2007 Kansas City Star Business Section Guest Colomnist: Tue, Jan. 23, 2007

COMMENTARY | Will history repeat itself?
Devaluing dollar drama

By GEORGE SHANNON
Guest Columnist

With financial delegations traveling to China and the U.S. trade deficit reaching 7 percent of gross domestic product, the need for a devaluation of the dollar has been in the media.

What happens when the dollar is devalued? Has the dollar been through a devaluation in recent history? If so, when and what happened? Is history likely to repeat itself? Do models exist for devaluation?

As an investment strategist and a portfolio manager, it is my responsibility to grapple with these questions and prepare strategies for my clients.

To answer some of these questions, I turned to a 2005 study by Caroline Freund and Frank Warnock of the World Bank and University of Virginia’s Darden Business School, respectively. This research studied 26 currency devaluations since 1973.

Freund and Warnock found the average “deep and persistent” current account deficit (that is, a trade deficit lasting three years or longer and reaching 5 percent of GDP or greater) results in a devaluation is 25 percent from peak to trough, lasts four years and proceeds at an average rate of -2.25 percent a year once the currency begins devaluation.

The last major current account adjustment in the United States was from 1982 through 1989. The accompanying devaluation was 35 percent from peak to trough and averaged -4.25 percent a year from 1985 through 1989, once the currency started adjusting.

The Freund and Warnock study develops a model that predicts if the adjustment were to have begun in 2005, the total devaluation would be 23.65 percent from peak to trough and average -2.25 percent a year for four years once the current account deficit started adjusting. The adjustment would reduce the annual current account deficit by 4.2 percent over the same period.

A review of recent market history reveals that from 1985 through October 1987, we had our own 1980s form of “irrational exuberance.” In reflection, perhaps the billions of dollars expected to become less valuable contributed to the tremendous amount of dollars “thrown” into U.S. stocks during that period by both U.S. and foreign investors.

Even thought the market was extremely exuberant, and did crash in October of that year, even at the low point for that pullback, the market provided a very attractive return for those who invested in 1985, at the beginning of the dollar devaluation.

Were history to repeat itself, we would need to first recognize that this devaluation began in 2002, and has already, on a broad market trade weighted basis devalued by 15 percent.

Although the popular press is just now talking about this devaluation, it is actually four years into a potential seven- to nine-year process. Most of the current press attention results from China’s resistance to devalue as rapidly as some would like, and from the speculation that China may hold as much as $1 trillion in our bonds.

However, the International Monetary Fund states in the September 2006 edition of World Economic Outlook, that there is only a one in six chance that this devaluation would become sudden and sharp as opposed to the gradual, more than seven-year process favored by central bankers. A Frank Warnock and Veronica Warnock study in 2006 found that if China were to quit buying our bonds, the Treasury rates would go up about 90 basis points. Were they to start selling them as quickly as purchased them, 10-year rates might climb as much as 184 basis points.

So, as the dollar is devaluating, and as the equity markets move towards exuberance, it might be wise to remember the lessons of the 1985 devaluation, and not become a casualty of excessive exuberance in the equities markets.

George Shannon is chief investment strategist and portfolio manager with Mader & Shannon Wealth Management in Kansas City.