HSBC: 20pc US dollar fall possible (page 1 of 2)

The US external imbalance has long been perceived as a medium term problem that will ultimately need to be corrected, but the current account deficit continues to grow. Domestic demand growth in the US still exceeds that in the rest of the G7, and this has been the major factor pushing the US deeper into deficit.

With the US presidential election to be held next November, the political imperative to have the economy as strong as possible makes it unlikely that the US economy will be allowed to grow significantly more slowly than the rest of the G7, so if there is to be any prospect of at least stabilising the deficit, the impetus will have to come from the lower dollar.

Even on our rather downbeat economic forecasts, the current account deficit will continue to widen in both 2004 and 2005, and will likely exceed 6% of GDP in 2005. On the more optimistic consensus growth forecasts, the deficit would be larger still.

What is a sustainable current account position? This is a very difficult question to answer as it depends crucially on international investors appetite for dollar assets.

According to IMF estimates current trends imply that the US net international liability position will rise to 40% of GDP by 2007, and the Japanese net international asset position will rise to a similar proportion of GDP by that time.

In both cases this would be unprecedented by the countries' own historical experience. Stabilising these net foreign asset positions would require an external adjustment of more than 3.5% of GDP according to IMF estimates, which could mean a painful recession in the US.

In the late 1990s the US private sector went into an unprecedented deficit as the investment boom was associated with a sharp increase in personal and corporate borrowing. The public sector balance went into surplus at that time.

The fall in the equity market and the subsequent economic weakness of 2001 have changed private sector behaviour as the corporate sector, in particular, has cut investment and increased savings. However, in order to sustain growth, the public sector has moved rapidly into deficit.

According to the most recent data, the private sector is now close to balance while the public sector has moved into a deficit of 5% of GDP. The public sector deficit is now almost exactly the counterpart of the current account deficit.

The rapid change in public and private sector balances has important implications for the so-called 'twin deficits' issue that was perceived as a major problem for the US economy in the
mid-1980s.

In 1986, the twin deficits reached about 9 percent of GDP and the shrinking of this imbalance to around 5% of GDP in 1989 was associated with a 50% fall in the dollar's trade weighted value between 1985 and 1987. In 2003 the twin deficits will be about 10 percent of GDP and are likely to increase to 11 percent of GDP next year.

There have not been many occasions since the current floating exchange rate regime started (1973) when countries have run current account deficits of more than 4% of GDP for three consecutive years.

According to the IMF, on the twelve occasions that this has occurred in industrial economies, these have usually been followed by an improvement in the current account of around 2% of GDP over the next three years, associated with a significant depreciation of the real exchange rate and a fall in output.

However, it should be noted that these episodes have normally been experienced by relatively small and open economies, not a large and relatively closed economy like the US.