US Dollar Weakness: Now and Afterwards

As a Latin America Monitor blogger I am not expected to write about US economy. But allow me to address some questions about the recent weakening of the US Dollar. I am doing that most likely because as an undergraduate in Brazil in the early 1980s I heard quite a lot about an imminent Dollar crisis and, therefore, the economic decline of the US. Some of my economics professors predicted back then the end of the American economic supremacy. The demise of the economic Empire! I promise to make sure not to make the same prediction and slip into the same pitfall. My mistake may well be another: to predict a vigorous the US Dollar in the near future and make room for my own undergraduate students to mock me in coming years.

According to the BIS’s real and effective exchange rate index, in March 2008 the US Dollar reached its lowest level since the 1960s. This is a statistical fact full of economic meaning. The currency will probably not hit rock bottom just yet, and further depreciation can be expected. Whether or not the weak US Dollar is a response to a weakened US economy is a question yet unanswered, far more than conventional wisdom.

The same thing has happened at least five times since the US authorities allowed the national currency to free float in 1973. In two of those cases, parity quickly appreciated to unprecedented high levels. No one knows how far the US Dollar will depreciate, nor the consequences of this phenomenon.

However, an answer to the question of what happens when the international reserve of value loses confidence will probably be forthcoming. The American monetary authorities will most likely decide to recover the US Dollar’s strength. In the past, they used interest rates to do so and rocked the world in general and developing economies in particular.

From developing economies’ point of view, the main (and huge) difference between now and the last weakening of the US Dollar, in late 1994, and also, most importantly, in the mid 1980s, is the fact that emerging market economies have amassed vast international reserves and there are no financial crises — currency-, banking- or debt-related — looming. Inflation rates worldwide are no that concern, and monetary authorities are much more committed to keeping prices stable. It seems that periphery is no longer the same, and that the center has grown to include China and the importance of the strength of the Euro. Things have changed, and so have the concerns. Still, “all that glitters may not be gold”

Graph 1. US Dollar: Real and Effective Exchange Rate 1964-2008 2000=100

Source: BIS. April 2008.

Meanwhile, America’s trade partners show minor changes only. As shown in table 1, the partners have not changed and nor has their importance relative to the entire US foreign trade. About 75% of total US trade is still done with the same six main partners.

The only news is the fact that from the early 1990s to 2004, China’s and Mexico’s weight as US trade partners grew. And China is the big novelty here. Even with a successful implementation of the new common currency, the Euro area is still as important to US trade as it was in the last decade.

Table 1. Weighting Matrix for Broad Indices (Based on 2002-2004 and 1993-1995) in per cent

Source: BIS

Chart 2 shows that the Euro has appreciated the most. It has been held as an international reserve of value at least since 2006, without any intention to stand as a perfect substitute to the US Dollar. How long will it last? That depends on how far the Euro area will let its trade balance get out of control. No changes have been observed in the US-Euro trade pattern; the Euro area is still the most important US trade partner, despite the important role Chinese trade plays. The recent strength of the Euro may foster the current notion of a shared (perhaps bipolar) international exchange rate regime.

Yet, I stubbornly assume that the Euro area does not care about the international financial architecture. They have their own trade balance concerns to worry about. Also, on the other hand, the America has much to lose in not financing its huge current-account deficits through its deep financial system. It seems that at some point in the future the American monetary authority’s willingness will match its goal of keeping US Dollar as the only international reserve of value. It is a great source of financing for American deficits and nobody in their right mind doubts that. And inflation will matter as soon as the recessive outlook fades.

What, then, are the major determinants of the US Dollar’s weakness? The primary answer is the US slowdown. How far the depreciation will go on? Surprisingly, the answer is not associated with the US economy’s recovery but with both the US inflation and its willingness to recover the currency’s prowess.

When inflation becomes the main concern instead of recession, interest rate will be raised and regardless of America’s economic performance, the US Dollar will climb back up. But something could be wrong with this analysis, because inflation will only come with improved economic performance. Maybe.

I also would consider the role played by the persistently high level of the commodities prices, something not so closely associated with US economic activities. In this front, Chinese economic performance matters, as does a rational response from investors by assigning a growing share of their portfolios to commodities. But this is a topic for my next piece.

Graph 2. Four Major Currencies: Real and Effective Exchange Rates 1964-2008 2000=100

Source: BIS