Foreign Economic Growth and the Dollar

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Analysts caution that rapid foreign economic growth could induce a depreciation of the dollar, as international investors diversify their portfolios for higher returns abroad. Although we cannot establish a simple relationship between foreign growth and the dollar, we can conclude that if a desire to diversify out of dollars lies dormant among investors, faster growth abroad may stir it.

The pace of foreign economic activity is accelerating and may actually catch up to the U.S. growth rate this year. As welcome as this news may be, many economic analysts caution that faster growth abroad could prompt a marked depreciation of the dollar in foreign exchange markets. A higher return on capital abroad, they contend, affords international investors a long-awaited opportunity to diversify dollar-laden portfolios. In some people's minds, the question is not if-but how quicklyinvestors will ditch dollar-denominated assets and how sharply the dollar will fall.

This Economic Commentary illustrates that rapid foreign economic growth exerts both positive and negative influences on the dollar. A simple systematic relationship (suitable as a basis for forecasting) does not exist, but other factors, notably the recent buildup of foreign claims against the United States, may very well bias the dollar toward depreciation as growth abroad accelerates. All told, however, forecasts of exchangerate movements, particularly those based on macroeconomic variables, have proven notoriously inaccurate.

Foreign Economic Growth

In 1998, as the aftershocks of the Asian and Russian financial crises reverberated around the globe, foreign economic activity slowed, especially in emergingmarket economies. The average rate of economic growth abroad fell from 4.2 percent in 1997 to 1.4 percent in 1998 (see figure 1). 1 Although foreign economic growth accelerated in 1999, it continued to lag the vigorous rates in the United States. During these three years (1997, 1998, and 1999), international investors fled emerging markets for more promising returns in the United States. Sizable capital inflows contributed to a 20 percent appreciation of the dollar and to a sharp expansion of the U.S. current account deficit. Recently, forecasters have upgraded their outlook for foreign economic growth; they now expect it to be on par with U.S. growth this year, approximately 4 percent. In 2001, they expect foreign growth, at 3.8 percent, to edge past U.S. growth. If a relatively strong U.S. economy attracted capital and precipitated a dollar appreciation, wouldn't slower U.S. growth have the opposite effect?

Economic Growth and Capital Flows

Analysts who expect the dollar to depreciate as foreign economic activity accelerates regard relative GDP growth rates as a reliable proxy for the comparative return on investing in different countries. Accordingly, they believe that as foreign economic growth quickens, the real risk-adjusted return to capital there will rise relative to that afforded by American investments.

As the relative return on U.S. investment slips, capital inflows into the country will slow. This could occur even if foreign economic growth does not actually exceed domestic growth; the impact could be all the greater if, as many anticipate, U.S. economic growth slows. The argument, therefore, predicts a positive relationship between relative rates of economic growth and net foreign investment.

Figure 2 demonstrates this correspondence. The figure plots economic growth differentials (foreign minus U.S. growth rates) against private net foreign investment flows, with positive net foreign investment values indicating capital outflows from the United States to foreign countries, and negative amounts indicating capital inflows. (These data do not include official capital movements, which need not be responsive to relative rates of return on investments.)

Since 1983, the United States has experienced a continuous inflow of foreign capital. …