HSBC: 20pc US dollar fall possible

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.

While it is very difficult to identify when a current account trajectory has become unsustainable, historical experience suggests that the US situation is extreme and unlikely to be sustained. The next question is whether the fall in the dollar we have already seen will be enough to a least stabilise the US external position.

Between 1995 and early 2002 the dollar rose by 45% on a trade weighted basis, and since then it has fallen back by 20%. Is this fall enough? As the fall in the dollar since early 2002 has only taken it back to its long term averages, it is difficult to argue from this that the US now has a competitive advantage that will allow it to win market share in export markets and cuts its external imbalance.

A similar picture emerges on measures of purchasing power parity for the dollar against the euro and the yen. While such measures are only of limited use for forecasting exchange rates (market rates can deviate from PPP by very large amounts for long periods), they are useful in giving an indication of relative competitive positions. Neither the euro nor the yen are very far from the OECD PPP estimates.

The conclusion has to be that the current level of the dollar is probably not consistent with a narrowing of the US current account deficit in coming years. If the deficit is to begin to shrink, either the US has to grow more slowly than its trading partners, or the dollar will need to fall further, or some combination of the two.

The US current account deficit continues to widen and US fiscal and monetary policies are aimed squarely at ensuring strong domestic economic growth in the coming year.

Historically, current account deficits of more than 4% of GDP for three consecutive years have not proved to be sustainable and they have usually been followed by a correction driven by lower output and a weaker currency.

It does not appear reasonable to expect the US economy to grow significantly slower than the rest of the industrial world in the coming year, so any prospect of a narrowing current account imbalance would require further dollar depreciation.

The fall in the dollar seen since early 2002 does not appear to have been enough to generate this, because it has only put the dollar back at close to long term 'fair value' levels. Our analysis suggests that it would take a further 20% decline in the dollar's trade weighted index next year in order to generate a narrowing of the current account deficit by ½% of GDP in 2006.

The levels for the euro and yen implied by a further 20% decline in the dollar index appear extreme, and we would hesitate to forecast them. However, the analysis suggests that the risks for the dollar continue to be skewed heavily to the downside and that further significant dollar weakness is likely during 2004, despite the recent signs of stronger economic performance in the US.