Jan Dehn, head of research at Ashmore, discusses why Trump’s diagnosis that unfair trade practices are the root cause of the US economy’s ailments is wrong.
Instead, he explains why the dollar, which has become misaligned over the last few years due to massive capital inflows, low US productivity and US inflation, is the real culprit. The benefits of having a strong US dollar post the 2008/2009 crisis have now become to the detriment of the country, which would do better with a weaker dollar.
The Trump Administration blames the loss of US competitiveness on unfair trading practices abroad, but this is a dangerous misdiagnosis of the US problem.
Firstly, trading practices have not changed materially. If anything, China has reduced the volume of counter-veiling duties against the US in recent years. Secondly, the real problem lies elsewhere, namely currencies.
US companies are struggling to compete, because the Dollar has become misaligned, that is, too strong given sluggish American productivity growth and relative inflation rates. In short, the US real effective exchange rate (REER) has become overvalued.
The primary reason why the US REER has appreciated so much is the nominal exchange rate. The Dollar has rallied dramatically, mainly due to massive capital inflows. US inflation has picked up relative to the other regions over this period, for example, the average rate of inflation in EM declined by about 20% over this period from just over 5% in 2010 to 4% today.
US productivity growth has also declined. While capital inflows could have contributed to strong supply-side growth, ultimately it did not. Most of the capital flowing into the US from the rest of the world went into US financial markets, which may even have contributed to lower productivity growth to the extent that rising stock prices diverted funds away from the real economy (contrary to the rationale for Quantitative Easing).
It is well-known that overvalued REERs can cripple growth. The US economy is so far only tracking 1.0% qoq annualised real GDP growth in Q1 2017, according to the latest Atlanta Fed’s GDP Now estimate. The main detractor from US growth is unsurprisingly international trade.
While US survey data has been stronger than the components that go into GDP survey data, it is notoriously sensitive to stock market sentiment, which has been exuberant since Trump’s election. The latest developments suggest that the Trump Administration and Congress may find it difficult to implement meaningful supply-side reforms that can boost real GDP growth to offset the crippling effect of the strong dollar.
If so, the dollar is overvalued relative to fundamentals and should decline. This begs the question how a weaker dollar will impact the global economy? In our view, a weaker dollar would be very beneficial for both US and global growth prospects for several reasons. Specifically, a weaker dollar would:
a) Deflate dangerous asset bubbles in the US by shifting the marginal unit of capital away from overvalued markets and into other markets that are not mispriced.
b) Increase US exports by increasing the competitiveness of US companies in overseas markets
c) Ease financial conditions in EM and other countries, which would be positive for growth and increase demand for US exports
A strong dollar is no longer appropriate – a weaker dollar would bode well
A few years ago the US very much needed a strong dollar policy, because it needed to attract capital inflows from abroad in order to prevent a financial disaster. Today, however, the US has plenty of capital and instead needs to grow its economy.
The strong dollar policy has outlived its purpose and today a weaker dollar would actually improve the health of the US economy. In the immediate aftermath of the crisis in 2008/2009, the dollar was trading at an eleven year low in real terms and financial system desperately needed capital from abroad in order be able to refinance the roughly 70% of GDP worth of debt, which falls due every year.
Hence, at that time the marginal benefit of capital inflows was sky-high, while the marginal cost to exporters of a rising dollar was very low. The red line was far above the blue line, so in net terms the rising dollar was very positive for the US economy.
Today, however, a huge amount of capital has flowed into US financial markets from the rest of the world to the point where the marginal benefit of inflows (for financing purposes) is now very low, even, perhaps, negative due to the risk of bubbles and sudden capital outflows.
Meanwhile, exporters are now suffering directly due to the strong dollar. Hence, the marginal cost to the US economy is now much higher than the marginal benefit and the US would therefore do better with a weaker currency.
The Trump administration is considering protectionist measures to help US exporters. This would be a dangerous policy mistake. Protectionism at this point would materially worsen the US REER problem by undermining productivity, pushing inflation higher and appreciating the nominal exchange rate further.
Most EM investors are intimately familiar with the impact of protectionism on growth and they understand that protectionism backfires badly. Let us hope that the Trump administration gradually acquires the same insight. If not, the dollar becomes an even stronger sell over the medium term.