Dissecting the Declining Dollar
By Luke Mullins
Posted March 7, 2008
As any American who's recently been to Frankfurt can tell you, the bratwurst is as tasty as always, but it sure is expensive! The sticker shock, of course, has less to do with the quality of the pork than the eroding value of the U.S. dollar vs. the euro, as well as the Japanese yen. The greenback has been slipping in value since 2002 but has hit historically low levels in recent days. U.S. News explores the reasons behind the dollar's dive and the outlook for the future.
How weak has the dollar become?
The dollar recently made record lows against the euro, while hitting its lowest level against the Japanese yen since 2005. At the same time, the U.S. dollar index—which measures the greenback against a basket of other currencies—has declined about 4 percent this year and roughly 12 percent since the end of 2006.
What's causing the decline?
• Central banker disunity. There are a host of factors behind the decline in the dollar, not the least of which is the divergence of U.S. monetary policy from the rest of the world's. In the face of slowing economic growth, the Federal Reserve has moved aggressively to lower interest rates, slashing the federal funds rate to 3 percent from 5.25 percent in September. But other central bankers have been much less willing to follow suit, amid concerns about inflation. The European Central Bank, for example, has maintained its key interest rate at 4 percent, while the Bank of England's rate stands at 5.25 percent. "The fundamental factor driving the dollar down is interest rate differentials between the U.S. and its major trading partners," says Adam Hewison, a former currency trader and current president of INO.com, a financial trading strategy website.
• Slow growth. Flagging economic growth in the United States has hurt the dollar as well. "If you are going to have slower growth, there should be less of a demand globally for U.S. dollars," says Joseph Brusuelas, chief U.S. economist at IDEAglobal Inc.
• Fed outlook. Furthermore, sluggish growth increases the likelihood that the Fed will continue its rate-cutting campaign, putting additional downward pressure on the dollar. "The Fed has cut rates significantly—225 basis points—we think they'll [cut]...before it's all said and done, down to 2 percent," Brusuelas says. "And that is dollar negative."
• Credit contagion. David Resler, chief economist at Nomura Securities, says the housing-triggered credit crisis is another key factor behind the dollar's dip. "It weakens the dollar because it discourages investors from buying dollar-denominated assets," Resler says. "That's led to a kind of reluctance to invest in the U.S. markets."
• Trade gap. The ongoing trade deficit for goods and services—which stood at more than $700 billion in 2007—has played a role as well. Although it has narrowed recently, the gap works to increase the supply of dollars in the global financial system, which pulls the currency lower.
• Currency diversification. Ken Mayland of ClearView Economics says that world central banks' efforts to diversify some of their reserve holdings out of U.S. dollars and into other currencies—such as the euro—have also contributed to the decline. "The profound weakness of the dollar over the past year only further encourages the desire to diversify more," Mayland says.
So what's ahead for the dollar?
With the outlook for growth deteriorating and the Fed poised to cut interest rates further, greenback watchers don't see the dollar's decline turning around anytime soon. "We expect the dollar to be rather weak this year, especially through the first six months of 2008," Brusuelas says. Meanwhile, Michael Englund, the chief economist at Action Economics, says the dollar could experience a two-year-long downward trend before hitting bottom. The trough will occur at the start of the next period of economic expansion in the United States, Englund says.
What does a weak dollar mean for the economy?
The currency weakness can hit the U.S. economy in the form of inflation, as imports become more pricey in dollar terms. "For example, Chinese products are getting more expensive at the Wal-Mart," says Peter Morici, a professor at the University of Maryland's business school. The falling dollar is also fueling speculation in commodities like oil, another source of inflation that is sapping U.S. consumer buying power. But it's not all bad news. By making American products cheaper overseas, the soft dollar has increased demand for U.S. exports around the world. As a result, exports have emerged as the silver lining in the otherwise cloudy U.S. economy. "It's a powerful shock absorber for the economy," says Englund, who calls the weak dollar a "net positive" for growth in the U.S. economy.
Surplus to Deficit in just Four Years
In a blistering 2007 essay in Vanity Fair, Nobel laureate Joseph Stiglitz, a former World Bank economist, notes that Bush took a nation with a budget surplus upon assuming office and turned it into a global debtor, and he has underinvested in education and alternative energy. "In breathtaking disregard for the most basic rules of fiscal propriety, the administration continued to cut taxes even as it undertook expensive new spending programs and embarked on a financially ruinous 'war of choice' in Iraq. A budget surplus of 2.4 percent of gross domestic product (GDP), which greeted Bush as he took office, turned into a deficit of 3.6 percent in the space of four years. The United States had not experienced a turnaround of this magnitude since the global crisis of World War II," Stiglitz writes. "Up to now, the conventional wisdom has been that Herbert Hoover, whose policies aggravated the Great Depression, is the odds-on claimant for the mantle 'worst president' when it comes to stewardship of the American economy. The economic effects of Bush's presidency are more insidious than those of Hoover, harder to reverse, and likely to be longer-lasting. There is no threat of America's being displaced from its position as the world's richest economy. But our grandchildren will still be living with, and struggling with, the economic consequences of Mr. Bush."
If the passing of American hegemony happens, it will occur very slowly--death by a thousand cuts of credit. One reason why it's so hard for Americans to contemplate their loss of prestige, symbolized by the fall of the once-almighty dollar, is that politicians and pundits tend to cast the issue as all-or-nothing. What would happen, they say, if China suddenly decided to dump the trillion dollars of U.S. debt it holds in reserves? This, however, will almost certainly never occur. While China and other big dollar-holding countries such as Singapore, Russia and the Persian Gulf states are very worried about the erosion in value of their dollar-denominated holdings and inflationary pressure, they also know that an abrupt move to cut their pegs to the dollar or to sell off in large amounts would force a run on the currency. That would leave them even poorer. Instead these countries are pursuing careful reallocations of their investment holdings, shifting slowly to the euro or a "basket" of currencies that will allow them to hedge against the dollar's decline. Credit will become more expensive, the U.S. economy will find itself increasingly crimped, and America's ability and willingness to act as the defense umbrella to the world will gradually peter out. The effect will be more like a slow-acting poison: drip, drip, drip.
But the financial world order is such a precarious house of cards today that the markets are getting increasingly jittery. Markets operate on confidence. And today's markets seem to have little confidence that the Bush administration can emerge from its economic never-never land, one in which as Dick Cheney's first-term pronouncement that "deficits don't matter" was allowed to stand unchallenged, in which zero-saving Americans continue their profligate spending habits and descent into deeper indebtedness by simply assuming the rest of the world will continue to fund those habits. "The American consumer is dramatically overleveraged," says Bob Hormats a vice chairman of Goldman Sachs International. That "means we have to borrow roughly $3 billion a day from rest of world. That inflow is now slowing down. Foreigners will say 'we're concerned about lending in dollars, so we're going to be more cautious about lending money to you.' At some point, if we get a lot less money, the dollar will plunge and interest rates will go up." Even wealthy Americans, Hormats notes, are beginning to ship their money abroad, to Europe and Asia, to hedge the dollar.
We should be careful, of course, not too pronounce the death of Pax Americana too quickly. That has been done before. The illness need not be terminal: deficits can be cured, and foreigners still crowd cargo containers and the backs of trucks to sneak into the land of opportunity. (China, by contrast, is not undergoing an immigration debate.) But the country is in such a fiscal hole right now that, as David Walker, the comptroller general of the United States, told my colleague Jeff Bartholet last week, "You could decide not to renew the Bush tax cuts, you could eliminate all foreign aid, eliminate all earmarks, eliminate NASA, eliminate the National Endowment for Humanities and eliminate the entire Defense Department tomorrow, and you still wouldn't solve the problem." This most critical of issues has barely made it into the presidential debates. The drooping dollar is driving it to the public's attention, particularly as gas, oil and other essentials continue to go up in price. Perhaps the next president, whoever he or she is, ought to pay more attention, too.
The Declining Dollar
Kate O'Sullivan
CFO Magazine, February 1, 2008
For every penny the euro increases against the dollar, United Technologies Corp. records an additional $10 million in earnings. A diversified manufacturing behemoth that earns more than 60 percent of its revenues outside the United States, UTC received an earnings boost of about $100 million last year as the dollar slid against the euro — and slid, and slid a little more. Despite its far-flung revenue streams, the company has never done any financial hedging, says vice president of accounting and finance Greg Hayes. Instead, UTC relies on what are essentially operational hedges: ensuring that it manufactures its products in the markets where they are sold. "The key is to manufacture locally and not put yourself into situations where you're affected by things you can't control, like foreign exchange," says Hayes.
With the dollar at its weakest point in a decade, protection against currency risk looms ever larger on the CFO's agenda. For U.S. manufacturers selling into Europe, the dollar's decline has been a boon, allowing them to accelerate overseas growth and boost earnings by 5 or 10 percent. But for other companies, particularly those based in Europe, the prospect of a permanently weaker dollar has heightened the need to diversify their operations, causing some to consider moving manufacturing facilities to a suddenly lower-cost United States. In Asia, rapidly rising currency values have CFOs thinking about ways to protect the margins on their extensive U.S. sales.
While companies have long used financial hedges for short-term currency problems, the fact that businesses are changing their operations in response to the dollar's fall suggests they suspect that the greenback's weakness may be a long-term phenomenon. According to the most recent Duke University/CFO magazine Global Business Outlook Survey, a stunning 50 percent of Europe's CFOs and 60 percent of Asia's think the decline in the dollar represents a permanent devaluation. A third of their U.S. counterparts agree.
"I think it's a fundamental adjustment," says Charles Kane, CFO of investment firm Global BPO Services and a lecturer on international finance at the MIT Sloan School of Management. "There are a lot of factors driving the dollar down." And it could fall still further, for example, if the oil-exporting countries decide to peg oil prices to another currency or to a basket of currencies.
Even those who say the dollar will bounce back are moving to protect themselves from the downside or to take advantage of its current underdog status. "The dollar has fallen too far too fast, at least relative to the euro," says Scot Carlson, former CFO of Black Diamond Equipment, a small climbing- and ski-equipment manufacturer based in Salt Lake City that sells one-third of its product in Europe but manufactures in the United States and China. Still, he says, "to be a global player, it has become increasingly important to hedge your bets."
Seizing the Day
Not that a sagging dollar is altogether bad news. The earnings benefit for companies with overseas sales is undeniable. According to the Duke/CFO survey, half of U.S. CFOs with significant international sales have seen a benefit from the dollar's decline.
For Compact Power, a small manufacturer of landscaping and construction equipment based in South Carolina, the falling dollar has meant a rapid rise in the company's overseas sales. The $100 million company began selling internationally two years ago, has doubled its international sales in the past year, and plans to double them again in 2008. "We've absolutely accelerated our international growth because of the exchange rate," says CFO Norman Boling. "The falling dollar has made us competitive in markets where we're up against established competition."