View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Economic SYNOPSES
short essays and reports on the economic issues of the day
2006 ■ Number 4

The Dollar U-Turn
Massimo Guidolin
lthough the United States has run current account
foreign reserves can also cause an excessive expansion of
deficits since 1990, those deficits have recently assumed
domestic liquidity, which poses inflation risks.
extraordinary proportions. Between 2004:Q4 and
As a result, many U.S. trading partners have resisted the
2005:Q3, the U.S. external deficit has averaged 6.4 percent of
weakening dollar and welcomed 2005 as a break to an unsusGDP. A current account deficit is the difference between a
tainable trend. A number of Asian countries still need to implecountry’s imports of goods and services and the sum of its
ment institutional reforms to prepare them for domestically
exports and net factor payments. Although other macroecodriven growth and end their dependence on export surpluses
nomic factors affect exchange rates (e.g., differential interest
supported by weak currencies. In July 2005, China took a step
and growth rates), many economists have suggested that, in
in this direction by revaluing the renminbi’s parity with the
the presence of large current account deficits, the dollar will
dollar by 2.1 percent and simultaneously switching from a
depreciate. As the dollar depreciates, the dollar price of foreign
dollar peg to a managed floating regime in which the parity
goods and services increases, while the price abroad (in foreign
is determined with reference to a basket of currencies. The
currency) of U.S. goods and services declines. As a result, U.S.
Chinese are implementing other structural reforms to increase
households and firms buy fewer imported goods, while foreign
the efficiency of currency markets and to enable all firms to
households and firms purchase more U.S. goods. Therefore a
hedge currency risks. This seems to herald further reforms
depreciating dollar ought to bring the current account back
that might re-establish more symmetry in international trade
toward neutral.1
relationships. If developing Asian economies will persist on
the reforming path, in the long-run the dollar may not have
The chart shows that over the period 2002-04 the real
to bear the entire burden of much needed adjustments in
effective value of the U.S. dollar has depreciated at an average
international current accounts. ■
pace of 4.7 percent per annum. This tendency reversed in 2005;
the real value of the dollar appreciated by 3.6 percent last year.
1
Blanchard, O., Giavazzi, F., and Sa, F., 2005, “The U.S. Current Account and the
Many commentators have expressed concerns about the
Dollar”, NBER Working Paper No. W11137.
incompatibility between the dollar U-turn and the current
2
Source: International Monetary Fund.
account deficit, predicting dollar depreciation in 2006.
Why has the dollar appreciated despite the very large
U.S. current account deficit? One factor is that, over the
Trade-Weighted Effective
Current Account Balance
Real Dollar Exchange Rate
as Percent of GDP
period 2004-05, the monetary authorities of a number
–2.0
114
of developing countries—mostly in Asia—purchased
Left Scale
–2.5
269 billion in U.S. dollar securities. China alone has seen
–3.0
110
Right Scale
its U.S. dollar reserves grow by $167 billion, to exceed
–3.5
$800 billion.2
–4.0
106
These Asian governments oppose an uncontrolled
–4.5
dollar depreciation for two reasons: (i) Their huge dollar102
–5.0
denominated reserves expose them to enormous losses
–5.5
–6.0
98
if the dollar depreciates significantly. A 20 percent dollar
–6.5
depreciation, for example, would reduce Chinese reserves
–7.0
94
by an amount between 2 and 9 percent of the Chinese
GDP and reduce Singapore’s reserves by between 18
and 25 percent of its GDP. (ii) Uncontrolled growth of
19
99
:Q
19 1
99
:Q
20 3
00
:Q
20 1
00
:Q
20 3
01
:Q
20 1
01
:Q
20 3
02
:Q
20 1
02
:Q
20 3
03
:Q
20 1
03
:Q
3
20
04
:Q
20 1
04
:Q
3
20
05
:Q
20 1
05
:Q
3

A

Views expressed do not necessarily reflect official positions of the Federal Reserve System.

research.stlouisfed.org