By Chan Kung and Wei Hongxu
As the outcome of U.S. presidential election in November becomes clearer, the uncertainty plaguing the country was removed, and we see the U.S. dollar’s slide has accelerated. On December 1, the U.S. dollar index had fallen to a more than two-year low of 91.318. With the promising progress on COVID-19 vaccine, the expectation of economic recovery in the United States is strengthened. In addition, the new administration of the United States may push for new stimulus package, hence the U.S. dollar is expected to depreciate along with the continuous increase of dollar liquidity, which is likely to be the underlying trend across global financial markets in the new year.
Chart: Continuous Decline of the U.S. Dollar Index
This year, the U.S. dollar index hit a high of about 102 in March during the turmoil in global financial markets, driven by tight liquidity and rising trade frictions between China and the U.S. Since then, the massive liquidity unleashed by the Federal Reserve’s unlimited quantitative easing (QE), combined with the elimination of liquidity risks after financial markets stabilized, and the continued spread of the COVID-19 pandemic have led to gradual depreciation of the U.S. dollar. This can be seen as an aftermath of the Federal Reserve’s policy. After excess liquidity continued to lift U.S. stocks and major capital markets, money began flowing to Asia-Pacific regions such as China amid expectations of a possible improvement in U.S.-China relations, further exacerbating the dollar outflow.
When then, are the prospects for the U.S. dollar next year? In terms of the current global political, economic, and the changes in the COVID-19 situation, the U.S. dollar is likely to remain weak next year. While the current progress of the vaccine development has raised expectations that the U.S. economy could achieve recovery, both Federal Reserve Chairman Jerome Powell and U.S. Treasury Secretary-designate Janet Yellen are now signaling a desire to keep stimulus policies in place to avoid a crisis. On the one hand, the Federal Reserve remains concerned about the instability of the U.S. economy and employment, calling for continued stimulus to help businesses and households weather the downside risks. On the other hand, Yellen stressed that, “It’s an American tragedy and it’s essential that we move with urgency. Inaction will produce a self-reinforcing downturn, causing yet more devastation.”
The attitude of key officials in the U.S. financial sector shows that they are still keen to push for the expansionary fiscal policy and the implementation of QE policy to promote the recovery of the U.S. economy. This also suggests that the U.S. will continue to “print money” to maintain economic stability and inflated financial market valuations.
From a global perspective, among the major economies’ continuous loosening policies, the United States still took the lead in massive easing. Research shows that the Federal Reserve expanded by about USD 3 trillion as of October this year, with the balance sheet expanded by 36%, lower than the 693% expansion since the financial crisis of 2008. Bank of Japan’s balance sheet amounted to USD 6.67 trillion at the end of October, up slightly from USD 5.6 trillion at the end of February, and the overall balance sheet expansion is relatively conservative, with an expansion of about 19%, far lower than the 528% expansion since the 2008 financial crisis. Bank of England’s balance sheet amounted to USD 1.09 trillion at the end of October, up sharply from USD 0.66 trillion at the end of February, an expansion of around 65%, well below the 731% expansion since the 2008 financial crisis. The European Central Bank has launched a cumulative EUR 1.35 trillion of emergency asset purchase program. As a result, the United States is still in a leading position in terms of the absolute size of the expansion. This also means that the U.S. dollar will be in a weaker position against other major currencies, which is why the U.S. dollar continues to depreciate against the euro and the Japanese yen. But at the same time, the U.S. dollar index would not continue to fall to the level of around 72 seen during the 2008 financial crisis.
With the Federal Reserve unleashing massive liquidity, concerns about whether inflation will affect its QE policy are less prominent in next year. On the one hand, the sustained downturn in international oil prices means that inflation is unlikely to rise significantly. On the other hand, the change in the Federal Reserve’s policy framework is in fact an early response to rising inflation, suggesting that it will not change QE policy for quite some time.
As the U.S. dollar continues to weaken, international capital inflows to emerging markets, including China, are actually on the rise. According to the Institute of International Finance (IIF), foreign capital inflows into emerging markets reached a record USD 76.5 billion in November, the highest ever for a single month. Since the beginning of the year, net foreign capital inflows into emerging markets reached USD 166.5 billion, including net inflows of USD 16.6 billion into the equity markets. These capital flows have naturally led to a rise in the RMB exchange rate. The RMB’s spot exchange rate against the U.S. dollar rose 1.78% in November to 6.5827, the sixth straight month of gains.
In terms of other currencies, however, the RMB is actually in a passive appreciation process. In November, the U.S. dollar index fell 2.31%, while the euro and the pound rose 2.41% and 2.94%, respectively, over the same period, indicating that the appreciation of the RMB does not match the depreciation of the U.S. dollar. If the depreciation of the U.S. dollar persists, it is bound to lead to the unilateral appreciation of RMB, which may make China’s capital market expand along with it, but also bring unprecedented pressure to China’s export enterprises.
The continuous “liquidity flood” and the continuation of the Federal Reserve’s QE policy would bring about a major problem, i.e., the accumulation of financial risks. Enterprises are more inclined to increase their leverage in an environment of weakening real demand and low-interest rates, while super-loose monetary policy has pushed up asset prices, raising both credit and market risks. Capital markets are likely to be more sensitive and fragile in the future, and financial risks associated with a more volatile market are issues that need to be taken seriously by regulators such as central banks and market participants.
Final analysis conclusion:
With the uncertainty in the U.S. election result being removed, this has reinforced the U.S. government’s and the Federal Reserve’s efforts to revive the economy with loosening policy. Under such circumstance, the U.S. dollar will continue to depreciate for some time to come. This has new implications for global markets including China, as well as on the global economy, particularly the financial risks that have been accumulating.
About the Authors
Founder of Anbound Think Tank in 1993, Chan Kung is one of China’s renowned experts in information analysis. Most of Chan Kung‘s outstanding academic research activities are in economic information analysis, particularly in the area of public policy.
Wei Hongxu, graduated from the School of Mathematics of Peking University with a Ph.D. in Economics from the University of Birmingham, UK in 2010 and is a researcher at Anbound Consulting, an independent think tank with headquarters in Beijing.