The market is increasingly concerned about a potential US dollar crash because the bulging US current account deficit is unsustainable and will have to be normalised soon. Even the IMF has warned that the US deficit is an accident waiting to happen because that deficit requires a continuing flow of investment funds into the US, and those funds will keep flowing only if the investment opportunities are not thought to have diminished. But the market is having doubts about superior returns in US investments.
If the IMF warning is right, Asia will be in for some nasty shocks because the US is Asia's largest export market outside the region, and a US dollar collapse will send financial shocks across the global system. Asia's net capital export status, resulted from its huge current account surplus, will also be reversed. This is because soaring US import demand in the late 1990s dragged America into a large current account deficit but boosted Asian exports and allowed the region to accumulate current account surpluses. A reversal of the US current account deficit will thus reverse Asia's current account surpluses.
O'Neill's logic
To calm market jitters about a dollar crash and a shift in the US strong dollar policy, US Treasury Secretary Paul O'Neill's has been defiant of the IMF warning with some radical arguments. He reckons that the current account deficit is a "meaningless concept" so that authorities should ignore it. This is because, according to him, the deficit is a result of US private sector's rational saving and investment decision and is thus not a fundamental economic symptom. While it is true that the current account deficit is an accounting counterpart of net capital inflow to the US due to perceived superior US investment returns that attract foreign investors, the logical underpinning behind Mr O'Neill's view is not robust.
First and foremost, ample evidence shows that the US private sector has over-spent, with over-stretched household and corporate balance sheets and excess investment. It is thus hard to argue that the resulted saving-investment imbalance that generated the large current account deficit, which amounts to over 4% of GDP, is not a fundamental economic problem.
Contrary to Mr O'Neill's perception, the US current account deficit is no longer a private-sector-only issue. The rise of terrorism has erased the post-Cold War peace dividend and raised US defence spending sharply. Coupled with the tax cuts to boost demand, all this has pushed the US budget balance back into deficit again. With both the private and public sectors in dis-saving, the US current account deficit is an overall economic problem.
It is also not true that private sector investment-saving decision is always rational, as Mr O'Neill sees. Private sector decisions are often affected by crowd psychology and distorted by hype and greed that generate overly optimistic outlook for profit growth and investment returns, as in the late 1990s. Thus, the net inflow of portfolio capital to the US in recent years does not eliminate the risk of a current account deficit normailisation because there is a limit to the willingness of investors to fund the US current account deficit by holding US dollar assets.
US dollar won't crash
So, if the huge US current account deficit is unsustainable and will have to be normalised soon, Asia will be facing a nasty external shock on two fronts. First, there will be a direct drop in US demand for Asian goods, as the US corrects her current account deficit by importing less. Second, as the US dollar falls sharply to address the deficit problem, it will hurt the competitiveness of Asia's export-oriented economies, pushing their current accounts back into deficit.
The risk of a crash in the US dollar thus stems from the reversal of portfolio flows, as investors grow wary of funding the US excessive import demand. The dollar has been held up by the perceived strength of the US economy, which saw an unexpectedly strong 6% annual growth rate in the first quarter of this year. But analysts have been quick to point out that except inventory rebuilding, there was, and will not be, other growth drivers.
Investment spending in the US has collapsed, and there is still a backlog of under-employed investment asset left over by the bursting of the high-tech bubble. While US consumers have been holding up well by spending their future income via borrowing, sooner or later they will have to repair their balance sheets. Thus, another consumption boom is not in the cards.
The ability of the public sector to boost demand is limited by the rising budget deficit, thanks to renewed defence spending against terrorism. That leaves exports. But don't bank on them, despite their merits of boosting growth and cutting the current account deficit. This is because a sluggish growth outlook in Europe and Asia would not underpin robust US export growth. After all, US exports won't climb much with the dollar at its present, strong, level.
So, with a huge current account deficit on the back of doubts about a strong US recovery, don't we have a recipe for a dollar crash? Not necessarily, because the currency markets are driven by perceptions of relative growth. The argument that the US would not grow quickly could also hold for Europe and Asia. Thus, if there are no good reasons to like the US dollar, there are similar reasons to be wary of the other major currencies such as the euro, the sterling and the yen.
As for the Asian currencies, they cannot afford to be expensive (a flip side of a dollar crash) simply because of the competitive pressure. A post-WTO China will exert increased financial and economic pressures on Asia because WTO requirements will push China's economic reforms, making her more competitive under a freer trade regime. China's enhanced competitive power will become a long-term source of tradable goods deflation, squeezing Asia's pricing power. This competitive pressure will manifest itself in downward pressure on many Asian currencies.
All this means that the US dollar could well be weaker as cyclical forces unwind themselves in the short-term, but there are economic checks and balances to prevent it from crashing through the floor. Thus, no major US dollar decline is expected to help correct the US current account deficit.
Asia continues to export capital
Further, from a secular point of view, there are arguments for the US current account deficit to stay. The rise of China and non-Japan Asia as the world's manufacturing centers is a big supply shock for the global system. It intensifies the need for global specialization, as rich economies are facing persistent competitive pressure to achieve sustainable economic growth by shedding labour-intensive and low value-added manufacturing businesses. Those who fail to change, like Japan, will suffer price deflation, currency weakness and eventually economic decline.
Intensifying global specialization also means that rich economies, like the US, might need to shrink the tradable goods sector and focus on services and high value-added output. It is thus conceivable that a new global equilibrium could require the US and other rich economies to run sustained current account deficits, which could be large at times, as they import most of the tradable goods from Asia to cater for consumption backed by high income. This is probably why the US current account deficit has not corrected throughout this economic slowdown, a significant difference from past recession periods.
Low-cost Asian manufacturers will benefit from continued globalisation. Their goods sector's output growth will recover robustly during the coming cyclical economic upturn. Asia's current account surplus will thus remain in the medium-term, reflecting a continuation of the US current account deficit. Since any current account surplus must be offset by a corresponding capital account deficit (i.e. capital export), and vice versa, for the balance of payments to reach equilibrium, this means that Asia will remain a net capital exporter. The bulk of this surplus capital will be recycled back to the US. If this is true, the risk of a collapsing US current account deficit and US dollar delivering a global economic disaster will be contained.
