The dollar’s fate:
Dustbin of history or cyclical recovery?
Contrary to what you’ve heard, the dollar’s slide isn’t a big threat to the economy. And the downtrend is getting long in the tooth, anyway.
Here’s a sampling of the news stories that helped deal the U.S. dollar a body blow in early November:
- Hedge-fund manager Jim Rogers announced he was selling all his dollars, buying yuan, and moving to China.
- An official in China’s National People’s Congress said China would diversify reserves out of weak currencies and into strong ones.
- Iran and Venezuela proposed OPEC should price oil in currencies other than the dollar.
- And last but not least, Brazil’s super-model Gisele Bundchen reportedly demanded compensation in euros rather than dollars.
The euro (EUR) rose to new record highs against the dollar, drawing a bead on the $1.50 mark (Figure 1). The British pound (GBP) and the Australian dollar (AUD) were at levels not seen in more than two decades (Figure 2). Even the low-yielding Japanese yen and Swiss franc participated in the move against the once Almighty Dollar.
On Oct. 1, former Federal Reserve Chairman Alan Greenspan commented on the end of the dollar’s dominance, noting the dollar’s status as the pre-eminent reserve currency eroding as the euro and British pound become more attractive. The dollar has been trending lower for the last five to seven years while the euro has risen since fall 2000, when the major central banks intervened in the foreign exchange market to support it. More than one economist has commented the dollar is in trouble. But is it really?
The facts contradict the story
The most authoritative sources of reserve currency allocation are the International Monetary Fund (IMF) and the Bank for International Settlements (BIS). Their most recent data covers the second quarter of 2006.
allocation of their reserves.) These modest figures seem to show only the slightest shift in reserve diversification. Why? Valuation. For example, suppose you are a central bank
with reserves evenly divided between dollars and euros. Over the past year the euro has risen almost 15 percent vs. the dollar. You are a patient central bank and have done nothing, but because of this valuation shift, the proportion (i.e., the net value) of your euro reserves has increased while the proportion of dollars has declined. This change in currency values gives the appearance of a greater shift away from dollars than is actually the case.
The data shows central banks that report their currency reserve compositions hold more dollars than ever before, but they also hold more euros than ever before — it’s not a zero-sum game. In fact, if there has been any trend in reserve diversification, it seems to be out of yen and into the
In the past many economists have argued that central banks could be thought of as long-term countertrend speculators — that is, when the U.S. dollar is weak, central banks intervene and buy it. Siwei’s comment implies just the opposite — that the People’s Bank of China would be a
long-term trend speculator. The last central bank to reportedly engage in such practices was Bank Negara (Malaysia’s central bank) in the 1990s, which abandoned the strategy after suffering sufficient losses.
Interventionists send mixed messages While speaking in the U.S. in mid-November, French President Nicolas Sarkozy seemed to encourage the U.S. to intervene in the foreign exchange market to arrest the dollar’s slide.
Why should it? The dollar’s decline is not adversely impacting the U.S. economy. If anything, it’s helping to substitute foreign demand for slackening domestic demand. Imported prices, excluding fuels, aren’t rising any faster than domestic prices. Intervention might also confuse the message U.S. policy makers have been sending to China and other countries: Let the free market determine the value of the currencies. President Bush could be the first president not to intervene in the foreign exchange market since the end of Bretton Woods, and with the Federal Reserve still looking to cut rates, a weaker dollar is consistent with current U.S. monetary policy.
Fed study: Limited impact of a weaker dollar
One of the interesting elements in the dollar’s recent decline is that few, if any, people are suggesting it is being driven by its perennial nemesis, the large trade deficit. Most recognize the divergence of monetary policy and the anticipated trajectory of interest-rate differentials are the significant forces driving the greenback lower. However, many expect the weakening dollar will shrink the U.S. trade deficit. Such hopes are likely misplaced.
In Japan, for example, only 26 percent of imports and 38 percent of exports are invoiced in yen. The share of exports invoiced in dollars often widely exceeds the share of exports accounted for by the U.S., which means many countries are using the dollar even when the U.S. is not one of the trade partners.
The third factor the authors examined was the value added to imports after these goods enter U.S. ports — specifically, storage, transportation, and marketing costs. These costs, which account for 30 to 50 percent of the final price (a notably larger percentage than in most other countries) for a wide range of U.S. goods, are denominated in dollars. Even without the other mitigating factors, this reduces the portion of the final price that is impacted, even in the best of conditions, by the vagaries of the foreign exchange market. This means the U.S. experiences less
pass-through of currency movement to import prices than other countries. The authors cite a 1975-2003 study that analyzed the impact of currency movements on import prices with a year
lag. The average pass-through for OECD countries was estimated at 0.64 percent, which means a 1-percent change in currency prices generates an average 0.64-percent change in import prices, with a wide variance around the mean.
In the Eurozone, the pass-through is estimated at a little more than 0.8 percent. In Japan, estimates vary between 0.57 percent and 1.0 percent, with the rate usually at the upper end of that range. By contrast, the pass-through to import prices in the U.S. is estimated at 0.42 percent — and even this might exaggerate the pass-through in recent years. Since 1990, the degree of pass through has dropped to 0.32 percent in the U.S., which is well below the OECD average of 0.48 percent over the same period. The dollar’s decline has been largely concentrated
against a handful of major currencies. The Federal Reserve’s major currency trade-weighted index has fallen a little more than 11 percent since the beginning of last year, while its broader trade-weighted index has fallen by a more modest 8.5 percent. These indices give more weight to countries with which the U.S. trades more and less weight to countries with which the U.S. trades less. The broader the index, the more countries are included (which often means less-developed countries with currencies historically undervalued by purchasing-power-parity models).
These arguments suggest the improvement in the U.S. trade balance, which contributed almost 1.5 percentage points to both Q2 and Q3 2007 growth, is more likely a function of growth differentials than the dollar’s decline. And through the early part of Q4 2007 import prices were still rising at a slower rate than domestic prices.
While we should be prepared for a weaker dollar in the near-term, the downtrend is getting a little long in the tooth as 2007 draws to a close. In terms of duration and magnitude, the downtrend does not seem exceptional, but market participants often underestimate cyclical influences and exaggerate structural influences.
Traders should not make this error with the dollar. Many foreign currencies, such as the euro, sterling, and Canadian dollars, are well beyond levels that reasonable valuation models would suggest are appropriate. As the late free-market economist Rudi Dornbusch taught us, an overshoot in the foreign exchange market is perfectly rational, but it is still an overshoot.
In the short-run, the U.S. dollar was punished for the Federal Reserve’s pro-growth policies of interest rate cuts. Depending on a number of imponderables, the other major economies may be four-nine months behind the U.S. easing policy, except perhaps the Japanese. The Bank of England and the Bank of Canada are the most likely candidates to follow the Fed, while, in contrast, the Reserve Bank of Australia and the Riksbank of Sweden might not be finished tightening yet.
Policy makers abroad will need to respond to several headwinds; many European countries already appeared to be losing economic momentum even before the credit crunch took hold. While the U.S. economy accelerated in Q2 and Q3, Europe slowed and Japan actually contracted in Q2, although it recovered somewhat in Q3. The tightening market conditions, the appreciation of the euro and the pound, and the rise in energy prices will take their toll. Individually, these challenges may not seem significant, but together they are likely to trigger a policy response. By that time the Federal Reserve will be done (or nearly done) tightening and the groundwork for the U.S. dollar’s cyclical recovery could begin.
A year from now, maybe we will be talking about “eurosclerosis” and America’s amazing ability to reinvent itself.
BY MARC CHANDLER