The dollar’s fate: Dustbin of history or cyclical recovery?

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 weakness of the dollar has transcended finance and entered popular culture. Everyone has an opinion — reminiscent of the late 1990s when cab drivers would offer Internet stock tips. This saturation would seem to imply a mature phase of market development.
Rogers’ stated intention to sell all his dollars and buy yuan is a clear example of the “irrational exuberance” of the dollar bears. His calculations attribute no value to political liberties — while the U.S. will allow Rogers to take his money out, Chinese authorities would likely be less accommodating if he changed his mind.

On Nov. 7, Cheng Siwei, vice chairman of the Standing Committee of the National People’s Congress, said, “We will favor stronger currencies over weaker ones, and will adjust accordingly.” This suggests China is going to diversify its approximately $1.4 trillion reserve holdings away from the U.S. dollar. But what incentive does China have, even if that is its intention? In reality, what China (and other central banks) might be doing is diversifying new
reserve accumulations, not its stock of reserve holdings.

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.

This data indicates at the end of 2006’s second quarter the dollar’s share of reserves slipped from 66.1 percent to 64.8 percent while the euro’s share rose from 24.8 percent to 25.6 percent. Together, the sterling and the yen made up only 7.5 percent. (Note: Not all countries report the
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
British pound.

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.

Also, the “dollar overhang,” or world’s dollar surplus, is not as large as often portrayed. True, although the U.S. economy comprises about one third of the world’s economy,the dollar makes up almost 65 percent of the currencyreserves. This discrepancy, however, is not a fair measure of the dollar overhang because the countries formally or informally tied to the U.S. economy — the “dollar-bloc,” if you will — comprise approximately two-thirds of the world economy. This figure is more in keeping with the dollar’sreserve percentage.

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 “Why a Dollar Depreciation May not Close the U.S.Trade Deficit,” in the June issue of the New York Federal Reserve’s Current Issues in Economics and Finance, Fed economistsLinda Goldberg and Eleanor Wiske Dillion persuasively argued there are three mitigating factors that may limit the impact of the dollar’s decline on the U.S. trade imbalance.

First, because nearly all U.S. imports and exports (93 and 99 percent, respectively) are invoiced in dollars, a weaker dollar’s impact on import prices is less than it would otherwise (and for other countries) be. By comparison, since the advent of the euro, the Eurozone and the EU countries have reduced their use of the dollar as an invoicing currency for intra-European trade: 54 percent of Eurozone imports and 59 percent of their exports are invoiced in euros. In trade with the U.S., however, the dollar is still predominantly used. Studies also suggest a high percentage of traded goods in Asia, Latin America, and Australia are still invoiced in dollars.

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.

Second, the article notes that foreign exporters’ long-term competitive strategies are aimed at preserving market share, which means they accept narrower profit margins by not passing through the costs of a weaker dollar to the U.S. The authors suggest this is largely a function of the large U.S. economy’s higher level of competitiveness. But there is another possible explanation. U.S. businesses (and Anglo-American economies in general) rely more on the markets, rather than banks, for capital. This means the cost of capital for Anglo-American companies rises if they do not meet the markets’ quarterly earnings expectations. This makes them keen to protect profit margins and more likely to pass along adverse currency movements.
In Continental Europe and Japan, by contrast, companies are more reliant on banks for capital, and banks tend to be more patient than the markets. The corporate expansion strategy that follows from this capital distribution model encourages companies to protect market share, which, in the short-run, may mean accepting a profit squeeze to maintain a longer-term strategic position.

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.

Temporal rift
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.


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