Reasons for the Movements in the Value of the US Dollar Against the Pound - Essay Example

Reasons for the movements in the value of the US dollar against the pound since January 2005 Introduction Since 2005, the dollar has lost almost hundred per cent of its value against the Euro, one-third of its value against the British pound and Japanese Yen, and almost one- fifth of its value against the Canadian dollar. All in all the U.S. dollar declined against all 16 major currencies except the yen as global stocks advanced, reducing traders' demand for safety in U.S. government debt (Zeng, Nielsen 2007). Less dramatic, but also worrisome, are declines against the currencies in major industrialized nations such as Australia, China, and Japan. The world currently undermines the importance of the dollar depreciation over the other currencies. However, it is not secret that dozens of countries all over the world including Great Britain define the value of their currencies through a fixed exchange rate with the dollar. Many others, especially in Asia, keep their currencies tightly linked to the U.S. currency (Altman, 2004) Much of the world has come to realize that the dollar's value is steadily being undermined. But few Americans understand that the government along with the Federal Reserve is accomplishing the undermining. And few also realize that the main cause of the continuing failure of the American dollar is federal indebtedness brought on by virtually uncontrolled federal spending. Responding to the vast hole they have dug for all Americans, the US leaders have paid the nation's bills by borrowing from almost every corner of the globe and by creating more currency out of nothing (inflation). According to the statistics from 2006, the YS current-account deficit equals $857 billion that is absorbing the major part of the world's capital outflows. To finance this constant deficit, the United States has accumulated trillions of dollars of foreign debt, depreciating their currency, the dollar, and appreciating other world currencies. Current paper looks at the trends and implications of the "cheap" US dollar and its effects on the world major currencies, emphasis the British pound. Causes of the dollar decline Since the introduction of the euro in 1999, the US experiences severe balance of payments deficits on current account. The biggest deficits were with China and Japan. However, in order to protect their export competitiveness, both China and Japan followed macroeconomic policies that would maintain fixed exchange rates between their currencies and the US dollar. In order to accomplish this result, both China and Japan had to intervene in the foreign exchange market by buying up massive amounts of US dollars while selling corresponding amounts of their own currencies, the Chinese Yuan and the Japanese yen. These purchase showed up as capital inflows into the US. However, as the US continued to maintain historically low interest rates to stimulate its domestic economy, some critics wondered if China and Japan would continue to hold so many US dollars (Eiteman, Stonehill, Moffett 2007). As a result of extensive US exports, the country has become the world's largest debtor, rather than the world's largest creditor, the position it held in earlier years. Net foreign purchases of US securities have retreated from their peak in 2001, while the US balance of current accounts has worsened, as show in Figure 1. Figure 1: Balance of US current account 1960-2001 According to APF Business news1, the US balance of payments deficit narrowed in the second quarter to 190.8 billion dollars from 197.1 billion in the first quarter, the Commerce Department reported Friday. The US current account figure, roughly in line with analysts' forecasts, represented 5.5 percent of US economic output or gross domestic product. For the first quarter, the current account deficit was revised up to 197.1 billion dollars or 5.8 percent of GDP. The improvement in the current account deficit, the broadest measure of trade and income flows, suggested some easing of balance of payments -- the huge debt the United States owes the rest of the world. The large deficit is a factor in the weak dollar, and a big debt to the rest of the world generally makes in harder to attract capital. Paul Ferley, economist at RBC Capital Markets, said the deficit seems to be showing some improvement with a weak dollar helping boost US exports. This means trade may offset some other weak sectors of the economy such as housing. Robert Brusca at FAO Economics said the deficit remains a problem for the economy at these levels. "While the US current account deficit has shrunk a bit relative to GDP it is still quite large and above the five percent trigger point may see as line of adverse demarcation for other countries," Brusca said. "The future for deficit contraction is still not clear." The report showed the second quarter trade deficit on goods and services was almost the same as in the first quarter at 177.7 billion dollars. The deficit on goods increased to 204.2 billion dollars, offset by a surplus in services of 26.5 billion. It was higher investment income and lower US government spending abroad which accounted for the current account improvement the Commerce Department said. Investment income increased to 190.3 billion dollars from 175.5 billion, mostly on interest and dividends. Foreigners shifted to being net sellers of Treasury securities, with a decline of 7.6 billion dollars in the second quarter. In non-Treasury securities, however, net foreign purchases rose to 235.1 billion dollars in the second quarter from 112.3 billion in the first. The category of "unilateral current transfers" to foreigners fell to 22.5 billion dollars, down from 27.0 billion, because of lower US government grants. As the result of the current account deficit in the US, the dollar fell 0.5 percent to $1.3688 per euro at 9:30 a.m. in New York, and earlier touched $1.3719, the lowest since Aug. 9. The U.S. currency also declined 0.3 percent to $2.0180 per pound and weakened 0.7 percent against New Zealand's currency. For the month, the dollar was little changed against the euro and gained 0.7 percent versus the pound (Zeng, Nielsen 2007). The U.S. currency fell 0.2 percent to $1.9661 per British pound, 0.5 percent versus the Australian dollar and the Canadian currency. The dollar touched 80.83 U.S. cents per Australian dollar, the lowest since December 1996, and a three-month low of 86.72 U.S. cents versus the Canadian currency. I The dollar also pared its gains against the yen to trade at 117.53 yen, falling from an intraday high of 117.95 before the Fed statement. The Japanese currency dropped against all 16 of the other major currencies tracked by Bloomberg including the euro and the pound as a global stock rally pushed investors to return to the so-called carry trade by buying higher-yielding investments funded by yen-denominated loans. Movement trends Even though the US deficit could continue to grow, a variety of economic shocks could spark changes in global trade, consumption, and savings patterns that might eliminate the US current-account deficit by 2012. US consumers may be forced to save more as the housing boom ends, for example. Asian countries might boost domestic consumption, perhaps through increased spending on education and health care, and save less in the form of US securities. Such changes would increase the supply of and lower demand for the US dollar, causing its value against other currencies to fall. Mc Kinsey analysis suggests that a 30 percent depreciation of the dollar from its January 2007 levels would fully balance the US current account by 2012. A smaller decline-of 20 to 25 percent from January 2007 levels-would reduce the deficit to roughly 2 to 3 percent of GDP, which many economists feel is sustainable (Farel, Puron, Remes 2005). A 30 percent trade-weighted depreciation of the dollar could play out in multiple ways. Historically, currencies have rarely moved evenly against one another. Since 2003 the dollar has fallen in nominal terms by 19 percent against the euro, 22 percent against the pound, and 6 percent against the renminbi while gaining 5 percent against the yen (Cline 2005) It is therefore considered three ways that the dollar might depreciate using 2005 data as our baseline (Figure 2). In the first, the dollar depreciates evenly by 33 percent against all other currencies2. In the second, Asian countries abandon their de facto peg to the dollar and their currencies appreciate more than other global currencies. In the third, Asian countries maintain their de facto dollar pegs and the dollar depreciates only against the euro and other world currencies such as the Canadian dollar and Mexican peso. Figure 2: Variations of dollar depreciation Source: McKinsey Global Institute analysis In any of these cases, even with a balanced current account in 2012 the US trade deficit in goods would remain quite large-around $720 billion, roughly today's level. However, the United States would export more services and earn more income from overseas investments. Indeed, rather than being a large net debtor, owing about 46 percent of GDP, the country would be a significant net creditor, with claims equaling some 28 percent of GDP. The factors underlying this dramatic reversal are the same ones that limit the accumulation of net foreign debt today: the positive spread between the interest that the United States earns on its foreign assets and what it pays on its liabilities, as well as the appreciation of US assets abroad (in this case accelerated by a depreciation of the dollar). Dollar-Pound movements Figure 3 shows data for British direct investment in the United States and the dollar/pound exchange rate. Figure 3: British direct investments in the United States, Dollar/Pound exchange rate index Source: U.S. Department of Commerce Over the 1998-2005 period, the pound appreciated against the dollar until 2001, when it has trended down as the pound depreciated slightly through 2004. From 2004 through 2005, there was little change in the dollar/pound exchange rate. As the pound appreciated against the dollar between 1998 and 2001, British direct investment tumbled sharply in 1999 and 2000, in concert with the slowdown in the rate of growth of U.S. GDP and the height of the value of the pound against the dollar. Since 2002, British direct investment dropped again in 2003, before showing some resurgence in 2004 and 2005, even though the pound generally depreciated against the dollar. The following graph shows the dollar/pound movements during the last months: Figure 4: Dollar/Pound exchange rate index today As we see, the dollar/pound exchange rate was different as from the April 30, 2007 till the August 24, 2007. During the period of 120 days, the maximum depreciation change of the US dollar against British pound equals 5% with 1 GBP equaling to $ 1.9608 US dollar in April 9 and 1 GBP equaling $ 2.0626 US dollar in July 243. Pound in relation to other currencies According to Bloomberg (Worrachate 2007), the pound rose against the euro as gains in European stocks prompted investors to resume buying higher-yielding currencies with funds borrowed in Japan. The pound held near a three-week high against the euro as signs of stability in financial markets revived investors' appetite for riskier assets. Futures traders are betting the Bank of England will leave interest rates unchanged this week, while the Bank of Japan will delay raising them and the Federal Reserve will cut them in September. "The pound is gaining ground as the market appears to have stabilized a bit,"' said Ian Stannard, a London-based senior currency strategist at BNP Paribas SA. "Carry trades have resumed, and that supports high-yielding currencies. But this could be short-lived though as bad news might not be over." Against the euro, the U.K. currency rose to 67.46 pence per euro from 67.60 pence on Aug. 31. It also reached 233.82 yen, from 233.49 yen. The pound fell more than 3 percent against the yen in August, the biggest decline since August 2004. It traded little changed against the dollar at $2.0179, after reaching a three-week high of $2.0233 on Friday. European stocks rose for a fourth day. Barclays Plc, the U.K.'s third-biggest bank, rallied after saying losses from failed debt funds probably won't exceed 75 million pounds ($151 million). The U.K.'s benchmark interest rate at 5.75 percent is the highest among the Group of Seven economies. That has helped the pound appreciate nearly 5 percent against the yen and almost 6 percent versus the dollar in the past 12 months. Effects of a "cheap" dollar The emerging macroeconomic threat to the world economy is generalized deflation. The fall of the dollar (mainly against the euro) will, as everybody notes, make American producers in world markets more competitive, and thus have some short-term buoying effect on the American economy. And low American interest rates with large fiscal deficits may provide further stimulus. However, because of a fundamental asymmetry in the world's money machine, coping with deflation in other industrial economies is much more difficult. In a deflationary world, each foreign government is paranoid about having its currency appreciate against the dollar with a consequent loss of mercantile competitiveness against its neighbors. So its central bank intervenes to buy the "excess" dollars from private holders. For example, the Bank of Japan has intervened quite massively in 2003 and earlier to sell yen for dollars in a desperate attempt to prevent the yen from appreciating--buying US$34.4 billion in May 2003 alone. Japan's official foreign exchange reserves now total an amazing half trillion dollars. The People's Bank of China has been selling yuan for dollars so that the recent run-up in its exchange reserves, which are now more than $300 billion, has been proportionately faster. And each central bank is more or less forced to cut interest rates to stem the conversion of private dollar assets into yen or yuan. The Bank of Japan has cut the short-term interest rate in Japan's money market to virtually zero. However, if either of these intervention efforts were to break down, with a sharp appreciation of the yen or the yuan, the deflationary impact would be substantial in Japan or China. The other major player, Western Europe with its new euro, is a huge economy somewhat better--but not completely--insulated from the dollar standard. Its foreign trade and international lending is denominated in its home currency, the euro. Traditionally, the European Central Bank does not intervene to keep the euro stable against the dollar and has been more sanguine, and probably too willing to ignore, the deflationary impact of the rise in the euro over the past two years from about US$.85 to US$ 1.17. True, on June 5, it cut its interbank rate sharply down to 2 percent partly in response to the euro's rise. But that might be too little and too late--given the weak state of the German and French economies. A direct effect of dollar depreciation is a rise in the dollar prices of imported products and services whose foreign-currency prices do not change. If everything else were unchanged, continuing depreciation would thereby create continuing inflation. However, everything else is not unchanged. Given the nominal prices of non-imported goods and services, dollar depreciation raises the relative price of foreign products. Changes in relative prices, however, do not cause inflation. Inflation refers to a rise in the overall average level of prices. Given the rate of inflation, a change in relative prices means extra- large price increases for some products, along with smaller priced increases - or actual price reductions - for other products. A rise in the relative price of imported products does not feed into inflation if nominal prices of other, non- imported products rise less rapidly. Why would these other prices rise less rapidly For two reasons. First, other prices rise less rapidly after currency depreciation because increased spending on imports leaves less income available to spend on domestic products, reducing demands for those products, and reducing (or scaling back increases in) their prices. Second, monetary policies may effectively target overall inflation, so that a change in the relative price of imported goods implies an extra- large increase in the nominal prices of imports along with extra-small increases (or decreases) in the nominal prices of other goods. A similar argument applies if monetary effectively targets nominal. This statement applies to depreciations that are not themselves the result of higher inflation. Also, this statement assumes that the demand for imports is inelastic, which is true (at least in the short run) in the United States. This statement does not always apply to smaller countries that depend more heavily upon imports (because the larger share of imports tends to make import -demand more price-elastic.) income. In that case, an increase in the relative price of imports may raise the price level slightly because higher import prices reduce overall real income. However, imports are a small fraction of the total U.S. economy. Consequently, even a large dollar depreciation, as in the past two years, does not lead to a large fall in U.S. real income. So a monetary policy that targets U.S. nominal income would permit only a small rise in the nominal price level. This conclusion would differ for a small country that relies heavily on imports and a monetary policy targeting nominal income; that small country would see an overall price level increase as a result of currency depreciation. The evidence for smaller, economies with large international- trade sectors supports this conclusion. However, because the United States has a large economy with a fairly small share of international trade, the real- income effects of changes in its terms of trade are sufficiently small as to play little role in explaining U.S. inflation. The second reason that the evidence does not support the idea that dollar depreciation creates inflation involves the underlying causes of that depreciation. When depreciation of the dollar reflects an increase in expected future inflation (as it may now, perhaps reflecting concern about the federal government's long-run fiscal position), then a subsequent increase in inflation may appear to result from that depreciation. However, both the deprecation and inflation actually reflect the same underlying change in conditions. Statistical analysis would - correctly - show no connection between depreciation and subsequent inflation if that analysis included other factors (such as past rates of inflation and past increases in interest rates and oil prices) that reflect the increase in expected inflation. Implications, policies and future trends The lower value of the dollar means that the value of returns from US assets are reduced as well, which would leave the overall rate of return on such investments unchanged.9 In one study, two economists argue that an appreciation of foreign currencies relative to the dollar could boost foreign direct investment in the United States, because the appreciation leads to increased wealth for foreign firms relative to their U.S. counterparts and greater access to low-cost funds in local markets.10 Another economist argues that appreciation of the yen in the 1980s provided some impetus for Japanese firms to increase their direct investments in the United States, because the appreciated yen lowered the price of certain firm-specific assets, such as technology and managerial skills, but that it did not necessarily improve the nominal returns to Japanese firms.11 Actual and expected changes in the exchange rate of the dollar may well influence the timing and the magnitude of foreign investors' decisions, but little research has been done on this issue. Policies for the United States For US companies and government leaders, economic common sense is surely the wisest course. The main emphasis should be placed on the genuine potential industries where the country is leading such as high tech sector for example. US will improve its current account deficit if it will focus on the exports of he products from this sector; it produces not only computers and semiconductors but also components for a wide range of goods, such as surgical instruments and medical devices, office equipment, farm and construction machinery and vehicles, and air-conditioning and heating systems. Development of the high-tech sector will require the US to provide an environment that facilitates innovation. Competition is vital, as is the free flow of ideas across companies and borders. Since the terrorist attacks of September 11, policy changes prompted by national-security concerns may have jeopardized this flow. The long delays in approving visas for highly skilled foreign workers and graduate students are shortsighted. Policies that discourage investment by foreign companies in the United States also will do more harm than good. Service businesses in the US should be ready to increase their exports to the UK and Europe by fostering their offerings according to the needs of local markets consumer preferences. Other companies should consider what other services they might provide. US trade negotiators can pursue reaching global agreement on the removal of tariff and non-tariff barriers to trade in services, and policy makers are encouraged to initiate broader long-term efforts to break down the language and cultural differences that constrain the growth of service exports. Foreign-language study, for example, should receive more emphasis in US schools. The US current-account deficit could continue to grow for at least the next five years. When the adjustment does take place, it is more likely to be gradual than abrupt. Still, a major depreciation of the US dollar and large shifts in global consumption and savings are possible. Governments, business leaders, and investors around the world should prepare for the potential effects. One the US current account deficit is balanced, the US will stop depreciating and will gain its lost over the past couple of year value. Future trends The major trends expected for the following couple of years is that the United States current account will run deficit. That is what the dollar will continue to depreciate and British pound will continue to increase in value over the US dollar. However the investments in the US economy are expected to grow. This is due to the foreign investors' appetite for dollar assets dominating over many past years. United States has offered better returns on financial assets and business investments that have other mature economies, such as Europe and Japan, along with lover volatility and better institutional protection than can be found in emerging markets. There is no prediction to expect that today's global trade, consumption and investment will persist in the future. The imbalance in the US foreign trade will require the country to save more and consumer less while other regions such as Asia, Canada and Europe will consume and import far more than they do today. As imports will become more expensive for consumers in the US, companies around the world will intensify their sales efforts elsewhere and lessen the global focus on the US economy. In this way the dollar will not depreciate so extensively but will align in the value with other currencies including British pound. The US runs a trade surplus with Great Britain in many services today including business services (such as accounting, computer and information consulting, and financial services), education, telecommunications, and travel. If the dollar will continue to decline and US services will become even cheaper for Europeans and British people, these surpluses will more than triple in value4. After depreciation of the dollar against the British pound, the US trade deficit in goods with Great Britain would shrink but not disappear. Two-thirds of the improvement would come from increased US exports to the UK - particularly of machines and other goods, such as farm and construction equipment. Also, US imports of manufactures goods would decline. The prudent course for the UK businesses that are executing transactions with the US is to prepare for an adjustment of the US deficit, whether that happens gradually or suddenly. British companies should prepare for the possibility that they will face new, more cost-competitive US entrants, possibly by continuing differentiating their offers. In general, the companies will also find the US a more attractive place to build manufacturing and R&D facilities to serve its markets. Conclusion A simple argument suggests that dollar depreciation may cause inflation, so that the large dollar depreciation seen in the past two years is a warning signal about inflation. However, the evidence does not support that view: once other factors that predict inflation are also included in the analysis, currency depreciation plays essentially no role at all in predicting future inflation. That result is not puzzling because the argument that dollar depreciation leads to inflation is incomplete. That argument considers only direct effects and ignores very real - and empirically important -indirect effects. 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