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Dollar’s exchange rate is important

by on 11/03/2020

For several decades, the global economy has built imbalances. On one hand, there are manufacturing countries, with trade surpluses, that are also net exporters, such as China, Japan, Germany, and on the other hand the US, that imports their production directly or indirectly. The net exporting countries, generating trade surpluses are accumulating financial assets as savings, while US creates deficits and has low saving rates.  To keep in balance this process, the exporting countries have to create demand for the currency of the importing country, US dollar, to keep its value high. To do it they invest in importing countries assets, whether in real estate, whether in bonds or corporate shares, through the stock exchange, or in private equity transactions.

 This process is possible, as long as the decision makers in the net exporting countries, as China believe in guaranteed value of their investments in the importing countries, the US. This process simultaneously causes some phenomena in the importing country as US:

 A.  Trade deficit.

 B.  Low domestic saving rates.

C. High asset prices, real estate and stock prices of publicly traded companies.

 D.  Increase of the gap between income from assets versus income from wages, in favor of income from assets. It also means an increase in economic inequality, between employees and rentiers. 

 This process is possible as long, as the demand for assets of importing countries is rising. This demand also creates demand for the currency of the importing country and revaluates its exchange rate against other currencies.  This is a seemingly paradox, that the currency of the importing country is strengthening in relation to the currency of the exporting country. This happens because of the great trust in economics and the political system of the importing country, that will ensure the value of its investments. (The Chinese trust more deposits in US than in China). A small disruption in the flow of capital from net exporting countries to net importing, and everything can collapse. This change of flow of currency can be result of export disruptions caused with the appearance of Corona virus in China, but could happen for any other reason as well.

The expected process will be a dramatic fall in US asset prices, which will be accompanied by the devaluation of the importing country currency, the US dollar.

Over the past turbulent days, few have noticed since mid-February the dollar had lost more than 5% of its value against the euro, and more than 8% to the Japanese yen.  This is as dramatic a change as the stock market collapses, and indicates a trend. The dollar’s weakening process has moderated due to rising demand for US government bonds, that used to happen in times of volatility in the past. But this time, it did not work. That means capital leaves US. When the foreign holding of US dollar are more than 6 trillion dollars,  about 30% of the HDP, such an outflow is deflationary. 

 The big question is where the finances, that are currently leaving the US stock exchanges will be invested?  The answer could be real estate and government bonds. Continued demand for government bonds may bring interest rates deep to the negative sign, and it is unclear how savers will behave in this situation.  The option of real estate is also not very attractive due to already high prices today and the relatively low yields that real estate investment are generating today. This situation may cause instability in capital flows and high volatility in the markets. 

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