Thursday, October 8, 2009

The Weak Dollar and Forecasts for 2010

This year, the Dollar has continued its long term decline which has been in progress since 2000. Since April the dollar / Euro exchange rate has moved from €1 to $1.3 to €1 = $1.48

Why is the Dollar Weak?

1. US Appears Unconcerned about a weak Dollar.

The big crisis facing the US economy is the recession and unemployment approaching 10%. Though the Americans may not wish to admit it, the depreciating dollar will help their economy recover. The Weak dollar will make exports cheaper and imports more expensive and this will increase domestic demand. If the US government is not committed to maintaining strength of Dollar, markets fear it is more likely it will fall.

2. Large Budget Deficit.

The US has a large budget deficit at close to $12 trillion. With financial bailouts and stimulus packages, the deficit is likely to keep growing. Substantial parts of this deficit is owned oversees. This will be easier to pay back if the dollar is weaker.

3. Inflation concerns.

There is also a concern that a large budget deficit will encourage the US authorities to target higher inflation to 'inflate away the debt' At the moment, inflation in US is very low, and spare capacity means inflationary pressures are limited. However, there will be a temptation to continue quantitative easing which could be inflationary.

4. Global Reserve Currency.

Many countries are not happy that the US dollar is the dominant reserve currency. Countries have so many reserves in dollars, but they see these reserves falling in value because of the weak dollar. Therefore, they want to diversify which is why dollar is falling and gold price is going up.

5. Oil Priced in Dollars.

There have been reports arab countries are considering dropping the dollar as the main currency for trading oil. If this occurs, then there will be less need for dollars as countries use other currencies. This would hasten the demise of the Dollar as a global currency. (demise of dollar at Independent)

6. Trade Deficit.

The US has run a persistent current account deficit, which reflects it has more imports than exports. In the boom years, it could attract capital flows to finance this current account deficit. But, in the post credit crunch era, this is more difficult. The depreciation in the dollar is thus necessary to rebalance the long term current account deficit.

7. The Rise of the Euro and China.

For a long time, the US maintained a powerful economic and political hegemony. But, the US economy iss being eclipsed by China and other emerging economies. Also, the Euro, provides a real alternative to the dollar. The ECB seem much more committed to low inflation and stability of the Euro which makes it more attractive.

Does this mean the Dollar will Collapse?

1. The US don't mind a gradual depreciation, but, they wouldn't want to risk alienating investors through creating high inflation and a rapid depreciation. Also, when the economy recovers the outlooks may change.

2. The budget deficit is large in the US, but, it is not the only country to have a ballooning public sector deficit.

3. It is true, China and other countries want to diversify from the dollar. But, it is equally true, China has so many dollar reserves it has a vested interest in avoiding a collapse in the dollar. A collapse in the dollar wouldn't just hurt the US, it would hurt all the countries who have dollar reserves.

People want to diversify from dollar, but if they do it too quickly they could lose a lot.

1 comment:

Anonymous said...

Thanks for all your interesting, well written and insightful essays. I just started doing Macroeconomics at AS-level and am confused about the concept of 'currency strength'. I have been wondering what causes a currency to be 'strong' or 'weak'?

Also, it was mentioned "Substantial parts of this deficit is owned oversees. This will be easier to pay back if the dollar is weaker." Why?

Also,"encourage the US authorities to target higher inflation to 'inflate away the debt'". Again, Why?

Thanks a lot.