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Why the dollar is in the dumps
BS Bureau
 
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December 06, 2007

In recent months, the US dollar has depreciated against virtually all major currencies, most significantly against the euro and the pound and, to a lesser extent, against the rupee and other currencies in the Asian region. Why is this happening and what does it mean for the global economy?

The explanation is a simple one. When the supply of a good exceeds the demand for it, its price goes down. So it is with currencies, and that is exactly what has been happening to the dollar.

For many years the US has run a trade deficit with the rest of the world, paying for all those imports with its own currency, which has global acceptance. These dollars floating around in the global financial system should logically have caused the currency to depreciate, were it not for the fact that many of the countries which run a trade surplus with the US were eager not to see their currencies appreciate for fear that that might hurt their exports.

So they created an artificial demand for dollars by accumulating dollar reserves, which, in turn, were mostly held in the form of dollar-denominated assets, mainly US treasury securities. Thus was completed a circle which, in effect, resisted the immutable law by allowing simultaneously a large US trade deficit and a strong dollar.

But this artifice has begun to crumble in recent months and the burden of excess supply is beginning to show. A number of factors are contributing.

One, as a result of high oil prices, denominated and paid for in dollars, there is a new set of countries with bulging dollar reserves. These do not have the same compulsions as the Asian export-dependent economies. They are far more inclined to trade their dollars for other currencies, which they use to acquire assets in other parts of the world.

Two, many of the Asian economies, at least temporarily, stopped accumulating dollar reserves as these exerted enormous pressure on their monetary systems.

Three, some of these countries are also beginning to re-structure the currency composition of their reserves, as they begin to look outside the US for investment opportunities.

Finally, the slowdown in the US economy is pushing investors to look for better returns elsewhere, contributing to a further exodus of dollars from the US.

There is clearly a threat of a self-fulfilling prophecy in this scenario. As the dollar depreciates, many with dollar assets will try and convert these into some other currency, which will only speed up the decline of the dollar. While such a free fall is theoretically possible, it is rather improbable.

As affluent as the Asian economies are becoming, consuming more and trading more with each other, the US still remains a significant export market. In all likelihood, they will resist the appreciation of their currencies beyond a certain point, which imposes a floor for the dollar.

Meanwhile, the dollar depreciation has started to work on narrowing the US trade deficit. Further, foreign investors, particularly from countries whose currencies have appreciated sharply, now find attractive bargains in US long-term assets, such as real estate.

So while the outlook for the dollar is still very much downwards, a combination of market forces and intervention by countries wanting to resist appreciation will slow that movement considerably. Given this, it is unlikely to be highly disruptive.

Indeed, if the US narrows its trade deficit, the dollar may even stage a bit of a comeback.


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