Commentary Type

Will Dollar Revive Following Dive?

Claire Brunel (PIIE) and Doug Dowson (PIIE)

Op-ed in the Omaha World-Herald


Early this year, a major investment bank made its annual currency forecast, predicting that the exchange rates of rich countries would experience "a year of stability."

In the year to date, the Japanese yen and the euro have appreciated against the US dollar by 6 percent and 10.5 percent, respectively, while the Canadian dollar has appreciated by 15 percent. Most importantly, when measured against the United States' major trading partners, the US dollar has depreciated by more than 7.5 percent.

So much for stability.

According to Alan Greenspan, exchange rate forecasting "has a success rate no better than that of forecasting the outcome of a coin toss." While most economists agree that exchange rates are unpredictable in the short term, in the longer term (more than a year or two out), currencies are influenced by macroeconomic conditions such as growth, inflation, and interest rates.

How, then, should we interpret the recent fall of the dollar?

First, the current account deficit of the United States-the difference between the value of US imports and the value of US exports-has grown from 1.5 percent of gross domestic product in 1995 to 6.2 percent of GDP in 2006. In 2006, for every $4 of goods and services we imported from the rest of the world, we exported only $3 worth.

To finance this deficit, the United States borrows money from the rest of the world by issuing large amounts of dollar-denominated debt (such as Treasury securities) and selling US assets. A growing supply of dollar assets that is not matched by a comparable growth in demand will lead to the price of those assets decreasing-and to a dollar depreciation. Indeed, the dollar began depreciating in early 2002, and has continued steadily ever since.

Second, productivity growth in the United States has declined relative to the rest of the world, which in turn has led to a lower expected rate of return for US investments. As these investments have become less attractive, domestic and international investors have demanded fewer dollar assets, thereby causing the value of the dollar to decline.

Third, foreign central banks and other holders of large dollar reserves have been rebalancing their portfolios out of dollar assets to better manage currency risk and increase returns. The most recent data indicates that the dollar now constitutes 65 percent of total foreign reserves, down from more than 70 percent in early 2002, while the euro has risen to account for 25 percent of reserves from 20 percent in 2002.

Since this process of diversification has been gradual, the long-term effects on the dollar have been minimal. But the threat of rapid dumping of the dollar remains.

In early August, rumors that China was liquidating its dollar assets (the so-called nuclear option) generated enough concern to prompt both Treasury Secretary Henry Paulson and President Bush to publicly dismiss the rumor as "absurd" and "foolhardy."

Finally, Kuwait dropped its dollar peg in May, and several other oil-exporting countries are under pressure to abandon the dollar as well in order to help contain rising inflation. If these countries were to suddenly drop their pegs, or just revalue their pegs at higher values against the dollar, it could put additional downward pressure on the dollar.

Adding to these longer-term trends are cyclical conditions both in the United States and abroad. The US economy has slowed amid the subprime mortgage crisis and broader financial pressures. Furthermore, the Federal Reserve began cutting interest rates in September and is expected to continue doing so, putting further pressure on the dollar to depreciate further.

What should we expect for the dollar going forward? In October, the International Monetary Fund stated that "the dollar remains overvalued relative to medium-term fundamentals." This suggests that the dollar will continue to depreciate in the coming months, most likely against Asian currencies like the Japanese yen and the Chinese renminbi.

Others think that the dollar has hit bottom and is well positioned for a rebound in 2008. If major central banks in Europe and elsewhere follow the Fed's lead in easing monetary conditions, and if the relative weakness of the dollar continues to boost US exports, the dollar could be on its way up.

Forecasters at Morgan Stanley predict that the dollar will fall through the next two quarters but then start appreciating again, following a "smile" trajectory. This should boost the confidence of Americans concerned about their lagging currency and bring smiles to the faces of investors with large dollar holdings.

But then again, what do forecasters know?

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