Tuesday, February 20, 2007

Random Shots

Swervin’ Mervyn, all is forgiven. The Bank of England has come out with a couple of pearls over the past few days. In a submission to the Treasury Select Committee, the BOE noted that “some depreciation of the real effective exchange rate will probably be necessary” for the current account deficit to narrow. Amen, brother!

King also made some very interesting comments re: Japan last week. “I have some difficulty trying to understand why the call for Japan to ensure that its economy is growing as rapidly as other economies seem to be growing is consistent with saying that they should take a policy action to raise the exchange rate when that policy action would be likely overall to have the impact of slowing domestic demand growth.” Another gold star for Mervyn. Will tomorrow’s MPC minutes send the pound or short sterling shooting higher? Macro Man hopes for the latter but is slightly concerned that it will be the former.

Is the US dollar overvalued? There appears to be a broad consensus that this is indeed the case. After all, how can you have a $60 billion per month trade deficit without a drastically overvalued currency? Macro Man has no beef with the assertion that the dollar remains overvalued against the CNY, SAR, and other current account surplus countries.

However, on a broad trade weighted basis, the answer is not so clear. The dollar appears to be clearly undervalued against the euro on a PPP basis. Ditto sterling and the Canadian dollar. The Mexican peso is a bit trickier, given the periods of high inflation that the country has sustained in the past; however, Macro Man’s best estimate is that the US dollar is moderately undervalued against the MXN. And what about the yen? Macro Man estimates USD/JPY PPP at 110; a moderate overvaluation, perhaps, but one that would appear justified by interest rate differentials and capital flows.

On a broad basis, Macro Man could construct an argument that the dollar is actually undervalued. What would we expect to see from an undervalued currency? Surely that exports would rise substantially faster than imports. In fact, that is exactly what has happened in the US once oil imports (which are price inelastic in the short run) are stripped out. The effect has been masked because the stock of US imports is so much higher than the stock of exports, so exports have to grow substantially higher than imports just to keep the trade deficit constant. That is exactly what’s happened. As the chart below indicates, export growth has been at its strongest level vis-à-vis imports since the current trade data series began in 1992.

Even if we include oil imports, export growth is outstripping import growth at its fastest rate since 1991 (goods only pre 1992). That trade improvement was the result of a retrenchment in domestic demand. This one? It could well be the exchange rate. This of course begs the question of how much improvement would be required to sate the bloodlust of the professional worriers. Anyone with thoughts on the matter, answers on a postcard please!


Anonymous said...

The argument that the dollar is, in broad markets, undervalued, implies two things: (1) that a 30 year consistent trade deficit record is due to "unequal trade barrier" problems and not the dollar, and (2) that accumulating debt, both private and public, has no linkage to the value of the dollar.

In some ways the first argument is supported, in that PPP shows the dollar is "high" with regard to some country currencies, and "low" in regard to others. That would indicate that even where apparently free floating currency regimes are in place, bilateral trade deficits continue. Is the record all that clear? It looks like there is sporadic FX intervention by almost every cental bank from time to time.

The second implication is that the cumulative debt load will not reduce the ability of private and US govt borrowers to repay loans, and not hurt credit worthiness. That is a matter of opinion, often argued by changing the yardsticks of measurement (% of revenues to % of GDP, for example.) More likely is that as debt service burdens in the US grow, the likely escape route for pain will be devaluation of the dollar rather than belt tightening at home.

I'm no purist, and like to win money in the market, but setting up the dollar as a strong currency may be good for today, but not last. I'm buying Japanese stock for the very reason it's currency is lower than usual, and likely to rise on rising exports, along with the currency itself. Here today, gone tomorrow, so to speak. OldVet

Macro Man said...

The problem with the debt argument is that most developed economies have a large stock of debt, and the US does not particularly stand out when you look at debt as a % of GDP.

The persistence of the trade deficit is an interesting phenomenon. It suggests that either a) the dollar has been persistently overvalued since the end of Bretton Woods, which is certainly possible given the dollar's usage as a reserve currency, or b) that the US has a higher income elasticity of demand for improts than its trading partners. This latter case has I believe been demonstrated econometrically, though I don't have the paper at hand.

All things being equal, this would suggest that the dollar would have to be 'cheap' (in some sort of Platonic, absolute sense) to stabilize the exteral accounts, given the US' relative preference for imports. To a degree, that is what I believe has occurred against non-Voldemort currencies over the past several years.

Anonymous said...

Maybe so. I've been trying for 3 years to figure it out, and may spend the next 3 doing the same. The import preference, or import elasticity of demand, explanation says Americans are more product/quality oriented than brand or national product oriented. Less faithful than other people, in consumption decisions. May be true, may be not. Americans do like low prices, for sure.

Yet American consumers do get attached to their Hondas and Toyotas, don't they? Maybe something else is at work, and it's the reserve currency explanation. Sort of a home advantage for Dollars. Or maybe we've just lost the tradeable industrial base that would allow much faster export volume growth during times such as these. Exports are doing quite well, but the base isn't big enought to match import growth.

The US doesn't stand out in a crowd of European countries in terms of debt loads, at govt level. But household and corporate level? With US so tied to mainlined gvt deficit spending, it's floating on borrowed air, so to speak. At some point, despite its favored status as a Reserve, that may tell the tale. Especially if foreign buyers of CDO's find mortgage and other loans starting to sour, and become financially annoyed at tarnished assets they bought during the boom.

What's the Japanese Central Bank going to do? Reports of a split seem highly exaggerated since the Nikkei didn't wobble Monday. Just more smoke? OldVet

Anonymous said...

hmmm. US exports are growing faster than its imports if you look at US trade with Europe and canada (ex energy), but not with asia -- or for that matter with the oil exporters. And I am not sure you can totally strip oil out. you have to pay with oil either by selling ious or by selling goods. germany sells goods; the US ious. and one reason why non-oil import growth has slowed is high oil prices.

I don't disagree with your basic characterization that the $ is in a different place vis a vis europe than vis a vis the rest of the world.

but i would make two broad points --

a) the recent US export boom reflects the $ move of 02-04; most models have a lag structure of 2-3 years. Its impact should be wearing off. Boeing export growth will slow now that it cannot produce any more planes,e tc. there is some evidence the pace of US export growth is slowing.

b) stability in the trade deficit requires roughly 60% faster export than import growth -- keeping that likely requires further $ depreciation (mostly v. EM world/ asia)

c) a stable trade deficit implies a growing current account deficit -- as net interest payments will rise. I have delved into why this hasn't (yet) happened in depth on my blog, and i am very convinced the United states run of good luck is about to end. look for a $100-150b deterioration in the us income balance over the next two years.

d) adjustment likely requires the trade deficit to fall, and that implies further $ falls (on a broad basis)

e) standard trade models showed (circa 1997) that the $'s level in the early 90s was consistent with a very slow deterioration of the US trade balance at trend US and trend world growth. on a broad trade wieghted basis, the $ is still above its level in the early 90s.

Of course, the biggest undervaluation right now is in China. Chinese export growth really picked up when the $/ RMB fell .. and it now has a very rapidly growing surplus. and the biggest RMB undervaluation isn't v. the $. it is v. the euro, pound and the like.

brad setser

Macro Man said...

I really have no idea what the BOJ will do, but I am not sure it matters (see newest post.) Clearly the politicians have learned their lesson, or at least gotten cleverer, at applying pressure to Fukui and co.

Vis-a-vis the trade deficit and the dollar. You could look at it like the dollar being, on aggregate, undervalued versus tradeable (i.e. free floating currencies of developed markets and places like Mexico) currencies and overvalued versus non-tradeable currencies (Asian and Gulf currencies.) What does that make it in aggregate? As Brad suggests above, it probably depends on the mix of imports between price inelastic (eg energy) and price elastic (eg consumer goods) commodities.

One anecdote on airplanes. I remember very clearly in Q4 2004, when EUR/USD was where it is now if not higher, that EADS (majority shareholder of Airbus) stated that its average hedge rate in EURE/USD was 1.00. Two and a bit yers later, one can only presume that it is substantially higher than one. So I wonder if the standard econometric lags between currency moves and trade patterns have been widened by more effective hedging techniques?

Anonymous said...

Hedging lengthening lags? Some base of long term purchasers would have to have opposite needs of long term producers, for that to work. I suppose there are matchups like that, in "slow burn" investments like oil field development, mining, heavy manufacturing.

Interesting discussion, thanks. OldVet

Anonymous said...

hmmm -- I would say that the dollar is roughly fairly valued v the floating currncies (given the need for adjustment) and overvalued v the pegs, not undervalued v europe and overvalued v the pegs. but obviously, if enough europeans think the $ will rally over time, it will help the US finance its deficit.

Incidenally, there isn't much evidence that consumer goods imports respond strongly to moves in the $. The RMB/ peso may have an impact on the location of production, but the best fit on imports is with the pace of US growth. Exchange rate moves have had a much bigger impact on exports -- and notably on capital goods exports, where the US competes at least in part with production in Europe and Japan. This may be a price/ volume issue -- a weaker $ raises import prices even as it lowers volumes. But the data here is pretty clear; exports are more elastic than imports.