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Analysis
Rising external deficit 'made in USA'

Rising external deficit 'made in USA'

US currency confusion remains well entrenched

by Mark Sobel in Washington

Mon 12 Nov 2018

In an OMFIF commentary in May entitled 'America's currency confusion', I observed that for more than two decades the US followed a bipartisan currency playbook – supporting free floating; avoiding intervention except in rare cases of disorderly markets; and eschewing statements except when US officials were compelled to reaffirm support for a 'strong dollar'.

This aimed at limiting excessive reliance on the US as the global growth engine, reducing global imbalances and resisting protectionist pressures. Yet President Donald Trump's administration was ignoring the playbook six months ago. The White House was commenting on currencies and implying support for a weak dollar, putting forth language perhaps questioning free floating, and running a macroeconomic policy mix at odds with reducing global imbalances. Now, it appears America's currency confusion has worsened.

Administration officials have generally avoided directly commenting on the dollar. But the president's criticisms of Federal Reserve rate rises and accusations that China and the euro area manipulate their currencies are seemingly motivated in part by a desire to see a weaker dollar. Treasury Secretary Steve Mnuchin's unfounded remarks about guarding against Chinese 'competitive devaluation' have a similar effect.

Further, the G20 and International Monetary and Financial Committee continue to use ill-advised language. This ambiguous wording suggests that exchange rate stability should be a target of policy – contrary to G7 commitments – rather than an outcome of sound fundamentals. But it is the increasing divergence between the US and other major global economies, aggravated by the imbalanced US macroeconomic policy mix, which remains the most striking aspect of the worsening currency confusion.

The US economy is strongly outperforming the euro area and Japanese economies. The administration's procyclical tax cuts, which have caused a sharp increase in US deficits and debt, are fuelling this, at least in part. Indeed, expansionary US fiscal policy is burdening monetary policy and pushing up market rates and the dollar.

US growth in the second and third quarters has been around 4% annually. The euro area growth rate moved below 2% in the third quarter, and recent data show signs of further weakening. Markets are increasingly concerned about downside risks in Europe due to Italian fiscal developments, Britain's exit from the European Union and German political uncertainties. Looking through volatility in Japanese quarterly growth, the International Monetary Fund forecasts annual average Japanese growth at around 1% this year.

Chinese growth rates are around 6.5%, as always in line with official targets. However, all other signs, including Beijing's policy responses, point to softening activity. The trade war with the US appears to be contributing to China's slowing.

These divergences are reflected in official monetary policy developments and movements in bond yields, which favour placements in dollar assets.

In view of the strengthening US economy and job market, the Fed has raised rates eight times since end-2015. The central bank is on track for four fed funds rate increases this year, and members of the Federal Open Market Committee point to several more in 2019. The Fed continues to pursue balance sheet normalisation, which, coupled with the added supply of Treasury paper due to the booming fiscal deficit, is putting further upward pressure on rates. European and Japanese monetary policy remains highly accommodative and official rates are likely to remain unchanged for a considerable period of time, even if the ECB concludes its tapering later this year. China has been cutting reserve requirements.

Since May, US two- and 10-year bond yields have moved up, while European and Japanese bunds have been relatively flat, and Chinese bond yields have fallen. The trade-weighted dollar has appreciated against major currencies, and by even more against emerging markets, including China.

These divergent cyclical developments and dollar movements will only worsen US external deficits, even at a time when China's current account surplus is projected to fall under 1% of GDP. The IMF projects the US current account deficit will widen to 3% of GDP, or slightly higher, in 2019-20 from around 2.5% this year. Given the US services surplus, the trade deficit will be far greater, averaging around 5% of GDP in 2019-20.

As US external deficits widen in response to relatively strong US economic performance and imbalanced macroeconomic policies, there is a considerable risk the Trump administration could amplify its protectionist rhetoric and actions. Yet rising US trade and current account deficits are largely 'made in America'.

Mark Sobel is US Chairman of OMFIF. He is a former Deputy Assistant Secretary for International Monetary and Financial Policy at the US Treasury and until early 2018 was US representative at the International Monetary Fund.

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