By Neal Kimberley
London
The dollar looks set to stay strong as a shrinking US current account deficit combines with the ending of Federal Reserve asset purchases to make greenbacks scarcer and more expensive.
The dollar index may have hit a four-year high yesterday, but the currency’s strength rests on solid foundations.
The current account deficit means the US effectively exports dollars to cover the difference between its import bill and its smaller export receipts.
Those exported dollars end up in other countries’ foreign exchange reserves and provide the liquidity that smoothes the workings of the global economy.
This reinforces the pre-eminence of the dollar as the dominant reserve currency. But it also means the US must run perpetual current account deficits for the world to keep getting its greenbacks.
This is the Triffin dilemma, as first expounded by the economist Robert Triffin in the 1960s. He said excessive US deficits would erode confidence in the dollar’s value, but he noted the flip side of the issue. If the US stopped running those deficits, the international community would lose its largest source of additions to reserves.
The resulting shortage of liquidity could pull the world economy into a contractionary spiral, leading to instability.
In fact, the US current account deficit has contracted in recent years, to $98.5bn in the second quarter of 2014 from $216bn in Q3 2006.
The deficit hit a 14-year low in the fourth quarter of 2013, helped by declining petroleum imports as the US reduced its dependency on foreign oil.
The bounty of home-produced US shale oil and gas also reduces US manufacturers’ production costs. That not only makes exports cheaper but also allowing local manufacturers to win back some of the domestic market from overseas competition.
Fewer dollars end up being exported abroad to meet the needs of the global economy. As demand for the greenback remains but the supply is reduced, the value of the dollar should rise.
Of course, the Fed’s ultra-accommodative monetary policy has included buying assets in return for newly “printed” dollars.
By increasing the effective volume of dollars available, the Fed has essentially provided a counterbalance, to some degree, to the lower volume of the currency exported as the US current account has shrunk, making the dollar less scarce.
But the scale of that Fed programme has been gradually tapered and is set to end next month.
The counterbalance is diminishing. The combination of Fed asset purchase tapering and the shrinking US current account deficit feed dollar strength.
Neal Kimberley is an FX market analyst for Reuters. The opinions expressed are his own.
