The Dollar : Medium and Long Term Prospects

Michael Dooley XXI Meeting of the Latin American Network of Central Banks

and Finance Ministries

May 13, 2005

Standard View Current Account Deficit at 6% of GDP Normal upward pressure on the euro and

other floaters Undervaluation of Fixed Asian Currencies Excessively high asset prices Asia overheating; adjustment through

inflation.

If it goes on, it will end badly

Currency crises. Large dollar depreciation. Banking crises. Rapid rise in US yields. Sharp recessions.

Meanwhile Europe and Latin floaters do badly.

Private sector capital less willing to move to US. So exchange rate rises, cutting net exports and

pressing goods markets. The high euro and other floating currencies is

here to stay. If floaters cannot generate internal demand, they

face economic stagnation.

External pressure to appreciate Asian currencies

Protectionist jargon: burden sharing, currency manipulation, undervaluation, beggar-thy-neighbor.

How patient can we afford to be? Five years is a long time for our

basic macro- models to be so far off-track on the most important macro phenomenon of the era.

Depression and halfway into the New Deal.

What drives the US current account deficit?

Source: Bloomberg, Haver

10-year TIPS Yield US Current Account Balance

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05

%

Obstfeld-Rogoff I

-7.0

-6.0

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

Q1-99 Q1-00 Q1-01 Q1-02 Q1-03 Q1-04

% of GDP, saar

Source: GMR

US Demand for Foreign Savings

r

CAUS Demand for

Foreign Savings

Real Interest

RateUS Demand

Source: GMR

Equilibrium current account and real rate, private supply only

r

CAUS Demand for Foreign Savings

Real Interest Rate US Demand

Private Sector Supply

Looser fiscal policy raises real rate and CA deficit

Source: GMR

r

CAUS Demand for

Foreign Savings

Real Interest

Rate

US Demand

Private Sector

Supply

With Looser

Fiscal Policy

Source: GMR

Equilibrium current account and real rate, private supply only

r

CAUS Demand for Foreign Savings

Real Interest Rate US Demand

Private Sector Supply

Push in from official sector lowers real rate, raises CA deficit

US Demand for Foreign Savings

Real Interest Rate US Demand

Official Sector Supply

Official plus Private Sector Supply

Pre-intervention Equilibrium

Source: GMR

The international monetary system adapts to economic problems.

Bretton Woods was an explicit compromise between the US and UK to solve the perceived problems of the depression and WW2.

The current ad hoc system exists temporarily to solve the problem of the emergence of Asia.

Revived Bretton Woods System

It is now generally accepted that the broad outlines of the current international monetary system are as we described them two years ago, and subsequently labeled “the Revived Bretton Woods system”. In summary, these features are:

Revived Bretton Woods System

the emergence of a macro-economically important group of countries with currencies managed vis a vis the dollar to support export-driven growth;

Revived Bretton Woods System

the US as center and reserve currency country providing financial intermediation services for Asian savings.

Revived Bretton Woods System poorer economies export large

amounts of capital to richer economies, in fact, almost entirely to the US;

unusually low and even falling short and long term real interest rates as a result of this glut of global savings.

Revived Bretton Woods System

Not agreed and under vigorous discussion are:

How long will this system last? Will it be a meteoric flash with a

spectacular end soon to come? Or will it last for the reasonably

foreseeable future?

Will it last? What drives the system?

The key economic problem of our time: To manage the economic emergence of

China. Employ 200 million underemployed

workers.

The political economy tradeoffs China chooses an export driven

development strategy. It wants to move workers into

industrial sector rapidly but faces increasing costs.

It has a domestic financial system that is a capital destroyer.

The political economy tradeoffs At the end of the game, it wants a

viable capital stock. This leads to a clash with trading

partners. Failure to deal with these two

distortions blocks development.

Solution: Set real exchange rate so that initial real

wage generates surplus for capital, including FDI.

Large initial stock of labor implies low initial real wage, but rising through time.

Large initial stock implies long adjustment period.

Solution: Adjustment may come from slowly

rising exchange rate or domestic wage and price inflation or both.

Direct investors use part of the surplus to keep import market open.

Imbalance in risks requires a net capital outflow.

Can a desired real exchange rate path be maintained?

Effective capital controls. Trade surplus must be sterilized. Domestic financial repression.

The rest of Asia manages exchange rates in synch.

China is their assembly center for now Letting go their exchange rates prices them

out vs. competitors. China’s exchange rate policy is theirs also. China’s surplus with the US is adds to

Asia’s as well.

Threats to this system from its internal dynamics?

Costs of carry. Reserve diversification. Overheating.

Reserve Diversification

Claim: small central banks will be first movers in this game and sell dollars for euros.

First order effect: appreciates euro, more pressure on Euroland.

Reserve Diversification

Note there is no one guaranteeing the USD-EUR exchange rate here.

Huge attention paid to any hint of shift in reserve management policies.

Cost of Carry None in Japan China stuffs its banks with paper at

3%. Depositors will pay the cost. Others are seeking added basis

points by diversifying into higher yielding USD assets.

Overheating? Experts have been predicting

inflation for years Inflation in China falling below US

now. Still has wide scope for sterilization.

Where is the beef?

China CPI

-5

0

5

10

15

20

25

30

J an-94 J an-96 J an-98 J an-00 J an-02 J an-04

CPI

Non-food CPI

%yoy

China: Money supply growth

10

12

14

16

18

20

22

24

Mar-98 Mar-00 Mar-02 Mar-04

M2 M1%yoy,3mma

China: Real 1-yr deposit rate

-20

-15

-10

-5

0

5

10

J an-94 J an-96 J an-98 J an-00 J an-02 J an-04

%

Small Adjustment in FX Regime is a continuation of the system.

Small adjustment of exchange regime: e.g. widening of bands, move to basket—amounting to 3% p.a. appreciation.

But real exchange rate will remain managed and undervalued.

Large interventions will still occur.

External threats to BW2?

Rising Protectionism Not a serious issue in US election. But now US seems to be pressing

hard with Senate amendment, Treasury calls for more rapid adjustment of exchange policy, EU textile investigation.

Geopolitical Bump Problems with Japan: new US-Japan security

pact, scramble for energy resources. with N. Korea: always heading for a

showdown. Problem with Taiwan: missile buildup,

increasing threat to US fleet.

Geopolitical Bump General military expansion. Ringing of China with alliances: Japan,

Taiwan, Vietnam, Central Asia, competition for India.

Reactions to potential end to EU arms embargo.

BW1 and BW2 Important difference may be oil. Lots to go around in BW1. Could be a problem for BW2. China a potential economic as well as

military threat.

Summary: The current global monetary system.

Asia fixes exchange rates at “undervalued” levels.

Especially against industrial center country with more flexible labor market.

Other industrial countries and some emerging market countries float, appreciate.

Generates export growth and current account surpluses.

Development strategy is to lend to rich countries.

Encourages large scale FDI to assure quality of goods, capital, and to secure export markets.

Intervenes heavily in fx reserves to channel domestic saving through foreign balance sheets.

Gradually lets real exchange rate appreciate, either through inflation or controlled nominal appreciation.