Waning Dollar May Not Help On Trade Deficit Front

The bold action by the US Fed may do little to ease the worries on the US trade balance front. Contrary to the popular opinions, the trade deficit of the all mighty US may not shrink in line with the perpetual slump the US dollar seems to have lurched into after the US fed cut its benchmark interest rates by 50 basis points on 18 September in order to prevent the economy from slowing down further as the sub prime contagion threatened to rip the global credit markets apart. The US dollar plummeted against all the major currencies after the surprise cut and is seen hitting all time lows against the Euro in the next few days.



The current account is the broadest measure of the U.S. trade balance as it includes, in addition to trade in goods and services, income received from U.S. investments abroad less payments to foreigners on their investments in the United States. In the second quarter, the United States had a $26.5 surplus on trade in services and a $9.4 billion surplus on income payments. This was hardly enough to offset the massive $204.2 billion deficit on trade in goods, and net unilateral transfers to foreigners equal to $22.5 billion.



The huge deficit on trade in goods is mostly caused by a combination of an overvalued dollar against the Chinese Yuan, a dysfunctional national energy policy that increases U.S. dependence on foreign oil, and the competitive woes of the three domestic automakers. Together, the trade deficit with China and on petroleum and automotive products account for about 95 percent of the deficit on trade in goods and services. To finance the current account deficit, Americans are borrowing and selling assets at a pace of $763 billion a year. U.S. foreign debt exceeds $6 trillion, and the debt service comes to about $2,000 a year for every working American.



The current account deficit imposes a significant tax on GDP growth by moving workers from export and import-competing industries to other sectors of the economy. This reduces labor productivity, research and development (R&D) spending, and important investments in human capital. In 2007 the trade deficit is slicing about $250 billion off GDP, and longer term, it reduces potential annual GDP growth to 3 percent from 4 percent.



There has been a lot of talk of the recent fall in the US dollar coming to the rescue of the economy by shrinking the value of the deficit. However, researchers at the University of Warwick, Warwick Business School and the European Central Bank have just published research that shows falls in US asset prices such as housing and equities have a substantially more important role for reducing US trade imbalances than changes in the US dollar exchange rate.



Their paper "Asset Prices, Exchange Rates and the Current Account," presented a few months back at the Royal Economic Society Conference at the University of Warwick, looks at the relationship between asset prices, exchange rates and the trade balance in the US over the period 1974-2005.



A number of scholars and policy makers believe that a large Dollar exchange rate depreciation is needed to increase US exports and, hence, reduce the trade and current account. However the researchers; Luciana Juvenal of the University of Warwick, Professor Lucio Sarno of Warwick Business School at the University of Warwick, and Marcel Fratzscher of the European Central Bank, found that equity market shocks and housing price shocks had by far the greatest effect on reducing the US trade imbalance accounting for up to 35% of the movements of the US trade balance. By contrast, shocks to the real exchange rate of the US dollar explained less than 5% of such movements and exerted only a temporary effect on the US trade balance.



Warwick Business School Researcher Professor Lucio Sarno said "Our findings suggest that a sizeable real depreciation of the US dollar may not be an inevitability for an adjustment of today's large current account imbalances, and that other factors, in particular global asset price changes, could be an equally or even more potent source of adjustment."



Luciana Juvenal of the University of Warwick said: "These results underline the importance of wealth effects, stemming from asset price developments, as drivers of today's global current account imbalances. The rise in asset prices over the past decade has in particular increased expected income of households in the United States and, therefore, raised their consumption. At the same time, investment has been facilitated in response to this higher demand and firms have found it easier to finance investment opportunities, thus overall worsening the US current account position. Significant falls in US asset prices, and equally stronger increases in asset prices in the rest of the world, will thus have the opposite effect and reduce trade imbalances."



The researchers show that a depreciation of the US dollar worsens the US trade balance slightly upon impact. After this initial reaction, the trade balance improves but the magnitude of the effect is fairly small. For instance a 1.2% real depreciation of the US dollar raises the US trade balance by about 0.06% of US GDP. This implies that even a relatively high real depreciation of the US dollar, for instance by 10%, would improve the US trade balance by a modest 0.5%.



The researchers found that both equity shocks and housing price shocks have larger, and more persistent effects on the US trade balance than a real exchange rate shock. A positive relative equity shock of 10% lowers the US trade balance by 0.9%. Moreover, relative equity market and housing price changes in particular throughout the 1990s have been substantially larger than those for real exchange rates.



However, the gush of liquidity provided by the liberal Fed interest rates cuts has made the US equity markets rally at a rampant pace. This is likely to trickle down to housing, which seems to be in a beleaguered stage at the moment in terms of prices as well as activity. However, the US consumers still continue to spend freely and the retails sales fail to show any convincing slowdown of sorts, which can be correlated with the slowdown syndrome in the economy. It goes without saying that in such a scenario, correcting the fundamental mismatch on the trade balance front is a difficult task, by merely banking on the dollar’s decline.