US dollar woes far from over

IN PERSPECTIVE
By BALJEET GREWAL

CONSIDER this – 2000 years ago, Rome was running a trade shortfall equivalent to 3% of its total economy, one of the many factors that led to the empire’s eventual downfall.

Fifty years ago, Brazil had a massive trade deficit, which were critical to its decline – the currency was battered over and over again.

Eight years ago, the tiger economies of Asia were plunged into a currency crisis, due to big domestic and over-reliance on foreign capital.

Today, international bodies assert that if a country’s trade deficit exceeds 4.5% of its gross deficit product (GDP), it’s a sign of real and present economic danger.

And yet the US economy continues to flaunt history and economics. At 6.4% of GDP (US$58.9bil), US trade deficits are perilous and significantly exceed those of Rome, Brazil or any Asian country one decade ago.

With the recent decline of the US dollar, there are good reasons to expect its slide to continue. Weak economic numbers triggered the fall of the greenback against slower housing starts, sluggish durable goods orders and lethargic consumer confidence – all point to a correction in the economy.

Compounding this is the US’ current account and budget deficit (3.5% of GDP) as well as the narrowing interest rate differential between the US and regional Asian countries. The impact of the subprime market and the widespread repercussions on consumer and corporate consumption exacerbates the dollar woes. All these factors combined offer the possibility of a prolonged economic malaise which continues to weigh down the dollar.

On the contrary, improved economic fundamentals in Asia (reduced external debt and budget deficits, higher international reserves, potential sovereign ratings upgrades and sizeable portfolio capital flows into Asia) have further supported regional currencies.

Further appreciation is on the cards, driven by dwindling US macro dynamics and slower growth expectations. Year-to-date 2006, the Malaysian ringgit has appreciated 5.52% against the greenback, the Singapore dollar at 5.97% and the Thai baht at 16.96%. More telling will be a likely renminbi appreciation fuelling regional currencies given China’s imminent economic reforms and move towards a flexible mechanism. Increasingly, the fortunes of economies in the region are being lifted, driven in many cases by demand from China.

While a weak dollar has seen currencies rally against a weary US economy, a significant correction in US macro data and serious negatives from a bourgeoning current account deficit may flip dynamics if left unchecked. The largest threat globally remains an unruly adjustment of the US dollar which could send regional markets into a downward spiral premised on a sell off in US dollar assets. The tumbling dollar will not only halt export growth but also see a flight away from capital markets. The US is still the single largest trading partner of most East Asian economies, and the Achilles heel of emerging Asia.

To offset this, East Asian countries will need to ensure that their currencies appreciate in unison and do not fluctuate sharply in value relative to one another given the weightage of trade. East Asian economies can withstand about 20% decline in the trade-weighted value of the dollar provided their currencies appreciate together – consensus show that the US dollar will need to decline by 30% in trade weightage terms for trade deficit to look palatable.

Collectively, Asian central banks hold about US$3.2 trillion in foreign exchange reserves, most of it in dollars, and their large purchases of US dollar leading to 2006 have played a crucial role in curtailing the dollar's decline. If the US dollar is certain to fall further, central banks will sell dollar reserves or switch into other reserve currencies, which will exacerbate the dollar’s fall.

On the contrary, if Asian economies try to prevent their currencies from rising against the dollar to preserve export competitiveness, then the result could be broadbased weakness in Asian currencies and a rapid accumulation of currency reserves. Delicate balancing of foreign exchange reserves in this instance is crucial, especially given the trade impact; hence a communal appreciation will thwart any potential regional imbalance.

So, does a falling US dollar spell disaster for Asia? Not necessarily. Asian economies today are characterised by current account surpluses, large foreign exchange reserves and high rates of domestic savings. Equity markets across the region have been breaching all-time highs, reflecting the underlying strength of economies across the region and the perception that Asian stocks represent the best growth prospects at reasonable risk premium.

Thanks in part to the de-linking of Asia's capital markets from the US (more visible in the bond market), and a greater reliance in intra-regional trade (particularly with China), Asian markets seem well-placed to withstand the slowdown in the US that is expected in 2007.

These improved economic fundamentals will serve the region well over the next few years as the global economy slows and investors become more risk-averse. Nevertheless, the dip in Asian capital markets and a slide in Asian currencies against the US dollar in August this year, from the fallout of the subprime crisis serve as a reminder that the region is not immune to a change in global investor sentiment.

Meanwhile, positive overtures from an appreciating ringgit will continue to buoy domestic markets. The ringgit surged to its highest level post de-pegging, closing at 3.3177 (Nov 9) to the US dollar in line with strengthening regional currencies. The broadbased impact from a stronger ringgit is positive in general; especially in sectors which derive ringgit revenue with USD denominated costs.

Note: The author is group chief economist at Kuwait Finance House, Malaysia (KFH). KFH is one of the largest Islamic banks in the world and the first Islamic Bank with an Economic & Investment Research team.