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December 2018
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Will currency depreciation solve the trade deficit problem?

The answer is plainly no. A depreciation of the US dollar will not remove the trade deficits. In 1970s, one dollar exchanged for 360 Japanese Yen. Now, one dollar is worth for only around 100 Yen. In other words, Yen has appreciated 72%. Still, Japan runs a huge trade surplus with the US today.

Exchange rate is just one of the many factors that drive the trade balance between two countries. Differences in interest rate, savings,  growth rate, level of financial development (in terms of how easy to get access to consumer credit) all played a role.

Here I show a historical graph from St. Louis Fed, which looks at the relationship between trade-weighted dollar index (with major trading partners) and the US trade deficits. The green line is the dollar index (left axis), the higher the value, the more valuable the dollar. The red line is US trade deficits (right axis) in billions of dollars.

As shown in the graph, from mid 1980s to early 1990s, the dollar index dropped (or depreciation) against major currencies by  over 40%, dropping from 150 to 85, and the trade deficits got eliminated.

During recent years, especially after 2002, the US dollar index declined from 110 to 70 (in 2008), another nearly 40% drop, however, the trade deficits soared.  So there gotta be some other reasons that drive the trade balances.

How about the super easy monetary policy by the Greenspan Fed? The extended period of low interest rate after 9.11 helped fuel the housing bubble, creating a fake appreciation of household wealth…American consumers became more confident than ever, resulting in surge of consumption, and imports.

My conclusion is: currency is certainly a factor in determining trade balances, but it’s not all that matters.  So don’t be fooled.

Finally, I wanted to entertain you with another piece of debate on the issue.

Put dollar depreciation in historical perspective

It’s a brand new year. I thought I’d have some big-picture review of what’s going on in the world economy today. Here is my first piece on US dollar.
The graph below will scare you a lot…in fact, the dollar index fall from 115 in 2002 to mid 70s at the end of 2007, that equals a 33% drop.
fredgraphfile
Hmm, a sharp drop, isn’t it? But wait a minute, have we witnessed the similar happened before? Let’s look at the following graph and have some historical perspective. From 1985 to 1989, the trade-weighted dollar index actually had a bigger fall, from 145 to 90, almost down 38%, and it fell even further until 1995.
TWEXMMTH_Max_630_378
One more graph. If we just look at the FX between US dollar and Japanese Yen. The previous drop was even bigger: from 260 yen per dollar in 1985 to around 125 yen/$ in early 1989 (anyone remember Plaza Accord?), that’s a stunning 55% drop (maybe I should use the word “collapse”).  In fact, the Dollar against the Yen continued to fall until mid 1995, touching 90, and since then fluctuated in the 100 -150 range.
YenDollar_FX
So why am I showing you these graphs? I simply wanted to remind you two things:
First, today’s weakness of US dollar is not unprecedented. So do not panic. From a contrarian investor’s point of view, when everybody is crying out in one direction, you probably should start to think about the other direction. However, this rule does not apply to FX between $ and Chinese Yuan. Yuan is set to appreciate even more.
Second, US dollar is still the world’s dominant currency, and it will remain so in foreseeable future. The dollar’s up-and-downs largely reflects the stance of U.S. monetary policy and cyclical feature of underlying economy. Large US trade deficits do not necessarily lead to large drop in currency value, especially when you consider in the process of depreciating, export surges thus improves current account.
I’ll have a piece on Yuan next time. Your comments are welcome.