What a declining dollar means for you

The stock markets may have reacted well to George W Bush’s re-election in the United States, but it has been a different story with the Dollar. The US currency has fallen four per cent (at the time of writing) against both the Euro and the Yen since Election Day.

President Bush does not have a brilliant track record with the Dollar. It has dropped more than 40 per cent against the Euro since 2002, hitting new lows this month. (The decline has not been so marked against other currencies, largely because China and Japan prop up the Dollar by investing heavily in US Treasury Securities. Viewed another way, they lend the US money so it can buy their goods). According to the US Federal Reserve’s trade-weighted major currency Dollar index, the Dollar has shed 21 per cent since Bush took office in January 2001. Previously, under Bill Clinton, the index had advanced 24 per cent.

Many analysts now believe that, as Bush has been re-elected for a further four years with a strong popular vote mandate and a larger Republican representation in congress, he is less likely to tackle the falling Dollar and the significant deficit problem.

This deficit – the US is spending nearly $600 billion a year more than it produces (compared to a current account deficit of zero in 1990) – is the main reason for the weak Dollar. There are three scenarios that could lower this deficit: if the federal budget was reduced, thus lowering the amount of interest paid to other countries to finance it; if trading partners like Europe and Japan’s economies expanded, thus increasing their demand for American goods; or if America allows its Dollar to fall to increase its exports.

Many analysts believe that the Bush administration has opted for the latter. A weaker Dollar would help American exporters, particularly car manufacturers and companies competing with imports from Europe and Asia.

US Treasury Secretary, John Snow, visited Europe in mid-November and admitted: “our deficit is too large. It’s unwelcome, it needs to come down.” He claimed Bush is “committed” to reducing it.

When asked about the Dollar’s recent decline, Snow asserted: “Our policy is for a strong Dollar… a strong Dollar is in both the national and international interest.”

Not many people appear to believe him though. For example, the Financial Times newspaper observed that this talk is “increasingly perceived as hollow”, saying that “this mantra of a strong Dollar has been repeated since the Clinton days and is wearing a bit thin”. The Economist magazine recently argued that Washington’s “professed commitment to a ‘strong Dollar policy’ might disguise a policy of benign neglect.”

While Snow may have reiterated this policy, he dismissed talk of co-ordinated intervention by central banks to support the Dollar, arguing: “Currency values are best set in open, competitive exchange markets.”He went on to call on the EU to increase its economic growth to take pressure off the US, saying that “the Eurozone is growing below its potential.”

Snow’s visit to Europe coincided with a two-day Ecofin (EU finance ministers) meeting, when it called on the US to take concrete action to protect the Dollar. It called the slide “unwelcome” and urged the US government to cut its deficits.

Monetary Affairs Commissioner, Joaquin Almunia, however, commented that Washington’s refusal to buy Dollars in the market undercut appeals by US policymakers for an end to the Dollar’s slide against the Euro. “The more the Euro rises, the more voices will start asking for intervention. It has to be a co-ordinated effort, but it seems that our friends across the Atlantic aren’t interested.” Jean-Claude Juncker agreed:“I think there’s an underdeveloped sense of hearing in the United States.”

The weaker Dollar will make European exports more expensive (and hence less competitive) in the US. Analysts warn that this could seriously dent the European economy, which relies on exports for much of its growth amid sluggish domestic demand.

On the other hand, as The Economist points out, a stronger Euro will contain Eurozone inflation and offset the higher Dollar price of oil.Plus, if the Euros in their pockets gain in value, European households might be more willing to spend them, overcoming the caution that has held the European recovery back for much of this year.

As for the future of the Dollar and the dangers of its weakness, there are different schools of thought: The US Federal Reserve Bank contends that there is plenty of money invested in global financial markets, allowing the US to borrow more than perceived possible 20 years ago. The Dollar may decline in value, but it will be gradual and help reduce trade imbalances by making exports cheaper and imports more expensive. The Bush administration has even implied that its huge foreign debt simply reflects the eagerness of others to invest in the States.

Other analysts expect foreign governments like China and Japan to continue to finance America’s borrowing – thus keeping the Dollar strong – to sustain their exports and create jobs at home.

Another group – including the International Monetary Fund – are concerned about a collapse in the Dollar, which could have implications for the global economy. It contends that the Dollar does need to depreciate another 20 per cent against major currencies, but warns about a run on the Dollar that would reduce its value by 40 per cent. This would negatively affect Europe and Asia, and could lead to higher interest rates for the US federal government and American private borrowers. It could also expose hidden weaknesses among financial institutions and hedge funds caught unprepared.

For these economists, the question is not whether the Dollar will decline, but how fast and how far it will fall. What does all this mean for European citizens?Well, if you’ve always wanted a shopping trip in New York or to buy a pad in Florida, now’s a good time, as your Euros or Sterling will take you further. On a smaller scale, it may be cheaper to order books from Amazon.com rather than Amazon.co.uk.

From an investment point of view, if you have savings in Dollars think about converting them to Euros or Sterling, or investing them instead. For investors with Euros or Sterling to spend and a long-term time horizon, US denominated equity assets will be cheaper and an investment opportunity. Many commentators believe the Dollar weakness is likely to overshoot, and if they’re correct and the Dollar recovers over the next five years, you could earn a reasonable currency gain on top of any market ones.

The Dollar’s fall also reminds us of the importance of diversification. A fully diversified portfolio, with shares from a number of different countries and sectors, is designed to ride out any big currency swings. If you have any concerns about your portfolio or savings, discuss your options with your financial adviser now.