December 2, 2003

The falling dollar.  The U.S. dollar continues to loose value against other major currencies.  The dollar continues to set new lows against the Euro and has fallen against the Yen.  The story is repeated against other currencies:  the dollar is falling.  What is going on?

The U.S. economy appears to be zooming forward, with inflation in check, yet the dollar is continuing to fall.  One would think, based on past experience that the dollar should be appreciating not depreciating.  But…this is not the past.

One of the things that has changed is that George W. Bush is President.  This administration, unlike its predecessors, seems to have no interest in a “strong dollar” policy.  Over the past decade or so, the U.S. administrations’ policy has been to push for a strong dollar in part to help the Japanese and the European export their goods.  The thinking was that a strong dollar would help to create economic growth in Japan and Europe and ease the pressure on the U.S. as being the economic engine that pulled the rest of the world along.  The strong dollar policy, it was thought, would also help developing countries by making their exports more attractive to Americans.

But, it can be argued, the strong dollar policy really didn’t work.  Both Japan and Europe put off (long needed) structural reforms in their economies because things weren’t “that bad” because they were exporting to the U.S.  Thus, Japan still has poorly run banks, far too many firms with excess capacity, and inefficient labor markets.  Much of Europe also has incredibly inefficient labor markets, excess regulation, and an inability of entrepreneurs to get the resources they need.  In Latin America far too many governments still think that they can simply “export their way to prosperity.”  Sorry…economic growth and development is more complex than that.

Thus the strong dollar policy has been abandoned.  Further complicating the situation are U.S. interest rates.  If you think about it, it is a fairly safe bet that U.S. interest rates are going to go up over the next several months, in not quarters.  With the U.S. economy picking up speed the demand for capital is likely to increase…thus interest rates will increase as firms compete for these funds.  In addition, the growing federal government budget deficit (who though Republicans would turn out to be the wild spenders they are?) is also likely to put upward pressure on U.S. interest rates.  Given this…would you be willing to buy U.S. government securities NOW, if you are fairly certain interest rates are going to go up (and thus the price of the bonds will fall)?  Heck no!  You will sit on the sidelines and wait for the interest rates to go up.  Thus, you see the reluctance of Asian central banks (a big buyer in the U.S. government bond market) and other foreign investors reluctant to buy U.S. bonds.  This is probably only temporary however.  This dampens the demand for the dollar the in FX market, pushing the dollar lower.

So where does this leave us?  The dollar will probably fall some more until either market interest rates go up and/or the Fed starts to tighten worrying that the economy is growing too quickly.  The larger lesson is for the rest of the world:  exports are important for economic growth but so are other things such as efficient domestic input markets, stable financial markets, and domestic demand.  Hopefully policymakers around the world will begin to realize that the way to make their economies grow is to create efficient, transparent, dynamic, flexible and expanding domestic economies.  The mercantilist approach of export promotion at the cost of everything else does not create sustainable long run economic growth. 

Maybe some good will come out of all of this.

Expanding Mexican Bond Market.  Have you noticed the expanding bond market in Mexico lately?  Over the past several months a number of Mexican entities including Petroleos Mexicanos and the Mexican Federal Electricity Commission have issued 10-year peso denominated debt.  The Mexican government recently issued 20-year fixed rate peso denominated bonds, known as Cetes, for the first time.  This will provide the market with an important bench market to price privately issued debt.

Problems still exist however, the secondary market is rather limited and there still exist excessive amounts of regulation for private firms wanting to issue debt.  But the trend is encouraging.  Mexico needs to continue and expand its economic and financial market reforms in order to keep this positive momentum going.  Hopefully other Latin American countries will follow Mexico’s lead.

Here comes Brazil.  Brazil seems to be making its way out of its worst recession in 5 years.  The economy squeaked out positive growth in the third quarter and is probably positioned for some decent economic growth in the coming quarters.  Inflation has been brought under control thanks to a very contractionary monetary policy and it looks like Brazil might get some much needed pension reform.  In addition, Brazilian President Luiz Inacio Lula da Silva has pushed for closer trade ties between India, China and Brazil.  This so-called new G-3 is calling on closer trade relationship between developing nations, which might not be such a bad idea.  Brazil bears watching.

Regards,

MB