. The recent sharp widening in the current account deficit, explained in a moment, could therefore be an ominous signal for the dollar.

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Different ways to think about the current account

It is worth noting that there are a few different ways to think about the current account. At a high level, the US current account deficit reflects the fact that US domestic savings have been too low to finance investments.

Most importantly, the US government has been a net borrower for a long time because of a persistent budget deficit, as per the figure below. US corporate sector balance has moved around zero, becoming more negative in the late stages of the business cycle (more borrowing/less saving) and improving in recession and early recovery (more saving/less borrowing). US households, for most of the time, have been net lenders (i.e. net savers).

The net balance of these three sectors has been persistently negative, highlighting that US domestic savings have been insufficient to meet domestic investments. Because of that, the US has had to borrow from abroad to finance the shortfall. Borrowing from abroad means running a current account deficit.

At a more tangible level, the US current account deficit has been mainly driven by a large deficit in goods. This, ultimately, is because the US consumes more goods than it produces, meaning that it imports more than it exports.

Somewhat balancing the deficit in goods, the US has been running a surplus in services. This mainly reflects the US’ positive tourism balance and surpluses in business and financial services.

Finally, the US has a positive primary income balance, as US residents earn greater return on their foreign assets than foreigners earn on their US assets. The secondary income balance is negative because the US gives more external aid than it receives.

 

The current account is also the mirror image of the financial account, the other major component of the balance of payments. The financial account is the net change of ownership of financial assets and liabilities between a country’s residents and non-residents.

We can see that when comparing the key components of the US balance of payments. Whenever the current account deficit (blue bars) has increased, the financial account surplus has also increased, and vice versa. This is necessary for the two sides of the balance of payments to balance.

Furthermore, because of the US dollar’s reserve currency status, the investment flows from the rest of the world have a strong impact on the US financial account, which in turn can affect the US current account.

While the balance of payments must balance, it is not predetermined at what level of currency this will happen. As we explain in the next sections, there are major headwinds that could necessitate a weaker dollar to balance the two sides.

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First headwind: trade imbalances

What can the US current account tell us about the value and the likely direction of the dollar? Before the Covid-19 shock, the monthly US goods or trade deficit was around $70 billion. This is close to the levels seen just before the financial crisis. Given that the US economy is much larger now, this in itself should not be too alarming for the dollar.

However, a large share of the US trade deficit used to come from oil imports before the US shale revolution greatly reduced the US’ dependence on imported oil and the drag on the trade balance. In fact in 2019, the US petroleum balance became positive for the first time ever. The ex-petroleum trade deficit, on the other hand, has doubled since 2013.

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Specifically, annual imports of non-petroleum goods have increased by half a trillion dollars, while exports are more or less unchanged. Furthermore, the gap between exports and imports started to widen in 2014. Even though the exact extent is debatable, the strong dollar and the 2017 US tax cuts have contributed to the deterioration of the non-petroleum balance. A stronger currency made US exports less competitive, while the tax cuts fuelled imports. This led to an annual non-petroleum trade deficit of more than $800 billion.

With US oil production now in retreat, the weakness on the non-petroleum side of the trade balance has become more concerning, as gains in oil exports can no longer mask the issues with the broader trade balance. This could spell trouble for the current account and consequently the dollar.

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The Covid-19 shock has led to large swings in the US current account. Similarly to the financial crisis, the trade balance improved sharply in early 2020, with imports falling more than exports because of a collapse in consumption and investment.

However, very expansive US fiscal policy, in the form of stimulus cheques and extended unemployment benefits, has been far more supportive of consumption. The result of this different kind of crisis response has been a fast recovery in economic activity. For example, US retail sales are now 8% higher compared to 2019.

This in turn has led to a spectacular U-turn in the current account balance, which fell to a 3.5% deficit in the second quarter, the largest deficit since 2008. The trend continued in the third quarter with the US registering a record monthly trade deficit of $83 billion in August.

Instead of reducing imbalances, the Covid-19 shock has increased them. As explained earlier, fast widenings of the current account deficit have tended to be associated with periods of notable dollar weakness. Against, that backdrop, it is not surprising that the dollar has weakened.

Second headwind: structural budget deficit

Even though persistent budget and current account deficits have not been an obstacle for dollar strength in the past, there is a natural limit on the willingness of foreigners to finance both.

While the cyclical component of the US budget deficit is likely to narrow once the effects of the Covid-19 stimulus subside, the non-cyclical or structural deficit is likely to remain substantial. This is because the share of mandatory spending, the budget outlays required by law, such as funding of Social Security and Medicare, has increased considerably since 2008 (see below). Given the US’ ageing population, these pressures will only intensify.

To entice foreign investors in the face of a deteriorating fiscal situation, a country can either hike interest rates or let its currency weaken, making its bonds cheaper for overseas investors to purchase.

The Federal Reserve (Fed) has said that it does not intend to increase interest rates any time soon under its new average inflation targeting policy. Central banks normally have less of control on the long end of the yield curve, so a sell-off in the long-term Treasury yields would make holding dollars more attractive per se.

However, given the high and growing debt loads in the US, the Fed could be forced to fix yields further out in the yield curve, reducing the efficacy of this automatic stabiliser.

Investors, faced with deterioration in the fiscal condition, in the absence of higher bond yields, would then need a lower dollar to incentivise them to purchase US bonds.

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Third headwind: possible end of American “exceptionalism”

Over the past decade, US capital flows have been underpinned by the notion of American exceptionalism, as US economic growth and capital market returns have been superior to most of the rest of the world. In addition, up until the Covid-19 crisis, US bonds offered higher yields than most other comparable securities. All together, this acted as a powerful gravitational pull for global capital flows.

However, because the Fed has cut US interest rates to zero and the US economy has been particularly scarred by the pandemic, American exceptionalism has been called into question. Thus, it is possible that some of the inflows will reverse.

How big are the potential outflows? Decades of current account deficit means that the US has built up a large net liability to the rest of the world, standing at $13 trillion or 67% of GDP. Foreigners own $42 trillion of US assets while US residents own just $29 trillion of foreign assets.

The figure below shows the composition of the US net international investment position (NIIP). Unsurprisingly, the debt investment balance is by far the largest contributor to the negative NIIP. There is a lot more overseas money invested in the US bond market than there is US money invested in overseas bond markets.

Crucially, the US NIIP has become significantly more negative in the last 10 years, with the balance deteriorating especially fast since 2018. This highlights the danger from the possible reversal in the appetite for US assets.

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The US does have the privilege of issuing the reserve currency of the world, so it might get away with policies that would be untenable for most other countries. However, this privilege is not set in stone, as the reserve currency status has changed over time. Should the persistent budget deficit and the continuing Fed balance sheet growth stoke fears of outright debt monetisation (financing of budget deficit by central bank), this could eventually lead to selling of US assets by global reserve managers.

Granted, the structural changes in the dollar’s reserve currency status would likely take years to play out. In the near term, the direction of the dollar depends on the broader supply and demand for the US assets.

Looking at the individual components of the US financial account, there is not much evidence of growing foreigners’ appetite for US assets. Most importantly, the demand for US Treasury bonds has been tepid, especially considering close to $500 billion of outflows in spring. In addition, foreigners have actually increased the sales of US corporate bonds in recent months.

While investors have warmed on US equities in recent months, this might be a short reprieve, as US equities could underperform in the recovery after a long period of strength.

Please see the full paper for details of the financial account.