The greenback’s fall from grace

Contributed by Simon Dowling,

Director of Close International

Asset Management Limited

RECENTLY, the value of the US dollar has weakened significantly against the pound, the euro and most other currencies. While the US administration publicly continues to confirm its commitment to a strong dollar, its actions and policies suggest otherwise. US Treasury Secretary, John Snow, on a recent visit to Europe, reiterated support for a strong dollar. However, it is widely accepted that the administration is happy for a gradual and controlled depreciation.

Investors and confidence

This apparent contradiction between action and words should not come as any great surprise. The US administration is unlikely to promote a policy of a weakening dollar in case it would cause any loss of confidence in the currency. After all, to service its twin trade and budget deficits, the US needs continuous investment from abroad. This will only continue if foreign investors have confidence in the dollar. In the short-term, a weaker dollar is in US interests and will help stimulate the economy, boost exports, create jobs and increase tourism figures.

The monetary policy of reducing interest rates over recent years has meant less attractive returns for foreign investors and this has contributed to the fall in demand for the dollar. One way to counteract a fall in foreign investment is to increase yields on government bonds, but this may have an inflationary side effect. The current administration’s policy of tax reductions will help stimulate the economy but may add to the federal budget deficit with increased demand for imported goods. This, in turn, may lead to a further depreciating dollar. In order for the dollar to remain strong during times of twin trade and budget deficits, there has to be strong foreign investment in US bonds and equities to exceed the outflow of dollars from the economy. This has not been the case in recent years.

Exports and imports

Recent figures suggest that the weakening dollar is beginning to have a positive impact on US export figures. This increase in demand abroad for US goods will inevitably lead to an increase in employment figures. Exactly what degree of impact the falling dollar will have on import figures is hard to predict. The US imports a large amount of essential raw materials and goods, which it will continue to import, despite rising prices that may contribute to inflation as well as the trade deficit. While running large trade and budget deficits in recent years, it could be argued that what the US has been doing recently, in part at least, is borrowing abroad to pay for imported goods, a situation that cannot continue long-term.

Oil makes up a large portion of all US imports. Oil is priced in dollars and the falling dollar will mean falling profits for OPEC producers. Oil producers are paid in dollars but have outgoings and expenses that need to be met in other currencies. Because oil is priced in dollars then most of the major currency areas will now benefit from cheaper oil.

China

China has been bank rolling a substantial portion of the US deficit in recent years, with the Chinese Central Bank holding billions in US treasury bonds and dollars. However, this is unlikely to continue in the long term, as China needs to spend considerably to expand and update its infrastructure. This leaves Washington in a precarious position should China sell substantial dollar holdings, which will weaken the dollar still further. In addition, Chinese goods are now more attractive to import because of the pegged currency – a situation that will only increase the already large trading deficit the US has with China.

The impact of a depreciating dollar on individual US firms can vary considerably, with some firms benefiting from increasing export opportunities to Europe and Japan. US corporations with overseas subsidiaries will see the profits remitted from these offices increase in value. On the other hand, firms who import essential raw materials will see their costs rise and face a choice of either trying to pass this price rise on to the consumer or absorbing the cost.

Long-term implications

Economists generally agree that the dollar does not look likely to strengthen anytime soon. If this is the case, then what are the implications for Europe and the rest of the world? In the long term, European companies who are dependent on the US market may begin to consider relocating some parts of their operations to cheaper locations thus causing a rise in unemployment. The European Central Bank would be slow to either drop interest rates or attempt to devalue the single currency by entering the currency market.

A weak dollar generally means that imported goods become more expensive in the US and may result in some of these goods being substituted for cheaper home produced goods. Countries like China, whose currency is pegged to the dollar, should see an increase in demand from the US for their products.

For the consumer, the implications again vary depending on where you live. Travelling to the US is now more attractive than anytime in the past, whereas Americans will now be more reluctant to travel outside the US. Finally, with American saving at record lows, it is heavily reliant on foreign borrowing for capital investment – a thriving Europe will help provide this capital. Only a fairly valued dollar will provide long-term stability and an environment for economic prosperity for all.

• For further information, please contact Close International Private Banking in Almancil. Tel: 289 395 077 or e-mail susan.hart@closeipb.com – website www.closeipb.com