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Economics Weekly - Global imbalances are correcting - dollar on the slide as returns fall; Weekly economic data preview - Economic data to bolster the view that slower growth may lie ahead

Economics Weekly  26 November 2007


Global imbalances are correcting - dollar on the slide as returns fall


Is the current fall in the dollar almost a case of be careful what you wish for? In other words, is the sharp fall in the US currency finally a response to the size of its current account deficit and repeated calls for global imbalances to adjust? We explore the issue in this week’s briefing and what it may mean for the world economy and exchange rates.


There have been long and persistent calls for global imbalances to adjust…

One of the main worries about the global economy over the last decade has been concern about the size of global imbalances, which had been widening. Principally, this has been the ever growing and persistent US current account deficit and the equivalent surpluses of emerging market Asia and the oil exporters, see chart a.


The US current account deficit has been running at 6% of its economy for the last two years. By contrast, the current account surplus of China has hit 12% of its economy this year, and that of other Asian emerging market economies has also been substantial. Over the next few years, we expect only a modest improvement in this profile, see chart a. Although the US current account deficit falls to 4½% of its economy on our forecast by 2012, it still remains some 1.5% of global gross domestic product. The euro area has been and is expected to remain broadly in balance and the surplus of the oil exporters (OPEC) should also come down over that period as they begin to spend more and imports rise. Our view is that fast Chinese growth will also lead to a rise in imports and so some a fall in its current account surplus to 4% of gdp, but in both the US and China the deficit/surplus as a share of the global economy will remain large. This carries dangers for the global economy, some of which we may be witnessing in the recent sharp fall in the US dollar.


…but this carries real dangers for the global economy

The risks to the world economy are twofold: the first is that the US authorities get fed up with the size of the US deficit and restrict imports by raising tariffs and erecting other protectionist barriers. This would lead to substantially weaker global economic growth, and possibly recession, as tit for tat measures from its trading partners are enacted. The US economy would also weaken, further destabilising the global economy. Everyone would lose out in this scenario; ending the longest global economic expansion since 1947-60. The second is that the financing of the US current account deficit becomes a major problem, especially if for whatever reason the rest of the world was no longer willing to fund it by buying US assets, see chart e for how capital inflows have declined as returns have fallen. This would lead to a sharp fall in the dollar, which, if it became a rout, could lead the US Fed to raise interest rates to keep down inflation and so precipitate a recession. That would then hit the global economy hard, even if there is more leeway for the rest of the World to absorb a US slowdown than in the past due to the strong growth of the emerging markets.


But is the credit market led turmoil also a factor in US$ weakness?

Is this what we are seeing at the moment - has the credit crisis made buying US assets less attractive? This may be the case, if the rise in the returns from US assets required to tempt foreign investors to buy US IOUs was linked to the high yields on credit instruments. As that has fallen away, so have the inflows into the US and so leading to a fall in the US dollar, see chart c. The only alterative for the US, therefore, may be to offer higher interest rates, but that could hit the economy. Is this the dilemma that is or may soon be facing the US monetary authorities? It does appear that way, with capital inflows falling just as the credit crisis has broken, see chart e.


Protectionism has risen but does not account for the fall in the US$

There does not appear to have been a worrying rise in protectionist sentiment, at least as far as higher tariffs and abrogations of trade agreements are concerned. Of course, there has been a rise in the use of bilateral deals rather than multilateral ones, and the Doha’s round of World trade talks has not been successfully concluded. This does suggest some rise in protectionism, but not enough to lead to reciprocal action from other countries. Moreover, our forecasts show that the US external deficit does shrink over time, albeit slowly, see chart a. Unfortunately, it does look as if the fall in the rate of return from holding US assets is leading to a fall in the dollar partly because of the loss of the high returns from credit market instruments, but also perhaps due to the recent cuts in US short term official interest rates and the expectation of more to come. Moreover, worry about returns may also be driven by the huge holdings of US dollars now held abroad, see chart d. The implication: if the US continues to cut short term interest rates, the dollar could fall even more sharply and its decline could become even more disorderly than it is at the moment, necessitating an international agreement to cap the decline.

Trevor Williams, Chief Economist


Weekly economic data preview


Economic data to bolster the view that slower growth may lie ahead


Perceptions of slower gdp growth, especially in the US, have significantly strengthened, following recent economic data releases, the publication of the BoE's November quarterly Inflation Report and the minutes of the last Fed and BoE interest rate setting meetings, which alluded to considerable economic slowdown in the US and the UK next year, but not recession. At the same time, although the ECB has conveyed serious concerns over inflation risk, it has held back from raising rates, fearing that gdp growth in the eurozone may region may stall. As a result, the implied financial market view has strengthened for interest rate cuts of 0.25% by both the Fed and the BoE in December, while there are no calls for a rise in Eurozone rates any time soon. Although interest rate cuts next month are a possibility, we take a different position, as tight labour markets, record high energy and foodstuffs prices and limited scope to increase production capacity may delay cuts in the UK, prevent or limit further reductions in the US and lead to higher rates in the eurozone. As equity markets have been badly hit by fears over slower growth, funds have flowed into 'safe haven' government bonds.


• Economic data releases may confirm suspicions that the UK economy is finally feeling the pinch from previous interest rates hikes, higher borrowing costs and tougher lending standards. On Thursday, the Nationwide November survey of house prices should weaken, supporting the downbeat Rightmove survey. We forecast a small 0.1% increase in the Nationwide index, compared with 1.1% growth a month earlier. Also on Tuesday, the BoE should confirm annual money supply growth of 11.8% in October, down from 12.8% in September. Data may show that net mortgage lending may have declined to £9.3bn in October, from £9.8bn in September. Whole-market mortgage approvals data may follow the weaker trend of the narrower building societies' (BSA) release, declining to a level of 98,000 in October from 102,000 in September. This will be the lowest mortgage approval figure since July 2005 and signals weaker housing market activity six months ahead. Also published Thursday, the CBI distributive trades' survey may fall to +8 in November from +10 in October, as retailers struggle to increase sales, despite heavy price discounting. On Friday, a GfK consumer confidence index of -8 compared with -10 last month, may bring to a close a week of more negative UK economic news.


• US data are likely to provide confirmation of continued strong economic growth in Q3 and rising inflation, but highlight further weakness in house-building and construction activity. On Tuesday, the market median forecast for the S & P/ Case Shiller monthly house price index is for an annual decline of 5% in September, compared with a fall of 4.4% in August. Also, the consumer confidence index for November may have dropped to 95.0 from 95.6 in October as higher energy prices and falling housing wealth weigh on sentiment. Further confirmation of weak housing market activity will come from lower existing and new home sales, published on Wednesday and Thursday, respectively. On Friday, the Fed's preferred measure of inflation, the core PCE deflator, is expected to rise 0.3% on the month and 1.9% on the year in October, compared with 0.2% and 1.8% in September, underpinning our view that US interest rates will stay on hold. Also, construction spending is expected to resume its downward slide, falling 0.2% in October following an upward blip of 0.3% growth in September.


• On Tuesday, the German IFO business survey for November could weaken, but not to the extent suggested by the ZEW survey of investors, which slumped to a 15-year low for the month. On Friday, following a strong set of regional numbers, EU-13 preliminary CPI inflation for November may be confirmed at a record level of 2.7% a year, up from 2.6% in October, justifying the ECB's hawkish bias towards interest rates. Q3 gdp growth of 0.7% (q/q) and 2.6% (y/y) may mark a growth peak, as industrial and consumer confidence for November, also published, are well below levels earlier in the year, highlighting the ECB's reluctance to raise rates despite its inflation concerns.

Nichola James, Senior Economist


Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500


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