Thursday, July 26, 2007

When will the dollar stop falling?

During 2007, the dollar has continued to fall reaching $2 = £1. With the continued devaluation of the dollar, many wonder how long it will keep occurring/

Reasons why dollar may continue to fall.

  • Large current account deficit. Currently around $700bn this is causing outflows of dollars to buy Asian (and Chinese goods). This increased supply of dollars, drives down the price. Whilst a deficit of this magnitude remains, downward pressure on the dollar is likely to remain.
  • Sobering thought. – To halve the deficit would require another 20% devaluation
  • US Dollar losing its Status as Reserve Currency.

Traditionally, (since the demise of Pound Sterling) the US dollar has been the number 1 currency of choice. This means various countries and investment banks are willing to hold dollars for a comparatively low rate of return. If people lose confidence in the dollar as the number one currency, they will lose the incentive to keep buying US debt and holding dollar securities.

Furthermore, US creditors could start cashing in their cheques, causing a further fall in the value of the dollar.

The US is losing its status as a reserve currency for various reasons:

  1. Loss of confidence in US economy – especially housing market
  2. Loss of political confidence. Invasion of Iraq had proved deeply divisive and has tarnished America’s reputation.
  3. Rise of the Euro as an alternative.

Reasons why dollar may not fall.

  • Some argue the US current account deficit occurs because Asian investors are willing to buy US securities. Basically, the huge surplus on the financial capital account enables the US to have a large current account deficit. Not the other way around. Therefore, many including some in US treasury argue a deficit need not cause devaluation, in the era of capital mobility.
  • The US dollar is becoming very cheap. For Europeans buying goods in America is very cheap. My Mac cost $1,000 in America. This equals £500 with the current exchange rate. If I had bought same Mac in UK, it would have cost £900. Such imbalances in purchasing power would suggest the dollar has fallen enough.
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