The dollar's depreciation may boost level of activity by US multinationals in Ireland, writes Philip Lane.
The re-election of President Bush has been greeted in the world's financial markets by a renewed slide in the value of the US dollar. Although the US economy is now growing at a respectable pace, investors do not believe that the new Bush administration and the Republican-controlled Congress will do much to address the twin US current account and fiscal deficits.
Indeed, if anything, the post-election political momentum is towards a further expansion in the scale of US government borrowing, especially if a debt-financed part-privatisation of the social security system moves ahead.
With no near-term fiscal correction in sight and the US private sector savings rate remaining remarkably low, the prognosis is that the US will continue to be a large-scale net borrower from the rest of the world unless some kind of correction takes place.
In response, the dollar has weakened for two reasons. First, for diversification purposes, many investors wish to reduce their portfolio exposure to American liabilities. Second, the market is aware that the growing US external debt must eventually be repaid through trade balance surpluses, which is facilitated by dollar depreciation. These fundamentals point towards further weakening in the dollar-euro rate (which has already declined by more than 60 per cent since the dollar peaked in October 2000), with a medium-term range of 1.45-1.70 increasing in likelihood.
Indeed, a gradual decline in the dollar is mostly good news for the US. By stimulating exports, it reinforces the recovery in the US economy and, over time, will rein in the US external deficit. In the short term, depreciation also generates a net capital gain for US investors: the dollar value of its substantial foreign-currency assets improves.
Rather, the main risk lies in a panic-style rapid decline in the willingness of investors to finance the US external imbalance. In this scenario, the dollar would undergo a steep fall, US interest rates would rise sharply and the US would suffer a serious recession.
Such a disorderly adjustment would also disrupt the international financial system, possibly inducing negative contagion especially among the emerging market debtor nations, and threatening those financial institutions that have developed highly leveraged strategies that rely on the continuation of a low interest rate environment. This crisis scenario is also of most concern to European policymakers, with the European Central Bank poised to cut interest rates if a sharp dollar depreciation takes place over a concentrated time period.
It is ironic that China has emerged as a major player in determining the future path of the US dollar. The rapid growth in Chinese exports has been facilitated by its policy of rigidly pegging the yuan to the dollar. Moreover, the Chinese central bank has become a major financier of the US current account deficit, with estimates of its dollar reserves in the range of $150-350 billion.
If China was to revalue its currency, many other Asian nations would follow suit and this would ease the burden on the dollar-euro rate in facilitating the correction of the US external imbalance.
However, while a modest revaluation may well take place sometime in 2005, it is unlikely to be sufficiently large to make a major difference. In addition to the central role of a competitive exchange rate in its development strategy, the scale of its dollar reserve assets means that the Chinese government also has a powerful financial motivation to limit a currency appreciation that would generate sizeable capital losses on these holdings.
However, no single investor can control the currency markets: with dollar holdings dispersed over many central banks and thousands of private investors, a the possibility of a "race to the exit" cannot be ruled out.
Dollar depreciation has significant benefits for Irish consumers. Cheaper imports (especially from the Asian economies that peg to the dollar) lower the cost of living; a weaker dollar also helps to cushion the impact of recent oil price increases; many Irish people will enjoy more affordable visits to the US. In addition, euro appreciation places downward pressure on ECB interest rates, which is good news for mortgage-holders.
Although the domestic tourism sector may suffer, the dollar depreciation may actually boost the level of activity by US multinationals in Ireland to the extent that their Irish operations serve as a platform for European exports that are made more competitive by a weaker dollar. However, those multinational and domestic operations that are directed towards serving the US market will come under pressure on account of the appreciation of the euro against the dollar.
In addition, countries in the dollar bloc will become more attractive as a location for footloose international investments. In the global competition for high-skilled workers there are conflicting forces: euro-denominated salaries now look more attractive but those with equity in US property have lost purchasing power in terms of entering the Irish housing market.
In terms of the financial sector, it will be interesting to observe performance differences across the institutional investors and pension funds depending on their level of exposure to the US market and the extent of their currency hedging.
To take one example, nearly a quarter of the National Pensions Reserve Fund is invested in US equities (according to its most recent annual report) and it follows a 50 per cent hedging rule. Accordingly, we may expect the dollar depreciation to have had an adverse impact on the recent performance of the fund. A significant number of the larger domestic corporates have extensive US operations: the dollar depreciation represents a serious challenge for the senior management teams of these firms.
Finally, the large swings in the dollar-euro rate in recent years highlight a structural flaw in the national pay agreements that have been delivered under the social partnership system. These settlements have typically specified a fixed schedule of wage increases over an 18-36 month horizon. However, a pay award that ensures competitiveness at a dollar-euro rate of 1.20 would no longer be appropriate at a rate of 1.50: an obvious solution is to index such awards to the external value of the euro.
Philip R. Lane is Professor of International Macroeconomics and Director of the Institute for International Integration Studies at Trinity College Dublin. He is currently on leave as a Government of Ireland Research Fellow, sponsored by the Irish Research Council on the Humanities and Social Sciences