The value of a nation’s currency relative to other nations’ has a dramatic impact on international trade and capital flows. Unfortunately, the many factors that influence that currency value are notoriously complex, volatile and unpredictable. An old saying claims that only two people in the world understand currencies, and they disagree.
As with most things, hindsight gives us a clear picture of why support for the dollar, and its value, have declined. The bursting of the tech bubble, the impact of 9/11 and the ensuing recession forced the Federal Reserve to lower its target interest rate to 1%, well below other developed countries. After inching up to 5.25% in mid-2006, the implosion of the housing market and the weakening economy have driven the Fed’s target rate back down to 2%, again lower than other developed countries. Huge government budget deficits increase the possibility, however slight, that those debts might not be repaid. The recent credit and financial crisis have also served to undermine the confidence of foreign investors.
The net result is that the dollar has been on a seven-year slide since late 2001, despite repeated statements from the government support of a strong dollar. The dollar lost nearly 50% of its value compared to the euro, over 30% to the pound, and over 30% to a basket of currencies of developed countries. The dollar even lost 62% of its value to the Canadian dollar, reaching “parity”, or equal value, for the first time in 31 years.
When the dollar is “strong”, it buys more foreign goods; when the dollar is “weak”, it either buys less foreign goods or takes more dollars to buy the same foreign goods. The US became so addicted to foreign goods when the dollar was strong that the trade deficit has remained at record levels since imports have cost more dollars to buy. The trade deficit hit a record of over $700 billion in both 2006 and 2007, and in July 2008 it hit a monthly record of $68 billion, driven largely by oil imports. A weak dollar does have a silver lining, however, and US exports of goods and services have been a bright spot in the economy, growing 13% in 2007 and over 18% so far in 2008.
Commodities, particularly oil, present a sort of chicken-and-egg problem for the dollar. Global commodities are priced and paid for in US dollars, but the producing countries use those dollars to buy goods from many countries. The weakening dollar added to the upward pressure on the price of oil, as the producers demanded more dollars to support their spending. Or, did the rising demand for and price of oil create downward pressure on the dollar, as the market knew there would be more dollars required to pay for oil? Likewise, as US drivers have responded to high gasoline prices by driving 6% less and global demand for oil has eased, oil prices have gone down 20% and the dollar has bounced up 8% against the Euro in the last few months.
International travel is directly affected by currency values, and in 2007 a record 56.7 million foreign visitors came to the US, setting a record for the first time since before 9/11. They spent a record $123 billion, and despite tighter travel restrictions 23 million were from overseas; the number of visitors from Italy, Spain, Ireland, Sweden, China, South Korea and Australia all set records. At the same time, US travelers overseas and to Mexico and Canada continued to set records, defying the higher costs caused by the weak dollar.
There a number of ways the relative strength of the dollar can affect investors. A weak dollar could contribute to inflation by making imports and commodities more expensive. That could hurt profits and lead to worries that interest rates will have to rise. A weak dollar has helped US multi-national companies because the profits they earn overseas are worth more when they are converted to dollars. In addition to impact on oil prices, demand for gold has benefited from the weak dollar by becoming the “safe haven” that was traditionally provided by the dollar. Foreign investment in US companies has increased, with the recent acquisition by Switzerland’s Roche Holding AG of Genentech and Belgian brewer InBev NV’s takeover of Anheuser Busch. These deals are in addition to various sovereign investment funds’ investments in ailing US financial firms.
Mutual fund investors were rewarded by the combination of the weak dollar and strong foreign economies. A combination of international stock indices encompassing Europe, the Pacific and emerging markets grew by more than 24% annually over the five years ended in 2007, nearly double the return for the broad US market in the same period. And investors “voted with their feet”, pouring $392 billion into international-oriented mutual funds in the last three years while actually withdrawing a net $4 billion from US-oriented funds over the same period.
Of course, no trend continues forever, and it remains to be seen whether the recent recovery of the dollar will continue. If the dollar has hit its bottom and continues to strengthen, all the currency-related developments of the last few years will unwind and reverse. I warned you currencies are confusing.