Will dollar ever buck the trend?
Some trends point toward reversing U.S. dollar's 10-year devaluation.
| Walter Kemmsies chief economist, Moffatt & Nichol |
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It is time to start wondering when the 10-year-long devaluation of the U.S. dollar might end and begin to reverse. As the U.S. economy strives to recover and decision makers have to look out over longer time horizons, this is one factor that has to be considered.
The chart shows three trade-weighted indexes of the foreign exchange value of the U.S. dollar:
' The Broad Index is based on the exchange rates of the largest 26 U.S. trading partners.
' The Developed Market Index is that of seven currencies (euro, Canadian dollar, Japanese yen, British pound, Swiss franc, Australian dollar and Swedish krona) that trade widely in currency markets outside their respective home areas. The Federal Reserve Board's staff refers to these currencies, along with the U.S. dollar, as 'major' currencies.
' The Emerging Markets Index comprises the remaining 19 currencies in the Broad Index that are not included in the Developed Market Index. Countries include China, Mexico, Korea, Taiwan, Hong Kong, Malaysia, Singapore and Brazil.
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All three indexes show the U.S. dollar peaked in 2002 and ' except for the period from mid-2008 to early 2009 when the global financial crisis unfolded and there was a flight of capital to 'safety' ' have been losing value across the board.
There are several reasons for this. Generally speaking, a country's currency gains value against other currencies when its economy is relatively stronger, it has lower inflation, and when these trends are reflected in higher real (i.e., inflation-adjusted) interest rates.
Over the last 10 years since the dollar peaked, U.S. interest rates have been low, inflation was above the Fed's target until the recession started in December 2007, and economic growth has been weak.
Employment growth from the end of the 2001 recession to the one that began in 2007 was the lowest since published records began in 1939. To some extent this can be blamed on the torrid pace of outsourcing that helped drive the U.S. trade deficit to an all-time high. While much of the outsourcing was bound to happen, due primarily to demographic trends, it is arguable that too much happened too quickly.
From a financial perspective the U.S. economy has also fared poorly in the last 10 years. Two wars and A recession bordering on a depression has left government agencies with very large deficits. U.S. infrastructure has been allowed to deteriorate. Consumers substantially increased their debt burden and have suffered a significant loss of wealth due to the decline in real estate and financial asset prices.
It is hardly any wonder the dollar index has declined 25 percent from its peak value in 2002.
Recent Trends. Some recent trends have contributed further to the dollar's decline: inflation fears and data indicating the economic recovery is proceeding a lot more slowly than many had hoped. The inflation fears are justifiable in that the Federal Reserve has had to pump large amounts of money into the economy as a result of credit markets freezing up. These fears, which may be exaggerated, have impacted the value of the dollar. The weak recovery also negatively impacts the dollar because the Federal Reserve will have to keep interest rates at low levels to encourage companies to invest and therefore create jobs.
The lower valuation of the U.S. dollar has helped exports by making them more competitive. By the same token imports become more expensive in dollar terms. Exports have accounted for about one-third of the economic growth in the last six quarters. While export growth has helped improve the trade deficit, much more is needed before the dollar could begin to appreciate. But trends are headed in that direction.
The United States has been running a trade deficit since 1982, which has averaged 2.7 percent of gross domestic product since then. With that track record, it is surprising the dollar hasn't lost even more value. The reason it hasn't lies in the role it plays in the world economy.
The U.S. dollar is the currency most often used to quote terms of trade between countries, and for most globally traded commodities, such as oil.
The dollar also plays a pivotal role in the financial sector. The U.S. dollar yield curve is very liquid, which allows most global companies and many countries to manage their interest rate risk by converting their obligations into dollar-denominated ones.
Yuan, Real. The U.S. dollar's declining value has therefore caused consternation in the world economy. China and Brazil have been considering alternative arrangements to facilitate trade between those countries. China has pegged its currency to the U.S. dollar since the 1990s, which has resulted in an undervaluation of the yuan since China has had stronger economic growth trends than the United States, particularly over the last 10 years. The Brazilian real's exchange rate to the dollar is set in the market place and has appreciated over the last 10 years. Because the yuan is pegged to the dollar, the Brazilian real is overvalued relative to the yuan, which is distorting trade patterns between those two economies.
Eventually China will have to stop pegging the yuan's exchange rate to the U.S. dollar. When that happens the yuan is expected to appreciate significantly. In terms of the dollar indexes above, this means the U.S. dollar's value relative to the emerging market currencies will continue to decline. That will help U.S. exporters selling to emerging markets and will likely help the dollar recover some value against the developed markets' currencies.
In the long term the dollar should recover, but first the trade deficit will have to improve substantially and that will require China to stop pegging its currency. This will help exports and will likely see importers shift their sourcing away from China towards countries with lower costs, including transportation costs.
Some of these trends are already beginning to unfold and it is quite possible the dollar's value, in terms of the Broad Index shown in the chart, could begin to start trending upward. Before then, watch the Federal Reserve. Once the Fed begins to raise interest rates the dollar is very likely to begin to appreciate.
Walter Kemmsies is chief economist of Moffatt & Nichol, a marine infrastructure engineering firm. He can be reached at (212) 768-7454, or e-mail, [email protected].