from Follow the Money

Do US “officials” really think the dollar’s current value is a market rate?

August 7, 2007

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IMF Article IV (think annual economic check-up) reports on the US usually make for pretty dull reading.   But not always.

The IMF – drawing on its model for equilibrium real exchange rates – argued that the dollar is overvalued by between 10 and 30% in real terms.    That seems right to me.   The US has a large trade deficit.  The dollar is still higher – in real terms – that it was in the first part of the 1990s.    Sure, the dollar is weak against the euro, the pound, the Canadian dollar and the Australian dollar – but it is still substantially stronger than it was in the 1990s v most of the emerging world.


But apparently a few US officials took umbrage at the suggestion that the dollar was overvalued – and argued that if the dollar’s value is determined in the market, it, by definition, cannot be overvalued.   The IMF reports (paragraph 18 on p. 13 of the document, which is on p. 15 of the .pdf)


“Officials were skeptical about the notion of overvaluation for a market-determined exchange rate like the dollar.”


My jaw dropped.  I guess US officials believe China’s assertion that the RMB dollar is a market-determined exchange rate.   Or that an unprecedented level of central bank intervention globally – emerging market central bank intervention almost certainly topped $1 trillion (annualized) in the last quarter, and likely was closer to $1.2 trillion -- has no impact on the dollar.


At least to people like me, the argument that the dollar’s exchange rate – against all currencies, mind you, not just against the major currencies – is a market exchange rate simply isn’t credible.   The US dollar’s value against most emerging currencies just isn’t determined in the market. Or rather it is determined in a market shaped by massive central bank intervention.  


And with emerging market central banks on track to sell $200b of dollars for euros and pounds (and probably substantially more; $400b isn’t out of the question if global reserve growth comes it at close to $1.2 trillion) to keep their portfolios balanced, I suspect that they are exercising some influence over a range of other exchange rates as well.


US officials also argued that the IMF’s exchange rate model:


“failed to adequately factor in non-trade fundamentals such as capital flows.”


Alas, most of those capital flows -- on a net basis -- don’t come from the private sector.   And I am not quite sure how the IMF’s model should take into account non-market fundamentals like large scale central bank financing of the US.    


The US does attract substantial gross private capital inflows, but those inflows are needed to finance the United States own (growing) investment abroad: almost all of the net financing needed to cover the US current account deficit now comes from the official sector.    The US data shows $150b ($600b annualized) in net official inflows in q1, and that likely understates the United States real dependence on central bank financing (see my House budget committee testimony). 


The IMF though doesn’t really explore the United States dependence on official financial flows either.  Indeed, its long-term projections essentially forecast the problem away.   That is one reason why I wasn’t all that impressed by the details of the IMF’s analysis of the US balance of payments.  


The IMF -- drawing on the TIC data – emphasized that private inflows now finance the bulk of the US current account deficit.  It also implied that growing demand for corporate bonds reflects shifts in private demand for bonds.  Maybe.   But official demand for some kinds of corporate debt was rising (until recently) and it sure seems to me that the really big trend has been super-strong demand for Agency bonds (foreigners now hold a rising share of all Agencies).  Indeed, the BEA’s revised data makes it clear that most Agency demand comes from central banks.  (the graphs are on p. 12 of the IMF's report; p. 14 of the pdf)


Indeed, the BEA’s revised data – based on the Treasury survey – suggests a much higher level of official demand than the TIC data.   Too bad the IMF didn’t look at that data.    Or try to explain how US dependence on central bank inflows could be falling when the IMF’s own data shows a very strong increase in central bank reserve growth toward the end of 2006…


Moreover, the IMF’s global forecast (still) shows a rise in the surplus of the oil exporters, a fall in the surplus of emerging Asia and Japan and a stable US deficit (see Figure 8 on p. 37 of the document, p. 39 of the .pdf). This global forecast is no more credible than the US argument the dollar’s value is a market exchange rate: both Japan and emerging Asia’s surplus are surging this year.    The IMF desperately needs to reduce the period between the production and the public dissemination of its reports – or at least update certain numbers and forecasts to fit known facts.


But the really big surprise comes in the IMF’s forecast for how the US will finance its deficit in 2007, and over time.   Global reserve growth has picked up strongly.   Just look at China and the other BRICs.    But the IMF forecasts that central bank financing of the US will fall from around $450b in 2006 to $300b in 2007 – and then level off at around $200-250b over time.    (See Table 5 on p. 48 of the document, p. 50 of the .pdf)


Who does the IMF expect to pick up the slack?  The world’s banks.  Net other investment inflows rise to around $500-600b (with most of the rise in 2007).  

That would be a huge swing.  Until now, the US deficit has been financed by foreign demand for US debt securities and central banks – not by the banking system.  It doesn’t make much sense either.


The IMF’s forecast that the US current account deficit will stabilize in 2007 is a bit more credible.   The IMF forecasts a $835b (6% of GDP) 2007 deficit, with a 0.4% of GDP improvement in the trade balance offsetting a 0.3% of GDP deterioration in the income deficit.    I personally don’t expect as big an improvement in the US trade deficit – not with oil back at $70 – if the US avoids a severe slump in the second half of the year, and I wouldn’t be surprised by a bit larger deterioration in the income balance.


But the IMF’s forecast for 2007 is certainly within the realm of reason.


I had a far harder time figuring out the IMF’s long-term forecast for the US current account deficit.   The IMF forecasts that the current account deficit will stabilize at around 6% of US GDP over time. 


Fair enough.  The key question is whether the assumptions that go into that forecast make sense.


The IMF projects that the trade and transfers deficit will fall from around 6% of US GDP in 2007 to around 5% in 2012 even as the US emerges from its 2007 growth slump.    $20b (between 0.1 and 0.2% of GDP) of this improvement comes from a mysterious $20b improvement in the transfers balance in 2008.


The rest of the improvement comes from a fall in the trade deficit.   To get that fall, the IMF forecast a major fall in US import growth.   Between 2004 and 2006, real US GDP growth averaged about 3.5% and nominal import growth averaged 13% or so.  Between 2009 and 2012, the IMF expects real US GDP growth to be around 3% but nominal import growth to under 5.5%.   Hmmm.  


That is a big change.


The assumptions that go into the income balance are also not totally clear.   The income deficit is expected to deteriorate by 0.5% of GDP – from 0.3% of GDP deficit in 2007 to a 0.8% of GDP deficit in 2012.   But if you sum up the current account deficits, US external debt should rise by around 30% of GDP, though summing up deficits over time with GDP rising obviously has some problems.   A 5% interest rate on that net debt implies a 1.5% of GDP deterioration in the US income balance.  The IMF’s more formal forecast (appendix table 1) implies a 20% of GDP deterioration in the US net foreign asset position, which suggest a 1% of GDP deterioration in the income balance.  


Put a bit differently, the cumulative US current account deficit between 2008 and 2012 is around $4.7 trillion, which implies – at a 5% average interest rate – $235b in additional interest payments.  But the IMF only forecasts a $85b deterioration in the US income balance.


I guess the IMF now believes in dark matter!


personally think there is meaningful risk that the US income balance may deteriorate by more than implied by the interest payments on the sum of future US current account deficits.  The average interest rate on the United States existing external debt is about 4.3%.   The existing stock of interest bearing US external debt is around $10 trillion.  A 0.7% increase in the average interest rate – to say 5% -- implies an additional $70b in interest payments.  And even if the long term fed funds rate is lower than the current rate, I would expect the average interest rate on the US external debt stock to rise over time.  Corporate debt usually carries a premium over LIBOR – or over treasuries.


If the IMF believes that say rising dividend income on US FDI (dark matter) will offset rising interest rates on US external debt, it should say so.   If the IMF believes that foreign direct investment in the US will continue to generate lower-than-treasury returns and that the average interest rate on US external liabilities will stay around 4.3%, it also should say so.   They key assumptions need to be spelled out a bit more.  Otherwise, it is hard to understand the basis for the IMF’s forecast on the income balance – and thus its forecast for “invisibles” and the overall US current account deficit. 


I harp on this because I was surprised to see the IMF forecast the United States dependence on official financing away – and to, in effect, forecast most of the expected future deterioration in the US income balance away.   Neither will help the IMF play a constructive role in the resolution of global imbalances.   


In the past the IMF's forecasts for the US balance of payments didn't really matter.  Now they do -- the IMF has far more to add to the debate on imbalances than the debate on US entitlements.


Then again, if the US Treasury thinks the US current account deficit is financed by private capital inflows and the dollar’s value – including the dollar’s value v. the emerging world – is determined in the private market, there isn’t much the IMF can do.

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