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US dollar set to receive pandemic shock

By Stephen S. Roach | China Daily | Updated: 2020-07-20 07:32

A test tube labelled with the coronavirus is placed on US dollar banknotes, in this illustration taken on March 1, 2020. [Photo/Agencies]

Pandemic time runs at warp speed. That's true of the COVID-19 infection rate, as well as the unprecedented scientific efforts under way to develop a vaccine. It is also true of transformational developments currently playing out in pandemic-affected economies. Just as a lockdown-induced recession brought global economic activity to a virtual standstill in a mere two months, hopes for a V-shaped recovery are premised on an equally quick reopening of shuttered economies.

It may not be so simple. A sudden halt-long associated with capital flight out of emerging markets-often exposes deep-rooted structural problems that can impair economic recovery. It can also spark abrupt asset-price movements in response to the unmasking of long-simmering imbalances.

Such is the case for the pandemic-affected US economy.

No free lunch or 'magic money'

The aggressive fiscal response to the COVID-19 shock is not without major consequences. Contrary to the widespread belief that budget deficits don't matter because near-zero interest rates temper any increases in debt-servicing costs, in the end there is no "magic money" or free lunch. Domestic savings in the US, already depressed, is headed deep into negative territory. This is likely to lead to a record current account deficit and an outsize plunge in the value of the US dollar.

No country can afford to squander its savings potential-ultimately, the seed-corn of long-term economic growth. That's true even of the United States, where the laws of economics have often been ignored under the guise of "American exceptionalism".

But nothing is forever. The COVID-19 crisis is an especially tough blow for a country that has long been operating on a razor-thin margin of sub-par savings.

Heading into the pandemic, the US' net domestic savings rate-the combined depreciation-adjusted savings of households, businesses and the government sector-stood at just 1.4 percent of national income, falling back to the postglobal financial crisis low of late 2011. No need to worry, goes the conventional excuse-the US never saves.

Rapidly falling savings rate a big concern for US

Think again. The net national savings rate averaged 7 percent over the 45-year period from 1960 to 2005. And during the 1960s, long recognized as the strongest period of productivity-led US economic growth in the post-World War II era, the net saving rates actually averaged 11.5 percent.

Expressing these calculations in net terms is no trivial job. Although gross domestic savings in the first quarter of 2020, at 17.8 percent of national income, was also below its 45-year norm of 21 percent from 1960 to 2005, the shortfall was not as severe as that captured by the net measure. Which reflects another worrisome development: the US' rapidly aging and increasingly obsolete stock of productive capital.

That's where the current account and the dollar come into play. Lacking in savings and wanting to invest and grow, the US typically borrows surplus savings from abroad, and runs chronic current-account deficits in order to attract more foreign capital. Thanks to the dollar's "exorbitant privilege" as the world's dominant reserve currency, this borrowing is normally funded on extremely attractive terms, largely absent interest rate or exchange rate concessions that might otherwise be needed to compensate foreign investors for risk.

That was then. In pandemic time, there is no conventional wisdom.
The US Congress has moved with unusual speed to provide relief amid a record-setting economic free-fall. The Congressional Budget Office expects unprecedented federal budget deficits averaging 14 percent of GDP over 2020-21. Despite the contentious political debate, additional fiscal measures are quite likely. As a result, the net domestic savings rate could be pushed deep into negative territory. This has happened only once before: during and immediately after the global financial crisis, when net national savings averaged-1.8 percent of national income from the second quarter of 2008 to the second quarter of 2010, while federal budget deficits averaged 10 percent of GDP.

Current account deficit should widen sharply

In the COVID-19 era, the net national savings rate could well plunge as low as-5 percent to-10 percent in the next two-three years. That means the savings-short US economy could well be headed for a significant partial liquidation of net savings. With unprecedented pressure on domestic savings likely to magnify the US' need for surplus foreign capital, the current account deficit could widen sharply. Since 1982, this broad measure of external balance has recorded deficits averaging 2.7 percent of GDP, but the previous record deficit of 6.3 percent of GDP in the fourth quarter of 2005 could be eclipsed. This raises a big question: Will foreign investors demand concessions to provide the massive increment of foreign capital that the US' savings-short economy is about to require?

The answer depends critically on whether the US deserves to retain its exorbitant privilege. That is not a new debate. What is new is the COVID-19 time warp: the verdict may be rendered sooner rather than later.

The US is leading the charge into protectionism, de-globalization and decoupling. Its share of world foreign exchange reserves has fallen from a little over 70 percent in 2000 to a little below 60 percent today. Its COVID-19 containment has been an abysmal failure.

Current account imbalances will impact interest rates

And its history of systemic racism and police violence has sparked a transformative wave of civil unrest. Against this background, especially when compared with other major economies, it seems reasonable to conclude that hyper-extended savings and current account imbalances will finally have actionable consequences for the dollar and/or US interest rates.

To the extent that the inflation response lags, and the Federal Reserve maintains its extraordinarily accommodative monetary policy stance, the bulk of the concession should occur through the currency rather than interest rates. Hence, I foresee a 35 percent drop in the broad dollar index over the next two-three years.

Shocking as it may sound, such a seemingly outsize drop in the dollar is not without historical precedent. The US dollar's real effective exchange rate fell by 33 percent between 1970 and 1978, by 33 percent from 1985 to 1988, and by 28 percent over the 2002-11 interval. The COVID-19-induced currency shock looks like it will be made in America.

The author is a faculty member at Yale University and the author of Unbalanced: The Codependency of America and China.
Project Syndicate
The views don't necessarily reflect those of China Daily.

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