How Low can the Dollar Go

 

27^th July 2007

The Malta Independent - Friday Wisdom

The value of the US dollar in the foreign exchange market has been falling like a stone and this week touched a record of over 1.38 dollars per euro. This time last year it was about 1.26 dollars per euro, meaning it has dropped nearly 10 per cent over the last 12 months.

The US dollar is a freely traded currency and its value is fixed by the market. It is the most important reserve currency offering international liquidity to finance international trade. Central Banks hold the largest portion of their reserves in US dollars and international commodities are generally priced in US dollars.

There is pretty little that monetary authorities can do to influence the value of their currency on the foreign exchange markets, although they do sometimes attempt to influence the markets by direct or verbal intervention.

Why should we care whether the dollar rises or falls? Simply because we import a lot of stuff priced in USD, most notably all our energy requirements, so the value of the dollar has a direct impact on the Maltese lira (or euro) cost of such things as vital to our life as fuel for our cars, machines and electricity generation or wheat for our daily bread.

The more the dollar falls, the cheaper in Maltese lira terms will be these important imports. So the fall in the US currency foreign exchange value has some benefits. The problem is that there seems to be some direct correlation between the dollar price of these commodities and the US dollar value and as the dollar falls, the price of oil and commodities goes up. Commodity prices are subject to their own demand and supply mechanism, and it is difficult to argue that their price movements reflects US dollar fluctuations. It is more likely that the value of the USD is influenced by commodity price movements, and US authorities adopt an unofficial policy of benign neglect for the US dollar value more willingly when commodity prices are shooting up rather than at times of commodity price stability.

The value of the USD is not fixed by the markets in isolation. If the dollar falls on the foreign exchange markets, then some other currencies are compensating by rising in value. Recently it was the euro, the pounds sterling and the Canadian, Australian and New Zealand dollars that had to act as a counter-balance for the depreciation of the US dollar. On the other hand, the Japanese yen has itself lost value against the USD and consequently has depreciated more aggressively against the other currencies. Other currencies that are benchmarked or pegged to the US dollar, especially the Chinese currency, have broadly moved in sympathy with the US dollar.

Why have currencies behaved so differently in so far as their US dollar values. For those currencies that are not freely convertible, especially the Chinese renminbi, the move in sympathy with the US currency is the direct result of administrative decisions by the monetary authorities of the respective currencies. As the economy grows and efficiency gains are made, this creates financial problems of its own in their domestic economies, particularly regarding price stability, and therefore countries that grow the way China is growing have to shift gradually to a freely traded currency status.

The value of other currencies that are freely traded are influenced by their level of the rate of interest and their position on the economic growth cycle.

So the Japanese yen has fallen against the USD dollar as Japanese interest rates are still very low and their economic growth following a decade of deflation is still fragile, as it is dependent on such low exchange rate for the yen to keep propping up demand for Japanese exports.

The strength of the Canadian, Australian and New Zealand dollars against the US dollar is because these currencies have a high rate of interest needed to control domestic price pressures resulting from resource-based economic growth. These countries are blessed with natural resources the price of which has exploded and resulted in strong economic growth, leading to excess demand over the productive capacity of these economies.

The enigma is more related to the euro. Why has the euro increased so much in value against the US currency, when interest rates in euro are below those of the US dollar in spite of narrowing differentials? The growth in the euro area is stronger than in the US but not by much to justify a 10 per cent relative change in just 12 months. So why are the markets pricing up the euro so aggressively against the US dollar?

I can think of two reasons for this. The euro is gracefully establishing itself as an international reserve currency second only to the US dollar. The more the US dollar falls, the more motivation international central banks will have to diversify their resources away from the US dollar, thus creating additional demand for the euro and additional supply of the USD as a direct result of such portfolio shifts rather than as a result of normal trade flows. The second reason is that European monetary are not totally displeased with the euro’s strength, as it neutralises the increase in the US dollar cost of energy and commodities.

But there is a limit as to how much the euro can go up and how much the US dollar can fall. And this week we must have come very close to that limit. Further increases in euro value in dollar terms will start hurting European export potential and will give more credence and support to French President Sarkozy’s claim that the European Central Bank cannot continue operating monetary policy in total disregard to the euro’s external value. If the euro remains this strong, the European Central Bank will be hard put to justify further euro interest rate increases. The bond markets can sigh with some overdue relief.