CONSIDER this: 2,000 years ago, Rome was running a trade shortfall equivalent to 3% of its total economy, which was one of the many factors that led to the empire’s eventual downfall. Fifty years ago, Brazil accumulated massive trade deficits which were critical to the country’s decline as its currency was battered over and over again. Eight years ago, the “Tiger” economies of Asia were plunged into a currency crisis, thanks to big deficits and an over-reliance on foreign capital.
Today, international bodies assert that if a country’s trade deficit exceeds 4.5% of its GDP, it’s a sign of real and present economic danger. And yet the US economy continues to defy both history and economics. At 6.4% of GDP (US$58.9bil), the US trade deficit is perilous and significantly exceeds that of ancient Rome, 20th century Brazil or any Asian country a decade ago.
And so, the recent decline of the US dollar comes as no surprise and there are good reasons to expect its slide to continue. Weak economic numbers – slower housing starts, sluggish durable goods orders and lethargic consumer confidence – all pointing to a correction in the economy, triggered the fall of the greenback. Compounding this is the US’ current account and budget deficit (3.5% of GDP) as well as the narrowing of the interest rate differential between the US and regional Asian countries.
The Federal Reserve has kept its target rate unchanged at 5.25%, with expectations of a possible rate cut in 1H07 due to slowing growth.
All these factors combined offer the possibility of a prolonged economic malaise which continues to weigh down the dollar.
On the contrary, improved economic fundamentals in Asia (reduced external debt and budget deficits, higher international reserves, potential sovereign ratings upgrades and sizeable portfolio capital flows to Asia) have further supported regional currencies.
Further appreciation is on the cards, driven by dwindling US macro dynamics and slower growth expectations. Year-to-date, the Malaysian ringgit has appreciated 6.1% against the greenback, the Singapore dollar at 7.3%, the Indonesian rupiah is up 7.5% and the Thai bath, 14.1%. More telling will be a likely renminbi appreciation fuelling regional currencies, given China’s imminent economic reforms and move towards a flexible mechanism.
Increasingly, the fortunes of the region’s economies are being lifted by intra-regional trade, driven mostly by demand from China.
Whilst a weak dollar has seen currencies rally against a weary US economy, a significant correction in US macro data and serious negatives from a bourgeoning current account deficit may flip dynamics if left unchecked.
The largest threat to the global architecture here remains an unruly adjustment of the US dollar, which could send regional markets into a downward spiral premised on a sell-off in US dollar assets.
The tumbling dollar could not only halt export growth but also see a flight away from global capital markets. The US is still the single largest trading partner of most East Asian economies, and the Achilles heel of emerging Asia.
To offset this, East Asian countries will need to ensure that their currencies appreciate in unison and do not fluctuate sharply in value relative to one another given the weightage of trade. East Asian economies can withstand approximately 20% decline in the trade-weighted value of the dollar provided their currencies appreciate together. Consensus shows that the dollar will need to decline by about 30% in trade weightage terms for trade deficit to look more palatable.
Collectively, Asian central banks hold approximately US$3.2tril in foreign exchange reserves, most of it in dollars, and their large purchases of US dollars leading to 2006 have played a crucial role in curtailing the dollar’s decline.
If the dollar is certain to fall further, central banks will sell dollar reserves or switch to other reserve currencies, which will exacerbate the dollar’s fall.
On the contrary, if Asian economies try to prevent their currencies from rising against the dollar to preserve export competitiveness, then the result could be broad-based weakness in Asian currencies and a rapid accumulation of currency reserves.
Delicate balancing of forex reserves in this instance is crucial, especially given the trade impact; hence a communal appreciation will thwart any potential regional imbalance.
So, does a falling dollar spell disaster for Asia? Not necessarily. Asian economies today are characterised by current-account surpluses, large foreign exchange reserves and high rates of domestic savings.
Equity markets across the region have been breaching all-time highs, reflecting the underlying strength of economies across the region and the perception that Asian stocks represent the best growth prospects at reasonable risk premium.
Thanks in part to the de-linking of Asia’s economies from the US (which is more visible in the bond market), and a greater reliance in intra-regional trade (particularly with China), Asian markets seem well placed to withstand the slowdown in the US expected in 2007.
These improved economic fundamentals will serve the region well over the next few years as the global economy slows and investors become more risk-averse.
Nevertheless, the dip in Asian capital markets and a slide in Asian currencies against the dollar in mid-May this year serve as a reminder that the region is not immune to a change in global investor sentiment.
Meanwhile, positive overtures from an appreciating ringgit will continue to buoy domestic markets. The ringgit surged to its highest level post de-pegging, closing at 3.5395 on Dec 12 in line with strengthening regional currencies.
The broad-based impact of a stronger ringgit is positive in general; especially in sectors that derive ringgit revenue with US dollar-denominated costs.
Most economic sectors see the benefits of a stronger ringgit and the “feel good factor” is expected to persist in capital markets with a year-end target of 3.50–3.53, complementing the 2006 forecast GDP growth of 6%.
The author is director and chief economist at Kuwait Finance House, Malaysia (KFH).
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