There’s a lot of hand-wringing in the foreign-exchange market about a fresh “currency war” breaking out, with countries and central banks taking action to support their weakening currencies to offset a strengthening US dollar. The last currency war took place a decade ago, but that one was about the opposite — finding ways to reverse the massive appreciation in local currencies because of a rapidly depreciating dollar. Regardless, the latest battle may end before it truly gets started.
To understand why, you have to go back even further — before the worldwide pandemic, before Europe’s debt crisis, before the global financial crisis — to the early 2000s, when global monetary policies were calibrated toward actual economic fundamentals rather than keeping economies from collapsing. Back then, a primary driver of exchange rates was the US current-account deficit, and the dollar would routinely rise and fall based on whether the shortfall would contract or expand. To be sure, this metric isn’t on par with unemployment or inflation when it comes to economic importance, but it’s critical for the currency market because by including investment flows on top of exports and imports, it’s the broadest measure of trade. And 20 years ago, the deficit was expanding rapidly, growing from around $50 billion near the end of the last century to more than $200 billion in 2005. As a result, the US needed to attract billions of dollars a day to finance the shortfall. Naturally, this had a negative effect on the greenback, with the US Dollar Index plunging some 33% between July 2001 and late 2004.
The current-account deficit steadily improved from that point on, but then the pandemic hit and global trade was upended. The shortfall has ballooned from around $100 billion at the end of 2019 to $291.4 billion as of the end of the first quarter, the US Commerce Department said Thursday. At 4.8% of current dollar gross domestic product, the deficit is back on par with the period when the dollar was depreciating swiftly.
All this wouldn’t matter much if the US was attracting an increasing amount of foreign investment to finance the deficit, but that may no longer be happening. The Treasury Department said last week that foreign holdings of US Treasuries dropped by almost $300 billion in the first four months of the year. Although the amount is a small fraction of the $23.3 trillion in marketable US government debt outstanding, and foreigners still hold some $7.4 trillion of that, it’s the direction that counts. Then there’s the Federal Reserve’s holdings of Treasuries on behalf of foreign central banks and sovereign wealth funds. That account has shrunk from $3.13 trillion in early 2021 to a recent $2.99 trillion. Again, not a huge amount, but the direction is concerning. Most worrisome of all, however, may be the dollar’s eroding status as the world’s primary reserve currency. Although the International Monetary Fund estimates the greenback makes up 58.8% of global foreign-exchange reserves, that’s down from a peak of 72.7% in 2001 and the lowest percentage since 1996.
Demand for haven-like assets amid the pandemic and higher relative interest rates have certainly underpinned the US currency, with the Dollar Index rising about 17% since the beginning of 2021. This has put tremendous pressure on other currencies. For example, the Bloomberg Euro Index has dropped 10%; the Bloomberg British Pound Index is down more than 7% since May 2021; Japan’s yen has plunged 20%; the MSCI EM Currency Index is off 4.61% since late February alone.
True, a weaker currency brings some benefits. For one, it makes a country’s exports more affordable. But that hardly matters when world trade volumes are still incredibly depressed because of supply chain disruptions. Plus, officials are generally more concerned with the speed of currency moves, which can disrupt an economy because companies have little time to adjust. As my Bloomberg News colleagues Amelia Pollard and Saleha Mohsin noted, the European Central Bank’s Isabel Schnabel highlighted a chart in February showing how much the euro had weakened against the dollar. Bank of Canada official Tiff MacKlem then bemoaned the decline of that country’s dollar. Swiss National Bank President Thomas Jordan then suggested he’d like to see a stronger franc.
In the case of the US, a weakening currency could give foreign investors even less incentive to buy dollar-denominated assets, making it harder to finance the record budget and trade deficits. That could mean higher borrowing costs for the government, companies and consumers. It’s been two decades since the US current-account deficit drove global currency markets, but that may be about to change and in a big way.