What is the current account?
Outside the United States, the current account is a familiar economic indicator. But here, foreign currency traders appear to be the only ones closely monitoring it. Bond and equity investors have tended to ignore this comprehensive indicator in the past although the monthly international trade balance on goods & services, which makes up a major portion of the current account, is considered a market-moving indicator.

Recently, the shrinking value of the dollar in the foreign exchange market has led an increasing number of investors to become more aware and concerned about the trends in the US current account. Everyone knows the US has run a trade deficit for years and years. The 'Made in America' label is always harder to find. Many also know that millions of US workers have lost their jobs in industries which have stopped producing goods domestically.

In addition to the trade balance on goods & services, the current account includes net unilateral transfers and a balance on income. Income receipts to the US are from US-owned assets abroad, which might come from direct investment receipts, other private receipts (these include interest and dividends), or US government receipts. A portion of income receipts also stems from compensation of employees. Income payments abroad include payments on foreign-owned assets in the US which take the form of direct investment payments, other private payments and US government payments, again including compensation of employees.

Unilateral transfers include US government grants, US government pension, private remittances and other transfers. This component has been negative since the series was first compiled in 1960 - except for the first two quarters of 1991 when several foreign countries helped defray the costs of the Persian Gulf War.

The chart above compares the balance on current account with the balance on goods & services. The two move in tandem. But notice that the discrepancy between the two series has widened in the past two years. The difference stems from the fact that the balance on income has posted a smaller surplus and unilateral transfers have become more negative.

The primary cause behind the escalating current account deficit remains the trade deficit on goods & services. As merchandise imports have increased rapidly, the trade deficit has widened. The surplus on our services balance has diminished over time as import growth has outpaced export growth. In the past two years, a major shift has also taken place on the income balance. It was nearly always positive, but since 2001, it has posted four quarterly deficits aside from some very small surpluses in 2003 that were well below historical averages.

All in all, the burgeoning current account deficit indicates that we have a higher propensity to consume imported goods & services than do our trading partners. Since we are purchasing the goods & services, we must be selling dollars in exchange for foreign currency (to buy these goods & services). In order for this trend to continue, there would have to be continuously strong demand for dollars in the foreign exchange market. If foreigners are not buying US goods, why would they want to hold our dollars?

How the current account affects the dollar
Herein lies the crux of the problem: Foreign countries must have inherent demand for dollars in order to allow US consumers and businesses to purchase unlimited imported goods & services far in excess of exports.

• Keep in mind that everything is based on supply and demand. The more goods we purchase abroad, the greater the quantity of US dollars that will need to be exchanged for foreign currency. If too many US dollars flood foreign shores, one would expect the value of the US dollar to decline and the value of the foreign currency to increase. That is, foreigners will require a greater number of dollars per their local currency. Thus, the widening trade deficit on goods and services should cause the FX value of the dollar to decline.
• As we have seen from the composition of the current account, the US can also sell financial assets such as stocks and bonds to foreign investors. This would help maintain a demand for dollars even though export demand for goods & services might be less than that for imports.
• The soaring stock market fueled healthy demand for US dollars as foreign investors flocked to the US. While most foreign equity markets also saw healthy price appreciation in the 1990s, gains were not nearly as large as for US equities. Furthermore, US economic growth was more robust than growth overseas. This helped to postpone the inevitable drop in the FX value of the dollar even though the current account deficit began to widen dramatically in the late 90s.
• The dollar strengthened even after the stock market peaked in 2000, but perhaps only because the US recession was milder than recessions faced by our major trading partners. The dollar peaked about 2002 though our current account deficit continued to widen.

In the past few months, financial markets have primarily focused on the dollar's collapse, albeit orderly, against the euro. The dollar has also fallen sharply against the Swiss franc, the yen, the Canadian dollar, and British sterling. The value of the dollar is not important per se, but primarily relevant in its trade value - what can it purchase? The Federal Reserve Board compiles a trade-weighted index for major currencies that take into account US trade with various countries. (Countries whose currencies are included in the major currencies index are the Euro Area, Canada, Japan, United Kingdom, Switzerland, Australia, and Sweden. The Euro Area includes Germany, France, Italy, Netherlands, Belgium/Luxembourg, Ireland, Spain, Austria, Finland, Portugal & Greece.) The major currencies index has declined roughly 21 percent from its peak in February 2002 through November 2003.

If we take a broader perspective, the dollar's decline doesn't appear as ominous. The trade-weighted value of the dollar against the broad index has not declined as sharply (-10.3 percent) as the major currencies index. Of course, the broad index includes currencies of countries (China, Taiwan, Korea, Singapore and Hong Kong) that are roughly tied to the dollar. (Countries whose currencies are included in the broad index are the Euro Area, Canada, Japan, Mexico, China, United Kingdom, Taiwan, Korea, Singapore, Hong Kong, Malaysia, Brazil, Switzerland, Thailand, Philippines, Australia, Indonesia, India, Israel, Saudi Arabia, Russia, Sweden, Argentina, Venezuela, Chile and Colombia.)

While the broad index shows a less dramatic decline in the dollar, the financial market's focus on the euro is not irrational since the index weighting reveals that the Euro-zone is the United States' largest trading partner, followed by Canada, Japan, Mexico, and China.

Advantages and disadvantages of a weak dollar
Treasury Secretary John Snow gets himself - and the dollar - into trouble because he is trained to think like an economist instead of the Treasury Secretary that he is. Administration officials and even President Bush have parroted the old Robert Rubin line that the US is following a strong dollar policy. But, in fact, a well-trained economist can't deny that a weak dollar has some benefits. Indeed, a weak dollar as well as a strong one both have advantages and disadvantages.

First and foremost, a weak dollar helps the export market. As the value of the dollar declines in the FX market, US exports become cheaper to foreigners and the demand for our goods expands. Eventually, increased demand for goods & services will augment the demand for labor. Thus, the weaker dollar can ultimately help to generate jobs in the US. Furthermore, traveling to the United States will also become less expensive, and foreign tourists will find extra bargains when they are shopping. Undoubtedly, cheaper exports of goods & services encourage foreigners to buy additional US goods and services.

As an American consumer, though, a weak dollar is a disadvantage. The size of the trade deficit leaves no doubt in anyone's mind that we purchase a lot of imports. As the value of the dollar decreases, it increases the costs of foreign-produced goods. The extent to which imported goods prices rise is debatable. Some importers desire to maintain, if not increase, their US market share. As a result, the magnitude of price increases for foreign-made goods may be less than the depreciated value of the dollar. Nonetheless, odds are that we would see at least some price hikes for imported goods when the value of the dollar declines.

A depreciating dollar may also hamper profit margins for producers that use imported goods in their production since the costs of the raw materials coming from abroad would rise when the dollar falls. If producers feel comfortable in raising their prices to cover the costs, this means that the higher costs will be passed on to consumers - and this leads to inflationary pressures. Given the current environment, inflation may not be a strong concern yet, but someone will indeed suffer whether it is the consumer facing higher product prices or the producer in the form of lower profits.

The weaker dollar also impacts financial market behavior. Foreign investors will happily buy US stocks or bonds when the values of these assets are appreciating more rapidly than in their local financial markets. However, when foreign investors want to realize their gain, they must sell the assets and convert them to their own currency. A weaker dollar value diminishes the total return of the US asset and makes alternative foreign stock and bond markets more desirable.

Thus, a weaker dollar may diminish the number of investors in the US stock and bond markets. Fewer potential buyers of US stocks would not necessarily lead to a crumbling equity market here, but it would put a brake on the pace of equity price appreciation.

The US has counted on foreign investment in Treasury securities. The growth in the US budget deficit is increasing and this means that the Treasury will need to augment the size of the Treasury auctions in the coming year. A falling dollar will reduce the quantity of foreign investors - unless interest rates rise to compensate. For an overseas investor, converting dollar assets to local currency could diminish total returns.

There is one benefit to a weaker dollar when multinational firms generate profits overseas. Profits are generated in the local currency, let's say the euro. When euros are exchanged for dollars, a greater number of dollars are repatriated. Thus, companies with profits generated in a country where the value of the dollar has depreciated see bigger profits even if the level of profits in local currency terms is unchanged.

BOTTOM LINE
The foreign exchange value of the dollar has declined because the US current account deficit has widened sharply over the past couple of years. Initially, the negative impact of the widening deficit was not felt in the currency markets because foreign investors demanded dollars to participate in the bull market in 1999 and 2000. Even after the stock market peaked and began its descent, the recession in the US was milder than overseas and this helped to keep the dollar relatively strong until early 2002.

The current account deficit should narrow over time, as the weaker dollar is likely to dampen import growth and encourage stronger demand for exports. Eventually the dollar should revive when the current account deficit narrows sufficiently. How much is "sufficiently"? That depends largely on market sentiment.

While US administrations have long felt it their duty to claim "a strong dollar is in the best interest of the United States", many foreign governments more readily admit their unhappiness when the value of their currencies appreciate against the dollar. A stronger currency means that US demand for their goods might decline, and many countries rely on robust US import demand. Asian governments in particular have been concerned that their currencies were appreciating too rapidly and have intervened in the FX market by buying dollars. In turn, these dollars were invested in US Treasuries. Foreign exchange intervention may be common but it only works in the short run. When market sentiment is decided against a currency such as the dollar, intervention is futile in a market as immense as foreign exchange. What's that old market saying? The trend is your friend.

Evelina M. Tainer, Chief Economist, Econoday