Friday, October 15, 2010

The dollar is down for the 10-count

Recently the dollar’s value has depreciated and there are quite a few stories being written. As in most interesting topics in economics, the answers are not simple. There are many things that impact the value of the dollar but in this post I want to focus on a three year trend of global financial flows. The main conclusion of this post is that recent changes in the value of the dollar have very little to do with all the fuss over China. Many of us have worried about what would happen when foreigners decided to sell their US assets. Well– the future is here now and the trends do not look like they are going to reverse. It will not be easy to restore foreign faith in US assets especially when the substitutes are looking increasing better.

But before we oooohhh and aaaahhhh over pictures of hot data in skimpy pink pants, let’s just discuss the basic or fundamental forces that impact exchange values. These have to do with the fact that many cross border trades require a domestic citizen of one country to first purchase the currency of the other country. If a US citizen wants to buy goods or services in South Korea or China – she often will sell dollars and buy Korean won or Chinese yuan. We already know well that the US buys more goods from other countries than they buy from us. The implication is that this deficit in goods trades means that we are selling more dollars than foreigners really want or need to buy our goods. Thus, there is a glut of dollars on world markets because of goods trade. This glut pushes the value of the dollar down. But this is old news – let’s move on to groovier stuff.

It is also true that when US citizens buy foreign bonds, stocks, and other financial assets they generally need foreign currency to make the purchases. In the chart from the link below you see the net of US purchases of foreign assets (BOPO) in each quarter since 2000. You can see that between 2000 and early 2007 the US was building up its foreign assets (it is conventional to assign a negative sign when US citizens take money out of the US to add to foreign asset postions). So the BOPO line is going downward as US citizens buy more assets abroad. But afterward, the building slowed and by the end of 2008 we were net sellers of foreign bonds, stocks, bank deposits, etc (line is rising). As a result we were first net sellers of dollars and then became net buyers. That speaks well for a rising dollar since 2007. But read on -- that's only part of the story.
BOPI shows foreign interest in US financial assets. It is conventional to use a positive sign when foriegners Notice a similar pattern with foreigners wanting more US assets until the end of 2006 followed by a diminished appetite for increasing their net purchases of US assets. While there has been some recovery of their interest in US assets through the first quarter of 2010, the overall result is at first an increased demand for dollars and then a reduced need for dollars.,BOPO&transformation=lin,lin&scale=Left,Left&range=Custom,Custom&cosd=2000-01-01,2000-01-01&coed=2010-04-01,2010-04-01&line_color=%230000FF,%23FF0000&link_values=,&mark_type=NONE,NONE&mw=4,4&line_style=Solid,Solid&lw=1,1&vintage_date=2010-10-14,2010-10-14&revision_date=2010-10-14,2010-10-14&mma=0,0&nd=,&ost=,&oet=,&fml=a,a

The net effect on the demand for US dollars from cross border asset flows can be seen by subtracting the US Net Purchases of Foreign Assets from the Foreign Net Purchases of US assets. This net amount is shown in the table below. The peak value of the net amount in early 2006 of $780 billion shows that foreigners needs for dollars to buy US assets exceeded by $780 billion dollars the sales of dollars by US purchases of foreign assets. Until 2006, therefore, we clearly see an increasing demand for dollars that should have been pushing the value of the dollar upward. Since 2006, we see less and less upward pressure on the dollar. The net amount fell to $165 billion in 2009 and looks headed even lower than that in 2010. Recent news suggest this is tue.

Year     NET Dollar Demand in billions of dollars based on BOPI and BOPO
2000     478
2001     400
2002     501
2003     533
2004     532
2005     701
2006     780
2007     631
2008     611
2009     165
2010*     55
* based on two quarters

Whereas speculators and governments can influence the value of the dollar – it is pretty clear that if we combine the long-term impact of goods trade deficits with a movement towards a finance deficit – we can see why there is plenty of fundamental pressure pushing the dollar down. Recent press stories are focusing on the relative strengths of emerging markets and the flow of investments moving to China, South Korea, Brazil, and many other countries. If this is the wave of the future, then it is difficult to imagine the dollar rising unless there is a change in the desire of foreigners for US goods, service, or financial assets. A rising dollar cannot come until the US clearly signals a return to competitiveness and strength.

These international asset transactions have several components – so I wanted to look further into the causes of these changes. What was accounting for financial transactions and money changing directions? What asset categories accounted for US citizens holding fewer assets abroad and foreigners wanting fewer US assets? To answer these questions I compared two time periods of equal length (12 quarters) – 2004 Q1 to 2007 Q1 versus 2007 Q2 to 2010 Q2.

Consider the US citizens holdings first. US net holdings of foreign assets fell by a total $1.9 trillion when you compare the changes in the second period to those in the first. That amounted to a decline of 58%. Foreign bank account holdings fell by about $840 billion and US citizens held about $587 billion less in foreign securities. But the largest reduction in US asset holdings abroad came in the category called “U.S. claims on unaffiliated foreigners reported by U.S. nonbanking concerns.” US financial intermediaries reduced their holdings of assets of their foreign counterparts by approximately $1 trillion. It is worth pointing out that virtually none of these swings were attributable to official or government flows in gold, currency, or reserves.

Foreigners held $2.9 trillion less of US assets in the time period from mid-2007 to mid-2010 when compared to the time period from early 2004 to early 2007. This withdrawal of foreign holdings from US markets was almost fully explained by a reduction in bank accounts of $1.6 trillion and a reduction in securities (not bonds) by $1.4 trillion. Again, almost none of the changes across these time periods had anything to do with recorded changes in official government activities regarding gold, currencies, or reserves.

Taking both US and foreign asset swings into account shows a net increase of a trillion dollars ($2.9 trillion minus $1.9 trillion) in sales of internationally trade dollars. We don’t yet have figures for 2010 Q3 but the current business and economic news suggest that these trends have picked up. Low US interest rates coupled with movement of funds into higher yielding assets in emerging markets suggest this trend could go for some time. When it looked like the US was emerging from its recession funds hung around for a while and the dollar played its role as a safe haven. But now that there is increasing worry about the US expansion while other nations promise stronger growth, the effect of these international transaction flows are having a more profound impact on the value of the dollar – moving it in a southerly direction.

While southern fried chicken is delicious, a currency crisis is not what this country needs. Quantitative easing and more stimulus will not help since QE will simply move more dollars off shore exacerbating the trends mentioned above. More stimulus will create bigger worries about US financial credibility and further movements away from US assets. It is time to move away from populism to solid thinking about the US economy. The future is here and there is no easy way out.


  1. Excellent. In essence we are not growing our assets at a rate equal to or greater than other countries and investment dollars are seeking better yields elsewhere. This is a long term trend but we(US) have only most recently discovered it. The practical answer is to find ways to attract that capital back. Those ways are in contradiction to our current thoughts about how to build wealth in the US that is not based on funny money or free credit. The question is what is the strategy and how should it be implemented?

  2. Simple. Quit playing the game of populism and direct policy to what makes assets valuable in the USA. Flooding the world with liquidity is not the right way.

  3. How do we make the asset values in the US more valuable?

    It appears that our FED Chairman is trying to flood the market with liquidity. If this keeps up the dollar will get less value for the domestic spender. Never mind the global exchange system. That spells inflation. It appears from his speech that they wanted a 1.7% inflation rate and are only getting .8%.

  4. Jim -- Let me count the ways...but among them are not flooding the world with liquidity and have a plan to manage the exploding national debt. Then they could try to reduce uncertainty for businesses about pensions, energy, healthcare and so on. Better regulation of excessive leverage wouldn't hurt. This is not brain science.

  5. OK, so where's the picture of the hot whatever in the skimpy, pink pants?