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Will the U.S. dollar continue to appreciate?

   Over the last 12 months the dollar has appreciated due to stronger economic trends in the United States compared to other countries. However, this may be coming to an end. 
  
The U.S. economy is growing, albeit at a slow pace of 2 percent, compared to an average rate of 3.1 percent during the 30 years prior to the recession that started in 2007. Yet, U.S. growth has been steadier than in the European Union where many of the member countries are experiencing recessions, and China, India and Brazil where gross domestic product growth has slowed significantly. 
  
While the U.S. economic recovery has reached a point where consumer spending and employment improvements are reinforcing each other, the negative effect of the automatic federal budget reductions (the “fiscal cliff”) in 2013 on economic activity could bring the dollar appreciation to an end. While exporters might be glad to see the U.S. dollar stop appreciating or even weaken, it’s unlikely that would boost exports since the rest of the world economy is struggling.

  
A country’s currency tends to appreciate if:

  • The domestic economy is growing faster than foreign economies.
  • Domestic interest rates are rising relative to interest rates of other economies.
  • Domestic inflation is not rising relative to inflation in other economies.
  • The domestic economy’s foreign trade balance improves.

   These factors have helped the U.S. dollar appreciate, with the following results: 

  • U.S. GDP growth has averaged 2 percent in the last four quarters. Many European Union member countries and Brazil have experienced a decline in GDP in the last six months or so.
  • U.S. interest rates have been relatively constant at historically low levels for the last few years due to the Federal Reserve’s efforts to help the economy recover. Most countries, in particular Europe, China and India, have begun to lower their interest rates.
  • U.S. inflation has averaged 2 percent, in line with Europe, but was lower than in Brazil, China and India.
  • The U.S. trade balance reached an average monthly deficit of $69 billion in 2007, the highest ever. As the economy went into recession the deficit declined but began to rebound with the recovery. Over the last 12 months to May 2012 it has averaged $63 billion. Year-to-date exports have grown marginally faster than imports, which have kept the trade deficit from returning to the high levels they reached in 2007. 

   Over the last decade currency markets have been impacted by China’s policy of pegging the exchange value of the yuan at a low level to the U.S. dollar. Given China has a trade surplus with the United States, it should have been selling U.S. dollars it was receiving to buy yuan. However, this would make the yuan appreciate. To avoid that China didn’t sell its U.S. dollars, but instead purchased U.S. government bonds. Between 1999 and 2008, China increased its U.S. treasury securities holdings from practically none to become the largest foreign owner, displacing Japan which had been the largest holder for decades. 
  
With the government deficit rising since 2001, interest rates in the United States should have increased substantially; however, they remained low. In addition to the actions of China, the Federal Reserve also targeted low interest. These trends combined to leave the U.S. dollar undervalued against the currencies of other economies such as the euro. Since 2005, China has been slowly taking steps to end its currency manipulation policy. Besides allowing the yuan to slowly appreciate against the U.S. dollar, China is also diversifying its foreign currency holdings away from it. If these trends continue, eventually the yuan exchange rate may float freely based on economic trends. However, this doesn’t necessarily mean that the yuan will appreciate significantly against the U.S. dollar.
  
Since February the U.S. dollar has appreciated against the yuan and may continue to do so for some time. Although China is trying to become less dependent on exports to maintain its economic growth by stimulating consumer spending, it will take some time for the Chinese economy to respond to this policy. In the meantime the slow recovery in the United States and the recession in Europe have negatively impacted China’s growth. 
  
Europe’s recession is largely concentrated in Greece, Spain, Portugal, Italy and the United Kingdom. The southern European economies are in recession due to reductions in government spending as a result of their inability to make payments on their debts. Economic trends in Europe are likely to worsen further before improving. 
  
Weak economic trends in Europe, Asia and Latin America relative to the United States should result in further appreciation of the U.S. dollar. However, the Congressional Budget Office estimates that U.S. economic activity will contract in 2013 if the large automatic spending decreases occur as mandated. This could also see the U.S. dollar stop appreciating. Concern over poor global economic growth and the possible “fiscal cliff” in the United States may be the reason why companies seem to have slowed their expansion plans in the last few months. If a recession occurs as a result of these trends, the U.S. dollar could depreciate against other currencies.
  
The depreciation of the U.S. dollar from 2001 to 2011 helped exports become more competitive and many companies have stated that they expanded their U.S. manufacturing operations for that reason. The increase in exports occurred while the world economy was growing at a higher rate. This time U.S. exports may not get the same support from a decline in the value of the U.S. dollar because its trading partners’ economies are weaker now.   
  
Kemmsies is chief economist of Moffatt & Nichol, a marine infrastructure engineering firm. He can be reached at (212) 768-7454, or e-mail.