The causes and implications of the beleaguered US dollar
Dr. Faizul Islam | Monday, 26 May 2008
SINCE the start of 2002, the US dollar has fallen to a new record low against the euro, deepening a six-year decline in which it has fallen more than 40 per cent against the European currency, and 25 per cent against a trade-weighted basket of 26 currencies. On May 13, 2008, one euro equalled $1.54. On June 4, 2001, one euro was traded for $0.84.
Reasons for the US dollar's slide: There were three major factors that precipitated the US dollar's slide recently. The number of jobless claims has increased and the monthly unemployment shot up which provided the clearest sign that the US economy may be sliding into recession. The housing market is going through a deepening turmoil. The number of American homes heading for foreclosures rose to the highest level on record in the fourth quarter of 2007. The share of the homeowners' equity in their homes fell to a post-World War II low.
The reasons for the long-term slide in the US dollar are several. The economic growth rate has been lower in the US, while the European economy appears to be rebounding. The economic growth rate in the US was 2.2 per cent in 2007, which was the lowest since 2003. The euro-zone economy grew 2.7 per cent in 2007. Resource-rich economies like Canada, Australia and oil exporting countries have experienced robust growth due to the booming commodities market. While the US Federal Reserve has been lowered the federal funds rate from 5.25 per cent in June 2007 to 2.00 per cent in April, the European Central Bank (ECB) has been raising the interest rate.
The US current account deficit in absolute dollars continues to worsen year after year. The trade gap was $417.4 billion in 2000, which nearly doubled to $811.4 billion, or almost 7.0 per cent of the gross domestic product (GDP) in 2006.
The economic growth is picking up steam in the euro-zone and the ECB and the Bank of England (BoE)have been holding it steady or raising it. The ECB has held its interest rate at 4.0 per cent, 5.25 per cent at BOE, in contrast to 2.00 per cent in the US.
After the 1997-98 Asian financial crisis, several countries of the world devalued or kept their currencies undervalued to boost exports. As a result, those countries have built up huge foreign exchange reserves through trade surpluses. In addition, the so-called sovereign wealth funds (SWFs) of the Middle East and Asia total nearly $3.0 trillion, in size, and may reach $12 trillion by 2015.
Currency analysts believe the US dollar is the most underperforming major currency during periods of rising oil prices, perhaps because the US is one of the major oil importing countries. There is an apprehension that Asia's central banks will diversify out of their large holdings of American debt.
The impact of a beleaguered dollar: A weakened dollar is having several effects. It is putting an upward pressure on prices of commodities that are traded in the US dollar. The value of about two-thirds of the world's central reserves which are held in dollars is diminishing. As the US goods become cheaper overseas, the US exports have gone up, which is likely to reduce the US trade deficit. Excluding oil imports, a weak dollar has helped the US merchandize trade to bottom out. Exports helped reduce the US trade deficit in 2007 by 7.0 per cent compared with 2006. Over the past six quarters, the US exports have contributed, on average, nearly one percentage point to economic growth measured at an annual rate, while the housing slump has reduced just over one percentage point on an average during the same period.
Foreign countries which borrow in dollars, and when their currencies collapse against the dollar, the local value of their debts rise, resulting in corporate bankruptcy. The price of the US imports has risen thereby making it difficult for the US Federal Reserve to tame inflation.
Foreign companies are accepting low profit margins to remain competitive and to sell goods to the US.
Since most countries in the Persian Gulf region have linked their currencies to the US dollar, the peg robs the central bankers of a key tool in fighting inflation; higher interest rates. As the US dollar continues to weaken and the Fed lowers interest rates, their central banks are having difficulty to raise interest rates to control inflation. Inflation in Saudi Arabia surged to a 27-year high of 8.7 per cent in February 2008. Workers in the United Arab Emirates have rioted recently, protesting their dwindling power. Kuwait already delinked its currency from the US dollar in May last year. The United Arab Emirates, Qatar and other Persian Gulf sheikhdoms are mulling whether to sever the currency pegs to the US dollar. Vietnam loosened controls on its currency after inflation soared to 15.7 per cent in February, the highest rate in 12 years.
In a recent CFO Magazine survey, half of European finance chiefs and 60 per cent of Asian finance chiefs believe that the decline in the US dollar represents a permanent devaluation while a third of US chief financial officers say that. As a result, several foreign producers including Germany's BMW and France's Alstom have recently announced either expanded US production or whole new plants mainly to seize the benefits of producing in the "dollar zone."
According to the most Treasury International Capital report, net foreign purchases of long-term US securities were $69.1 billion in December 2007, down from net purchases of $70.3 billion in November, 2007 and $118 billion in October, 2007. If this trend continues and foreign investors divest more US securities than they acquire, bond rates and thereby mortgage rates would rise and hurt the US economy.
Is the status of the US dollar as a reserve currency under attack? At the beginning of the twentieth century, the US was already the world's largest economy, but the British pound still accounted for nearly two-thirds of official foreign-exchange reserves held by the central banks. The dollar did not emerge as the dominant currency until after the World War II devastated Europe. Even then, some commodities were still traded in pounds. The dominance of the dollar was possible because it was backed by the sheer size of the US economy and the relatively sound monetary policy.
After the World War II, the dollar with its large and liquid capital markets served as the world's reserve currency, medium of exchange, and a store of value.
There are apparent worrying parallels between the dollar's recent fall and the decline of the pound as a reserve currency half a century ago. The dollar's decline is creating an atmosphere of crisis that the world's bloated currency reserves are crammed with depreciating dollar assets. The dollar is still deeply rooted as a reserve currency for central banks.
According to the International Monetary Fund (IMF), the share of the dollar reserves peaked at 80 per cent in mid-1970s, bottoming at 45 per cent in mid-1990s, and now accounting for 65 per cent, despite widespread fear of a mass exodus from the greenback. If the dollars hoarded by China and the Middle East oil exporters (not included in the IMF estimates) were factored in, the dollar's share would been still higher. (The euro accounts for about a quarter, up from 18 per cent when it was introduced in 1999). The dollar has weathered storms in 1977-79, 1985-88 and 1993-95, despite predictions that governments were about to switch their reserves to another currency.
According to the Bank for International Settlements (BIS), the dollar is involved in 86 per cent of the $3.2 trillion in daily global currency transactions, often as a middle step in exchanges between two other currencies. While this share is down from 90 per cent in 2001, no other currency comes close to that.
The dollar is deeply entrenched in international trade because businesses lower their transactions by dealing in a common currency. Because the US is such a huge trading partner for so many countries, the reserve build-up cannot easily unravel.
In what is construed to be an unusual departure, Director of National Intelligence Michael McConnell briefed the Senate Select Committee in early February of this year on a surprising potential foe: the falling dollar. His testimony went beyond the conventional world of spycraft, and acknowledged concerns about the financial capabilities of Russia, China and Organisation of Petroleum Exporting Countries (OPEC) bloc and the potential use of their market access to exert financial leverage to achieve political objectives. Noting the impact of a weak dollar is having on national security, he said some oil producers such as Syria, Iran and Libya have asked to be paid in currencies other than the US dollar while others such as Kuwait are delinking their currency peg to the US dollar. He emphasized that the US cannot afford to neglect the dollar and thereby give up the global influence that comes from providing the world's key reserve currency.
If history is any guide, a revamping of the global financial system to replace the dollar as a world's primary currency would take several decades and a massive change in the economic landscape.
The writer is a Fulbright scholar and teaches economics and finance at Southeastern University,
Washington, DC
Reasons for the US dollar's slide: There were three major factors that precipitated the US dollar's slide recently. The number of jobless claims has increased and the monthly unemployment shot up which provided the clearest sign that the US economy may be sliding into recession. The housing market is going through a deepening turmoil. The number of American homes heading for foreclosures rose to the highest level on record in the fourth quarter of 2007. The share of the homeowners' equity in their homes fell to a post-World War II low.
The reasons for the long-term slide in the US dollar are several. The economic growth rate has been lower in the US, while the European economy appears to be rebounding. The economic growth rate in the US was 2.2 per cent in 2007, which was the lowest since 2003. The euro-zone economy grew 2.7 per cent in 2007. Resource-rich economies like Canada, Australia and oil exporting countries have experienced robust growth due to the booming commodities market. While the US Federal Reserve has been lowered the federal funds rate from 5.25 per cent in June 2007 to 2.00 per cent in April, the European Central Bank (ECB) has been raising the interest rate.
The US current account deficit in absolute dollars continues to worsen year after year. The trade gap was $417.4 billion in 2000, which nearly doubled to $811.4 billion, or almost 7.0 per cent of the gross domestic product (GDP) in 2006.
The economic growth is picking up steam in the euro-zone and the ECB and the Bank of England (BoE)have been holding it steady or raising it. The ECB has held its interest rate at 4.0 per cent, 5.25 per cent at BOE, in contrast to 2.00 per cent in the US.
After the 1997-98 Asian financial crisis, several countries of the world devalued or kept their currencies undervalued to boost exports. As a result, those countries have built up huge foreign exchange reserves through trade surpluses. In addition, the so-called sovereign wealth funds (SWFs) of the Middle East and Asia total nearly $3.0 trillion, in size, and may reach $12 trillion by 2015.
Currency analysts believe the US dollar is the most underperforming major currency during periods of rising oil prices, perhaps because the US is one of the major oil importing countries. There is an apprehension that Asia's central banks will diversify out of their large holdings of American debt.
The impact of a beleaguered dollar: A weakened dollar is having several effects. It is putting an upward pressure on prices of commodities that are traded in the US dollar. The value of about two-thirds of the world's central reserves which are held in dollars is diminishing. As the US goods become cheaper overseas, the US exports have gone up, which is likely to reduce the US trade deficit. Excluding oil imports, a weak dollar has helped the US merchandize trade to bottom out. Exports helped reduce the US trade deficit in 2007 by 7.0 per cent compared with 2006. Over the past six quarters, the US exports have contributed, on average, nearly one percentage point to economic growth measured at an annual rate, while the housing slump has reduced just over one percentage point on an average during the same period.
Foreign countries which borrow in dollars, and when their currencies collapse against the dollar, the local value of their debts rise, resulting in corporate bankruptcy. The price of the US imports has risen thereby making it difficult for the US Federal Reserve to tame inflation.
Foreign companies are accepting low profit margins to remain competitive and to sell goods to the US.
Since most countries in the Persian Gulf region have linked their currencies to the US dollar, the peg robs the central bankers of a key tool in fighting inflation; higher interest rates. As the US dollar continues to weaken and the Fed lowers interest rates, their central banks are having difficulty to raise interest rates to control inflation. Inflation in Saudi Arabia surged to a 27-year high of 8.7 per cent in February 2008. Workers in the United Arab Emirates have rioted recently, protesting their dwindling power. Kuwait already delinked its currency from the US dollar in May last year. The United Arab Emirates, Qatar and other Persian Gulf sheikhdoms are mulling whether to sever the currency pegs to the US dollar. Vietnam loosened controls on its currency after inflation soared to 15.7 per cent in February, the highest rate in 12 years.
In a recent CFO Magazine survey, half of European finance chiefs and 60 per cent of Asian finance chiefs believe that the decline in the US dollar represents a permanent devaluation while a third of US chief financial officers say that. As a result, several foreign producers including Germany's BMW and France's Alstom have recently announced either expanded US production or whole new plants mainly to seize the benefits of producing in the "dollar zone."
According to the most Treasury International Capital report, net foreign purchases of long-term US securities were $69.1 billion in December 2007, down from net purchases of $70.3 billion in November, 2007 and $118 billion in October, 2007. If this trend continues and foreign investors divest more US securities than they acquire, bond rates and thereby mortgage rates would rise and hurt the US economy.
Is the status of the US dollar as a reserve currency under attack? At the beginning of the twentieth century, the US was already the world's largest economy, but the British pound still accounted for nearly two-thirds of official foreign-exchange reserves held by the central banks. The dollar did not emerge as the dominant currency until after the World War II devastated Europe. Even then, some commodities were still traded in pounds. The dominance of the dollar was possible because it was backed by the sheer size of the US economy and the relatively sound monetary policy.
After the World War II, the dollar with its large and liquid capital markets served as the world's reserve currency, medium of exchange, and a store of value.
There are apparent worrying parallels between the dollar's recent fall and the decline of the pound as a reserve currency half a century ago. The dollar's decline is creating an atmosphere of crisis that the world's bloated currency reserves are crammed with depreciating dollar assets. The dollar is still deeply rooted as a reserve currency for central banks.
According to the International Monetary Fund (IMF), the share of the dollar reserves peaked at 80 per cent in mid-1970s, bottoming at 45 per cent in mid-1990s, and now accounting for 65 per cent, despite widespread fear of a mass exodus from the greenback. If the dollars hoarded by China and the Middle East oil exporters (not included in the IMF estimates) were factored in, the dollar's share would been still higher. (The euro accounts for about a quarter, up from 18 per cent when it was introduced in 1999). The dollar has weathered storms in 1977-79, 1985-88 and 1993-95, despite predictions that governments were about to switch their reserves to another currency.
According to the Bank for International Settlements (BIS), the dollar is involved in 86 per cent of the $3.2 trillion in daily global currency transactions, often as a middle step in exchanges between two other currencies. While this share is down from 90 per cent in 2001, no other currency comes close to that.
The dollar is deeply entrenched in international trade because businesses lower their transactions by dealing in a common currency. Because the US is such a huge trading partner for so many countries, the reserve build-up cannot easily unravel.
In what is construed to be an unusual departure, Director of National Intelligence Michael McConnell briefed the Senate Select Committee in early February of this year on a surprising potential foe: the falling dollar. His testimony went beyond the conventional world of spycraft, and acknowledged concerns about the financial capabilities of Russia, China and Organisation of Petroleum Exporting Countries (OPEC) bloc and the potential use of their market access to exert financial leverage to achieve political objectives. Noting the impact of a weak dollar is having on national security, he said some oil producers such as Syria, Iran and Libya have asked to be paid in currencies other than the US dollar while others such as Kuwait are delinking their currency peg to the US dollar. He emphasized that the US cannot afford to neglect the dollar and thereby give up the global influence that comes from providing the world's key reserve currency.
If history is any guide, a revamping of the global financial system to replace the dollar as a world's primary currency would take several decades and a massive change in the economic landscape.
The writer is a Fulbright scholar and teaches economics and finance at Southeastern University,
Washington, DC