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Fall dollar for trade imbalances Original Source Link: (May no longer be active)
http://www.economist.com/finance/displayStory.cfm?story_id=2269166http://www.economist.com/finance/displayStory.cfm?story_id=2269166
Currencies
A faded green
Dec 4th 2003
From The Economist print edition
The dollar will need to fall further to eliminate America's imbalances
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SHADES of peach adorn America's recently redesigned $20 note, but currency traders care little for pretty colours. The dollar has steadily been losing value in the foreign-exchange markets. This week it reached its low against the euro since the single European currency was launched in 1999, breaking through $1.20. The dollar has fallen by 31% against the euro from its peak in July 2001. Recently it has also hit a three-year low against the yen and a five-year low against sterling.
It may seem curious that the dollar is falling when America is enjoying a remarkable spurt of growth and Europe looks far less perky. America's GDP grew at an annual rate of 8.2% in the third quarter. The Institute of Supply Management's widely watched index of manufacturing activity hit a 20-year high in November. Meanwhile, the euro area's economies are on the mend, but are expected to grow by only 0.5% this year and 1.8% next, according to The Economist's monthly poll of economic forecasters.
However, currencies are not economic virility symbols, but assets on which investors expect a return. The dollar used to be buoyant because investors expected to make more from dollar assets than from those denominated in other currencies. Now they are not so sure. Their worries over America's twin deficits, on the current account and the federal budget, loom large. With a current-account deficit of 5% of GDP, America must borrow $2 billion each business day. Tax cuts, spending on the war in Iraq and a new scheme to provide prescription drugs to the old are dragging the government's books into disarray.
How much further might the dollar fall? Predicting the future price of a currency is a mug's game. But there are good reasons to believe that over the medium term the dollar could drop a lot lower, especially against the euro. Whether that will have the desired effects, in reducing America's imbalances, or in causing the expected chaos in Europe's economies, is a different question.
A stronger euro should be bad news for European firms, even if it means cheaper Florida holidays for their employees. A rise in the euro against the dollar causes exports from European firms to become more expensive relative to American ones, cutting into Europe's sales. Similarly, American firms' products become relatively cheaper, both for Americans and for foreign buyers. By creating more exports and curbing imports, a weaker dollar should thus help to cut America's huge current-account deficit.
Or so the textbooks have it. In the past, a falling dollar has indeed reduced America's imports. In the 1980s, the last time America had such a large current-account deficit relative to GDP, an agreement to let the dollar depreciate helped to reduce America's consumption of Japanese cars and Swiss watches. This made for a fairly painless adjustment for America, if not for its trading partners.
But there is reason to think that these days currency movements are not as effective as they once were in bringing economies into balance. A recent report by George Magnus of UBS, an investment bank, doubts that a sliding dollar will do much to eliminate America's trade and current-account imbalances.
Weakened link
First, in an increasingly integrated global economy, companies' pricing power has been eroded around the world. In addition, low inflation has made price increases more obvious. So it is harder for firms to pass on cost increases of any sort, whether rising input prices or higher wages for unionised employees. In the same way, it is more difficult for a European car company, say, to raise its prices in America in response to a stronger euro. According to a study cited by Mr Magnus, the ability to pass on the effects of a stronger currency has been waning in recent years (see chart).
Other factors also weaken the power of currency movements. Rather than try and raise prices when their “home” currency strengthens, foreign firms may hold prices and accept lower margins, especially if they think the currency will weaken again or if they are determined to maintain market share. Manufacturing operations that are spread across countries make it easier for firms to match their dollar sales with dollar costs, reducing the effects of currency movements. And there is often a long delay, perhaps of more than a year, before consumers and producers adjust to changes in prices. For all these reasons, the dollar may have to fall much farther before America's imbalances are unwound.
Perhaps this is why European stockmarkets seem to have shrugged off the strong euro, rising this week to their highest levels this year. According to a report by Ian Scott of Lehman Brothers, this is all the more noteworthy when listed European companies have seen the proportion of their sales going to America rise to 17% this year from only 10% in 2000. This should make them more sensitive to the falling dollar. It may be, argues Mr Scott, that European shares look so cheap that a rising euro is not enough to put investors off.
However, the euro's strength might start to pinch soon—especially if the European Central Bank does nothing to offset its tightening effects. Dollar bulls may still hope that the greenback is overshooting, but past experience shows that overshooting can go a long way. And the dollar is still far from cheap. On a trade-weighted basis, it is above its average over the past 30 years. A continued slide should surprise no one.
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