Although a bit ethnocentric in the approach, it’s becoming increasingly important to consider the implications of dollar depreciation in the  global economy. I say this not simply because I’m a citizen of the United States, but because this trend is becoming pronounced enough to warrant specific commentary. And certainly I’m not the only person speaking to this topic, but I do think the American society needs to begin thinking differently about the value of a dollar.

There are an uncountable number of factors that have lead to dollar weakening over the last 20 years: introduction of the Euro, ever increasing US imports, increased US national debt and government spending, free trade agreements of all sorts, Internet commerce, and globalization, just to name a few.

The important question then becomes is this a good thing? The answer depends on who you’re asking and when you’re asking them.

Just last Friday, Saudi Prince Turki al-Faisal, wrote in an article that “The United States has no alternative to oil to meet its massive energy needs and should recognize its energy interdependence with the Middle East“.  Critical to understanding the implications of this statement is the fact that oil is currently priced in dollars. If the value of the dollar decreases, the cost of oil increases inversely for all nations which use the U.S. dollar as their currency (and there are several, including Cuba, although in that case unofficially).

For nations which use other currencies however, there’s a relative change in the price of oil as the dollar depreciates. To use the Euro for a moment, the Euro/Dollar exchange rate is currently $1.462. The price of oil is currently $72.32, and therefore the price of oil for countries in the Euro zone is €49.46.

(72.32/1.462=49.46)

 On March 4th of this year the Euro/Dollar was 1.254 and oil was priced at approximately $55 a barrel. In terms of Euros, that means the price of oil, denominated in Euros, was €43.85.

(55.00/1.254=43.85)

So how is it that a 6 euro increase in the price of oil translates to a 17 dollar increase for the same commodity? For my American car loving friends, this should have caught your attention.

In practice, the price of a currency is dependent on five factors:

1. Changes in Relative Inflation Rates
2. Changes in Relative Interest Rates
3. Changes in Relative National Income
4. Changes in Government Controls
5. Changes in Expectations

This alone is insufficient to really analyze the current situation however. We also have to look at GDP, which is comprised of four factors:

1. Consumer Expenditures
2. Gross Domestic Investment
3. Government Purchases
4. Net Exports

 Let’s take a look at GDP first.

• There has been a decrease in Consumer Expenditures ($133.4 Billion 1Q 2009) and Domestic Investment (down 1% 2Q 2009).
• There has been an increase of Government Purchases. ($1.5 Trillion in TARP/TALF funds and Economic Stimulus)
• There has been a decrease in Net Exports. ($-101.5 Billion 1Q 2009, down from $-154.9 Billion 4Q 2008) [Bureau of Economic Analysis]

 The net effect of this trend was a 1Q reduction in GDP of 6.4%, and 1% in 2Q.

In particular, although Net Exports decreased 50% between 4Q and 1Q, the U.S. still imports more than it exports, or said another way, the demand for dollars continues to decline. With fewer dollars in demand, this increases the price of goods imported to the US and hence we have $72 bbl oil.

Although a metric I’ve not seen used anywhere before, I think it’s important to consider the net effect of imports as a proportion of consumer expenditures.  Net Exports (or really net imports) were 76% of Consumer Expenditures in 1Q. 

 (101.5/133.4=.76)

Even more critical is the idea that this is a measure of gross imports. Total imports for 1Q was $373.4 Billion. If we compared this figure against Consumer Expenditures, the rate is 284%.

With that in mind, the US has some serious questions to consider about its future, but it’s clear that this trend is unsustainable in the context of the global economy, even though an inflection point was reached in 1Q.

Returning to exchange rate factors, there has been considerable debate about whether the US has avoided serious inflation or serious deflation. In the longer term, unless the US garners some discipline over its spending, production, and trade habits, the country faces the threat of increased inflation. Although the Volatility Index (^VIX) has subsided from a high 80 late last year, to a more manageable 25 currently, this only suggests that the country is expecting a sustained decline in the value of the dollar. This isn’t to say the US is the only country in the fiscal lifeboat. A report I read some time last year estimated consumer debt in the UK was 105% of GDP.

Interest rates remain remarkably low all things considered. As we well know however, the ability to obtain loans is substantially diminished. It’s no wonder that interest rates remain low so long as the eligibility to obtain loans remains strict. In the current environment, the Fed and Treasury have a fine path to walk in managing the availability of credit relative to interest rates. Making more people eligible for loans increases risk, and therefore interest rates. Fail to make enough credit available, and both investment and savings decrease.

National Income for the US will likely diminish for the 2009 year, further reducing the country’s Purchasing Power. It’s precisely here where I think the Blue Dog Democrats have it right over most Republicans and several Democrats, in so much as purchasing power is a direct function of the ability to pay for goods and services. If our annual tax revenues are roughly $14 trillion, and the country spends $16 trillion, the purchasing power of the country will be substantial for that year, but in the subsequent years the $2 trillion dollar debt becomes a cumulative weight on national purchasing power; inclusive of both the balance of the principal and the interest. Government bonds have been trading with extremely low yields for more than five years. Even 30 year long bonds are trading at less than a 5% yield. Certainly the risk of covering a 30 year bond in the current economic environment should warrant more than a 5% ROI, but the Fed and Treasury have made a point of trying to supplant interest rates in order to encourage borrowing. This does not however encourage lending. As late as two years ago there were rumblings across the world about removing or diminishing the power of the dollar as the world’s reserve currency, and although in the end I think this is a necessary step to the peaceful continuance of global trade, this doesn’t mean that the US shouldn’t try to bolster the attractiveness of the dollar and American exports.

As a result of the Great Recession, there have been substantial changes in government controls world wide, but with specific respect to the US, new calls for financial regulation will reduce capital flows in the short term. The benefit to this action however is a much more sound platform from which future capital transactions can occur. Done well, and I expect global real GDP growth could reach between 4 and 7% annually by 2012, and US real GDP growth between 5 and 8%.

The net effect of expectations on dollar values relative to other currencies is continued depreciation over the next few years. The opportunity the US has here is increasing its exports. As the cost of dollars declines, the attractiveness of US goods increases. This should be considered an opportunity for companies to shift some labor and manufacturing to the U.S. It should be particularly and increasingly attractive for foreign companies to hire US labor because the cost in their currency to hire US labor will be reduced.

With that in mind, US companies need to innovate and find new markets for new goods. The challenge US companies will face is the direct disadvantage of working in an environment with diminishing dollar/dollar exchanges (as opposed to, for example, Euro/Dollar exchanges). That is to say, because there’s no translation exposure to the benefits of a depreciated dollar for US companies in sourcing US labor and supply, they have to survive on the value of the dollar as it is. By the same token however, US companies have a substantial opportunity to take advantage of the depreciated dollar in terms of foreign sales.

What may go missing in this conversation, and shouldn’t, is the current increased deviation of currency risk. The spread of currency risk is more volatile for the US than perhaps it’s ever been. Some of this risk has already been priced into the value of the dollar relative to other currencies, but it’s not something to be ignored by any government or person. Stable governments and lasting peace rely on stable financial systems and trust. To that end, the side effects of the bitter pill the US swallowed last November will be felt for some time to come, but that’s no reason to ignore the doctor’s prescription for fiscal health.

 

Tags: Currency Valuation :, Euro/Dollar :, Foreign Exchange :, GDP, Net Exports, Purchasing Power, ^ VIX :

This entry was posted on Friday, September 11th, 2009 at 4:50 am and is filed under International Finance, International Management, International Strategy, Introduction to International Business. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.