History offers warning on dollar and deficits
Economic fallout could be severe if the U.S. dollar falls from dominance as the world’s reserve currency
It’s no secret that Uncle Sam has been living beyond his means. During the past 25 years, U.S. national debt as a percentage of gross domestic product has almost tripled to 98%, according to the Congressional Budget Office. It’s projected to hit 166% by 2054.
The U.S. government has been able to run up that debt, in part, because investors around the world are still willing to buy its IOUs. Last year alone, the U.S. Treasury auctioned off $28 trillion in securities.
But investors may not always be so willing, according to new research from Mindy Xiaolan, associate professor of finance at Texas McCombs. She finds the U.S. government’s fiscal capacity — its ability to raise money — depends on the dominance of the U.S. dollar. Dollar-denominated assets make up 57% of global currency reserves, and dollars are used in 88% of foreign exchange transactions.
Her research highlights potential losses U.S. government bondholders could face if another currency ever replaces the dollar as the global reserve currency. The federal government might have to face significant fiscal adjustments, while investors in U.S. Treasury bonds could take a bath.
“When a country’s fiscal fundamentals deteriorate, and their currency loses its privileged status, its government’s borrowing capacity may become limited,” she says. “The market value of its debt will be lower, and the bondholders will suffer losses.”
Whether such consequences could strike the U.S. is “a trillion-dollar question,” she says.
Fiscal History Repeats Itself
How can Xiaolan make such forecasts? Because it’s happened before.
With Zefeng Chen of Peking University, Zhengyang Jiang of Northwestern University, Hanno Lustig of Stanford University, and Stijn Van Nieuwerburgh of Columbia University, her research compared America’s fiscal trajectory with those of two other countries that once boasted the world’s No. 1 currency.
- In the 17th and 18th centuries, the Dutch Republic and its florin dominated international trade.
- After 1800, the United Kingdom and the pound took over the role — until World War II, when the dollar took its place.
“The key common feature of those nations is that they were all the leading economy during their specific time frames,” she says.
While those governments were riding high, investors viewed their bonds as the world’s safest assets. Analyzing historical prices, Xiaolan finds investors paid a premium of 1% to 1.5% for Dutch and British government securities over those of other countries.
Over time, investor demand for safe assets gave both countries room to borrow beyond what was fully backed by their primary budget surpluses, generally to fund wars. Holland’s debt reached more than 200% of its GDP during the age of Napoleon, while the U.K.’s topped 130% of GDP at the end of WWII.
But when both currencies fell from their pedestals, economic reckonings came.
- Bondholders lost big. Dutch bonds traded 70% below their face value, while U.K. bonds dropped 61% in value.
- Deficits dried up. Holland’s postwar surpluses averaged 3.3% of GDP, while the U.K.’s were 1.8%.
Will the Dollar Be Next?
Today, Xiaolan says, the U.S. government is treading a similar path. Its fiscal capacity appears to exceed what is justified by its underlying fiscal fundamentals.
The researchers analyzed the federal balance sheet as if it belonged to a private corporation, to assess whether present and projected cash flows are sufficient to redeem its debts.
Before WWII, they were. In the 80 years since, however, they have only been enough to cover 32% of the outstanding national debt, the researchers estimate. That gap has gotten steeper during the past two decades, as the Great Recession and the COVID-19 pandemic have spiked deficits.
For now, global investors are still allowing the U.S. to run up more debt than it can afford, a phenomenon she calls exorbitant privilege.
But she sees warning signs that global investors might be losing patience. The market value of U.S. government debt, reflecting what investors are willing to pay for it, has dropped more than 15% since its high in 2020.
If investors sour on Treasury securities, she says the U.S. might incur greater costs to finance deficits. Like Holland and the U.K., it might be forced to start running surpluses — which it hasn’t done since 2000.
“It may become more difficult to expand the balance sheet if we lose the privilege to borrow at a relatively low cost,” Xiaolan says. That might help reduce the reliance on deficit financing, but it would come at a price: the ability to stimulate the economy with short-term deficits.
No Strong Competition, Yet
For now, she says, the dollar has one thing going for it: a lack of competition. When Holland and the U.K. each faltered, another country and currency were ready to take their place. For America, by contrast, potential rivals such as China and the eurozone are suffering economic woes.
“While fiscal conditions haven’t significantly improved since COVID, the economy continues to grow at a steady pace for now,” Xiaolan says.
History, however, warns that our strength won’t necessarily last. “I think our message is that maybe we should be a little bit cautious as a country,” she says. “We may not permanently enjoy this privileged status.”
“Exorbitant Privilege Gained and Lost: Fiscal Implications” is published in Journal of Political Economy.
Journal
Journal of Political Economy
Article Title
Exorbitant Privilege Gained and Lost: Fiscal Implications
Cross-border M&A activity predicts changes in economic growth, foreign exchange returns
image:
Steven J. Riddiough is an Associate Professor of Finance at the University of Toronto, where he teaches courses in international finance and corporate finance. His research interests span international finance, empirical asset pricing, and household finance. His research has been published in leading academic and practitioner journals including the Journal of Financial Economics, Review of Financial Studies, and the IMF Economic Review. His paper “Global Imbalances and Currency Premia” (with Pasquale Della Corte and Lucio Sarno) won the Kepos Capital Award for the Best Paper on Investments at the Western Finance Association Annual Meeting. Previously, Steven was a Senior Lecturer (Assistant Professor) in Finance at the University of Melbourne, which he joined following the completion of his PhD in Finance at the Warwick Business School. During his PhD studies, Steven worked as a Lecturer in Finance at Imperial College London, undertook research in the International Finance Division at the Bank of England, and consulted to the Canada Pension Plan Investment Board. He began his career as a Foreign Exchange Research Strategist at the Investment Bank, Credit Suisse.
view moreCredit: University of Toronto
Toronto - In a world facing rising economic uncertainty and instability, look to cross-border investment activity for solid clues about what's next for economic growth and foreign exchange rates.
That's a key finding by Steven Riddiough, an associate professor of finance at the University of Toronto Scarborough and Rotman School of Management, and Huizhong Zhang from Australia's Monash University. They assessed nearly a quarter century of data on cross-border deals involving more than 40 countries and identified a predictive relationship between changes in a country's foreign investment activity and future changes in its economic growth and currency values.
It's a useful discovery for global investors and anyone setting policies that depend on accurately gauging the economic future. Although it's generally thought that foreign exchange rates are driven by changes in fundamental economic indicators like economic growth, researchers have had trouble showing a strong relationship between them in practice.
Cross-border merger and acquisition announcements, however, act as an easily identifiable "signal" for changing expectations within the market about economic fundamentals, say the researchers. That's because they are the moment when companies reveal previously private "micro-level" information about on-the-ground conditions affecting expectations for their industries. Once that information is out for everyone to see, it begins to affect other market players' economic expectations, which in turn influences currency values.
Micro-economic information like that is otherwise hard to get, said Prof. Riddiough. "Most economic announcements that might signal future growth are macro in nature -- economy-wide information on growth, labour markets, inflation, interest rates, and so on," he said. In contrast, "firms are at the coal face of the economy, giving them a real-time perspective on current and future economy-wide trends."
He and Prof. Zhang found that unusually high amounts of investment flowing out of a country to another were followed by a weakened domestic currency in the month after, and about a 1% drop in the originating country's economic growth rate within five years. However countries who were on the receiving end of unusually high foreign investment saw about a 1% bump in their rate of economic growth within five years, and an increase in the relative value of their currency over the following month.
The study looked at data on all cross-border investment deals between 40 developed and emerging market countries and the United States between 1994 and 2018. The U.S. was chosen as the anchor economy because it is the most active in the world when it comes to cross-border investment and provided a common currency (U.S. dollars) for the researchers' evaluations.
Instead of looking at the results of individual investment deals, the researchers focused on overall trends in investment activity and what happened afterwards. Their findings were most relevant to predicting changes for domestic economies.
"It is more about outflows than inflows," said Prof. Riddiough. "When domestic firms are undertaking more international M and A investment it tends to signal future weakness in the domestic economy and a weakening of the domestic currency. Vice versa, when domestic firms undertake less international M and A investment than typical, it tends to predict stronger future home conditions."
The study appears in the Review of Financial Studies.
Bringing together high-impact faculty research and thought leadership on one searchable platform, the Rotman Insights Hub offers articles, podcasts, opinions, books and videos representing the latest in management thinking and providing insights into the key issues facing business and society. Visit www.rotman.utoronto.ca/insightshub.
The Rotman School of Management is part of the University of Toronto, a global centre of research and teaching excellence at the heart of Canada’s commercial capital. Rotman is a catalyst for transformative learning, insights and public engagement, bringing together diverse views and initiatives around a defining purpose: to create value for business and society. For more information, visit www.rotman.utoronto.ca
-30-
Journal
Review of Financial Studies
Method of Research
Meta-analysis
Subject of Research
Not applicable
Article Title
Cross-Border M&A Flows, Economic Growth, and Foreign Exchange Rates
