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The currency market trend comes as the U.S. coronavirus vaccination drive progresses. (Source photo by Reuters)
Datawatch

Dollar remains overvalued against yen and other currencies

Difference with theoretical value sows seeds of market unrest

TAKAKO GAKUTO and KAZUYA MANABE, Nikkei staff writers | North America

TOKYO -- Demand for dollars is driving the U.S. currency far above its fundamental value, increasing the risk of market volatility.

The U.S's progress in rolling out the novel coronavirus vaccines is raising hopes for rapid recovery in the world's largest economy, spurring demand for the greenback.

But the U.S. economy's swelling government debt would suggest that the dollar should be declining in value, according to Nikkei equilibrium exchange rate, calculated by Nikkei Inc. and the Japan Center for Economic Research. The Nikkei EER is based on a country's economic fundamentals such as government debt and current-account balance.

The difference between the dollar's theoretical and actual values will eventually cause a backlash. If the dollar weakens rapidly, it could shake the global economy, which has been hit hard by the coronavirus pandemic.

As of April 16, the dollar traded at 108 yen, 14 yen higher than the U.S. currency's Nikkei equilibrium exchange rate, or its theoretical value, against the Japanese currency, which stood at 94 yen.

Generally, the currency of a country that is saddled with heavy government debt and a large current-account deficit, suffers a decline in its comparative value.

The dollar's Nikkei EER against the yen stood at 94 yen between October and December 2020, compared with 110 yen between October and December 2019, before the coronavirus outbreak spread.

The U.S. moved to shore up its flagging economy with massive fiscal spending amid the pandemic, resulting in government debt ballooning further.

The change in the dollar's Nikkei EER against the yen between the fourth quarter of 2019 and the same quarter of 2020 means the greenback lost its value by 16 yen during the period.

Furthermore, given future fiscal spending by the U.S., the dollar's Nikkei EER against the yen will inevitably face downward pressure.

President Joe Biden's administration has already unveiled an additional stimulus package worth about $2 trillion and is also considering infrastructure investment. If the administration fails to secure funding, including through tax rises, U.S. government debt will swell further.

As personal consumption in the U.S. is recovering rapidly, there is a chance of the country's trade deficit expanding due to increased imports. Theoretically, the dollar's downward trend is likely to continue.

Nevertheless, the dollar's exchange rate is moving in the opposite direction. The dollar changed hands at 103 yen at the end of 2020 but was quoted at close to 111 yen at the end of March -- its highest level in about one year.

The dollar's strength in currency markets reflects confidence in the U.S. economy.

The International Monetary Fund estimates that the U.S. economy will expand 6.4% in 2021, its biggest growth in 37 years and exceptionally high compared with the rest of the world.

The difference between the dollar's theoretical value and actual exchange rate could also be seen in the wake of the global financial crisis in 2008. The dollar later weakened in currency markets in tandem with its theoretical value.

At the time, U.S. government debt was rising to cope with the global financial crisis. It is now rising again.

U.S. government debt as a percentage of gross domestic product surged by 13 percentage points in 2009 from a year earlier and 19 percentage points in 2020, year on year.

Tsuyoshi Ueno of Japan's NLI Research Institute pointed out that the "twin deficits" of the U.S. have often been factored in by the financial markets in the past, causing a stronger dollar to be corrected.

If the dollar's appreciation continues, some emerging economies that have dollar-denominated debts will face increased repayment burdens.

The central banks of Brazil and Turkey have already raised interest rates. The dollar's appreciation poses a risk to the global economy, as it could cause concerns about debt in emerging economies.

Meanwhile, it is unclear how long the economic recovery in the U.S. backed by government aid will continue. If the economy runs out of steam, there is a possibility the market will turn to the actual power of the dollar.

Caution will be needed if the dollar's depreciation progresses rapidly in tandem with its theoretical value. If the dollar's depreciation and price rises move in tandem, financial markets will risk being shaken as they assume continued monetary easing.

Close attention should be paid to the movement of the dollar, as fluctuations serve as a litmus test for the global economy in the post-coronavirus era.

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