Expert View: The long, unwinding road to a dollar adjustment

The weakness of the dollar is making headlines again, reviving the old concerns about the sustainability of the US current account deficit and the size of the dollar adjustment needed to correct it.

Here are the facts: the US, the richest country in the world, consumes more each year than it produces. Its already high standard of living is being increased by net imports from abroad worth some 6.5 per cent of GDP. These imports (eg from China) are paid for in dollars, with which the Chinese monetary authorities obligingly buy US securities. So until recently US plc lived beyond its income by increasing its debt to the Chinese. Since then, Russia and other oil exporting countries in the Middle East have been buying US assets.

How long can this go on? One school of macroeconomists argues that sooner or later these countries will grow tired of supplying manufactured goods and oil in return for paper IOUs.

As soon as they stop buying dollar securities, the dollar will fall. This fall will make imports into the US more expensive, US exports more competitive, and hence correct the deficit. Are we witnessing the start of that adjustment?

Perhaps, but this argument, which has been around for at least 10 years, is countered by another: the last thing that those with dollar assets want to do is provoke a decline in the dollar, since this will (a) reduce the value of their hard-earned savings, and (b) make their exports less competitive. The much-deplored global imbalances actually seem to suit everyone rather well, which is why they have persisted so long. To spearhead their rise as an industrial power, the Chinese like to produce very competitive manufactured goods. The Americans are happy to go into debt to buy those goods.

And why not? If a high-earning individual, who also has assets worth around three times his income, decides to live beyond his means by borrowing 6.5 per cent of his growing (at 5 per cent) income, his debt will gradually build and stabilise at one-and-a-third times his income - not much given that people habitually take on house mortgages of three to four times their income.

In the same way, America plc is currently enjoying a living standard 6.5 per cent higher than it can earn, paid for by borrowing and by selling assets. If this continues, the cumulative borrowing plus sale of assets will eventually rise to nearly half of the US's asset values.

Would going into debt, or selling US assets, to foreigners on this scale be politically acceptable? If not, then the only remedy is a decline in the dollar. The econometric rule of thumb, according to a recent paper by Barry Eichengreen of the University of California, is that getting the deficit down from its current 6.5 per cent of GDP to, say, 1.5 per cent would require a 50 per cent fall in the dollar.

Although this would constitute an almighty upset if it happened over a year, history shows it could easily take place over a longer period. The real dollar exchange rate declined by 47 per cent between March 1985 and February 1991.

More recently, between October 2002 and December 2004, the dollar registered a decline of 23 per cent. It looked as though the long-awaited depreciation had started. But throughout 2005 and 2006 the US Federal Reserve put up interest rates, stopping the decline in its tracks. Many attribute the current weakness of the dollar to the possibility that US interest rates have now peaked, so the differentials that have been moving in favour of the dollar will start to move against it.

Others say that the fall in the oil price has reduced the dollar earnings of the oil exporters, who have been the main buyers of dollar assets recently. For both these reasons, another period of dollar weakness, similar to 2002-04, may now be getting under way. But it will take a very long time to unwind those global imbalances.

Bill Robinson is director of economics at PricewaterhouseCoopers