December 20, 2004
Is the Dollar Really Overvalued?
Over the past couple of years, I've argued strongly and repeatedly that the deep and ongoing U.S. current account deficit will compromise growth in U.S. gross domestic investment for years to come. As the size of the U.S. current account deficit gradually receives more attention, it has become an article of faith that the U.S. dollar is overvalued.
Not so fast.
The basic assumption of the overvalued-dollar thesis is that the current account deficit is simply an import/export problem that will go away if prices (mainly currency valuations) are right. As I've argued before, this misdiagnoses the problem. The U.S. current account deficit is mainly a problem of woefully inadequate U.S. savings. I'll be the first to argue that a revaluation of the Chinese yuan is coming, and that a cheapening of the U.S. dollar relative to Asian currencies will help to “improve” the current account deficit. Unfortunately, this “improvement” will be similar to the improvement in gas mileage that a car gets when it rolls off the side of a cliff into the deep blue sea. Ultimately, undisciplined U.S. spending, poorly allocated capital spending in the late 90's, huge fiscal deficits, excessive consumer debt, and a speculative housing market have virtually ensured an aftermath of slow growth in gross domestic investment (some combination of real estate investment and capital spending) for years to come.
So where does this leave the U.S. dollar?
It's important to recognize that the dollar's valuation is neither the cause nor the solution of the U.S. current account deficit. Sure, if you think of a current account deficit as being caused by an overvalued dollar, it's simple enough to think that a future depreciation in the dollar will clear up the deficit. But if you think of the current account deficit as resulting from insufficient savings, then forcing the adjustment burden onto the dollar (rather than adjusting savings behavior and fiscal policy) can lead to a currency crisis.
Here's why: in anticipation of ongoing current account deficits (which will have to be financed by massive and continuous foreign capital inflows), the currency at some point has to decline so deeply that it a) reprices imports and exports enough to impact the deficit, and b) sets up expectations for a sustained future appreciation in the currency. That anticipated appreciation, in turn, encourages the foreign capital inflows to finance whatever ongoing deficits remain. The U.S. has thus far avoided a currency crisis because of the unsustainable willingness of China and Japan to finance enormous deficits by accumulating U.S. Treasuries, despite an inevitable depreciation of the U.S. dollar.
In short, if the U.S. is expected to run large and sustained current account deficits as a result of a saving-poor economy, the U.S. dollar will eventually be forced to a substantial “undervaluation,” in the sense of being priced to deliver adequately high future returns to foreign investors on the savings they will have to provide in order to finance those deficits.
In the meantime, to the extent that China and Japan actively hold down the values of their own currencies and prop up the value of the dollar, the currencies of other trading partners have to shoulder more than their share of the adjustment burden. That's exactly what seems to be going on.
Valuing foreign currencies
In September 2000, with the euro worth about $0.85, I published a piece called Valuing Foreign Currencies that describes my approach to estimating currency valuations. Basically, a currency is both a means of payment and a store of value, which means that it has to be priced on the basis of what I call a “joint parity” involving both price levels and interest rates across countries. At the time of that article, I argued that the euro was substantially undervalued. This was very unusual given that the U.S. was already running deep current account deficits, which would have justified a much weaker dollar.
Since then, the euro has advanced by over 56% against the dollar, to a recent value of $1.33 per euro. Below is an updated chart. The red line is the exchange rate ($/euro), the blue line is an estimate of “purchasing power parity” or PPP, which is based on relative price levels across countries, and the thin green line is a “joint parity” estimate of the exchange rate warranted by both price levels and interest rate conditions across countries (data prior to 1999 is for the German mark, appropriately scaled - see Valuing Foreign Currencies for more detail). As you can see, the euro has moved from substantial undervaluation to substantial overvaluation. From the European standpoint, the U.S. dollar looks cheap (but could get even cheaper). Joint parity looks about $1.13 per euro.
The same is true, to a lesser extent, for the British pound ($1.94 versus about $1.85 at joint parity), and the Canadian dollar ($0.81 versus about $0.75 at joint parity). That said, it's essential to note that a deviation from joint parity doesn't have to be closed quickly, nor does it mean that the currency can't become over- or undervalued to a much greater extent. Typically, foreign currencies can take as much as 5-10 years to move from extremely undervalued to extremely overvalued conditions.
Still, for countries not actively managing their exchange rates, the dollar seems to be modestly undervalued – enough justify a certain amount of foreign savings inflows. Though our bilateral trade deficits with countries like Canada, England, and Germany remain large despite the weaker dollar, they have been fairly well behaved, and they have not exploded like our deficits with China, Japan and other Asian countries which are trying to hold the dollar up and their own currencies down.
Evidently, the euro and other non-Asian currencies have been forced to shoulder more than their share of adjustment burden – appreciating further than they otherwise might. As long as China and Japan continue to aggressively support the U.S. dollar, however, there's no particular reason to expect this burden to lighten. While the dollar has declined notably against an equal-weighted basket of foreign currencies, it has declined far less on a trade-weighted basis, resulting in no improvement at all on current account. So despite the apparent overvaluation of the euro, pound and Canadian dollar, I would currently bet against none of them.
As for the Japanese yen (below), currently at $0.0096 (104 yen per dollar), I would estimate joint parity at about $0.01 (100 yen per dollar), so from a parity standpoint, the yen still appears to be slightly undervalued. Given our large continuing deficits with Japan, of course, it would not be surprising to see the dollar overshoot to the downside relative to the yen. In my view, a value like $0.012 (83 yen per dollar) is very plausible.
Finally, with respect to China, it seems clear that the longer the yuan is held at unsustainably low levels, there will be little reason for other currencies like the euro and pound to normalize relative to the dollar. It's predictable, then, that the Europeans will probably begin placing greater pressure on China to revalue in the months ahead. One place to watch for excitement: short-term Chinese interest rates. Any anticipation of yuan revaluation would increase the willingness of yuan holders to retain the currency in short-term deposits, and to defer payment of US dollars for trade purposes. We're already seeing short-term Chinese money market yields moving down despite tightening moves by the Chinese central bank, which suggests a modestly increased anticipation of a revaluation. We haven't seen anything pronounced yet, but we're watching things like dollar-yuan interest rate spreads and such. The longer the yuan remains pegged at artificially low levels, the greater the pressure for the dollar's depreciation to be exaggerated against the euro, pound and other currencies.
Regardless of what happens with the yuan, it is important to remember that the enormous U.S. current account deficit is primarily a reflection of excessive consumer spending and debt, inadequate saving, an overheated housing market, and a reckless lack of fiscal discipline in Washington. If the burden of adjustment for all of this bad behavior is placed on the dollar, it will be no surprise if the dollar behaves just as badly.
In any event, Wall Street's hopes for a sustained capital spending boom in the U.S. anytime soon are vastly exaggerated.
As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and still moderately favorable market action. Sentiment has become unusually unfavorable on a number of counts. Investors Intelligence reports that the percentage of bullish advisory services has jumped to 62.1%, a 17-year high last seen in January 1987, while bears have dropped to just 21.1%. The CBOE volatility index is now down to 11.95%. Though low volatility does not necessarily imply a market peak, the corollary generally does hold true: market peaks are generally attended by low volatility. In contrast, corporate insiders are now selling well over 6 shares for every share purchased, and because the shares being sold are so high-priced, the comparison is striking in terms of dollar values. Thompson Financial reports that insiders made $6.6 billion in sales last month, compared with just $144 million in purchases. That sales figure is the highest since $7.7 billion at the bubble peak in August 2000. New stock issuance is now eclipsing the volume seen at the bubble peak. Rounding out this inventory of speculative fervor and lax fiduciary discipline, junk bond spreads are pricing in no material probability of corporate defaults in the years ahead.
As a technical side note, the Dow indices are displaying some important divergences as well. Despite the recent broad market advance which took the Transports to substantial new highs, the Dow Industrials have failed to surpass their February 11 th high of 10737.70, closing last week at 10649.92. Utilities also exhibited some initial signs of stalling out last week. This isn't a significant concern in and of itself, but when valuations, sentiment and economic factors are unfavorable or tenuous, it is extremely important to be observant for early, often seemingly insignificant deteriorations in the quality of market action. We don't observe enough evidence here to shift to a fully defensive position, but we're already sufficiently hedged not to carry a great concern about an abrupt deterioration, should it occur.
In bonds, the Market Climate remained characterized last week by modestly unfavorable valuations and modestly unfavorable market action. The Strategic Total Return Fund continues to hold a duration of about 2.5 years, mostly in Treasury Inflation Protected Securities, as well as a roughly 17% position in precious metals shares.
Wishing you a very Merry Christmas, joy in your heart, and peace on Earth.
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