11/24/2009

By Hans Wagner

One of the most important global economic trends is the U.S. dollar devaluation. In this article on global economic trends, we are addressing three of the important fundamental factors encouraging U.S. dollar devaluation.

The devaluation of the U.S. dollar vs. other currencies depends on a number of factors, primarily relative interest rates and inflation of each country, the level of deficit spending by governments, and the demand and prices for imports and exports.

Interest Rates and Inflation

Economists have assumed that higher interest rates will lead to an appreciation in the currency. On the demand side, they assume that higher interest rates will attract foreign capital that increases the demand for the local currency. On the supply side, higher interest rates tend to reduce domestic consumption, reducing the demand for imports that lowers the supply of currency leading to a higher value. Unfortunately, this simple view does not always work out as expected.

The August 5-11, 2007 issue of the The Economist showed that countries whose currencies have gained the most against the dollar are high interest rate economies. High interest rates tend to help a currency rise relative to other currencies. Inflation offsets these high interest rates, so it is important to understand the real interest rate. Countries that experience rising inflation may see a short-term rise in their currency due to higher interest rates. For inflation prone countries, this will be short lived, once investors understand the inflation prospects. Higher inflation leads to a reduction of capital flow as investors do not want to lose the value of their money. Therefore, investors look to the real interest rate (the nominal interest rate minus the inflation rate). Higher real interest rates tend to attract capital, which helps to drive up the price of the currency.

Presently in the U.S., inflation is very low and some fear that deflation could be near by. The Federal Reserve is keeping interest rates low by maintaining the fed funds rate in the 0.00 to 0.25% range. They are also buying mortgage securities, which helps to force longer-term rates down. The intent of these low rates is to encourage the economy to recover.

When investors look at the inflation rate for a country, they must consider the current rate as well as the future rate. After all, they want to be sure to account for any changes in the rate of inflation, as it will affect their investment. If inflation is more likely to rise in the next several years, then investors will look for higher interest rates to protect their investment. If longer-term rates do not adequately cover their inflation expectations plus a return on their money, capital is likely to flow out of the country, forcing currency rates to fall. Since the Federal Reserve is working hard to keep interest rates low, it is by default encouraging those investors who fear inflation in the future to move their capital out of the U.S., causing dollar devaluation. When capital flows out of a country, the value of the currency tends to fall. As long as inflation expectations give investors a very low real return on their investment along the yield curve, we should expect U.S. dollar devaluation. This is especially true if capital can find a more attractive place to go.

Spending Deficits

The U.S. is running a very large deficit that is approximately 40% of the total expenditures of the government. To fund this deficit the government sells bonds to whoever will buy them. Many of the buyers are foreign banks and governments. When these bonds are sold, it acts as a capital inflow to the U.S. that should encourage the dollar to rise. Currency traders realize that this money is not a capital investment; rather it is a loan to cover expenses. It is not being invested into any form that will generate money that can be used to pay back the loan. This raises the prospect that the money may never be paid back. If there is a default then the money is a loss. In these cases, it puts more downward pressure on the dollar. As the deficits grow, currency traders become increasingly concerned that their money is more at risk. This forces the dollar devaluation.

Trade Balance

Another important factor in the value of a currency is the status of the trade balance. Countries that have a positive trade balance where exports exceed imports, see capital flow into their economy. This capital inflow encourages the value of the currency to rise, raising the cost of exports, and lowering the cost of imports. In theory if all other things are equal, this will tend to stabilize the trade balance.

For countries that experience a trade deficit, like the U.S., capital flows out of the country. This outflow puts downward pressure on the currency as a balancing mechanism.

When the prices of oil, copper, gold and other commodities rise, they tend to take with them the currency of the country exporting the material. As demand for commodities, increases it tends to raise the value of currencies of commodity-producing countries. Rising prices of commodities help the commodity-rich nations to experience falling trade deficits and might even lead to positive trade accounts, as long as they manage their imports. Currencies of commodity exporters fall when commodity prices fall. The reverse holds for commodity importers.

A negative trade balance encourages U.S. dollar devaluation as capital flows out of the country. As long as the U.S. imports more than it exports, the negative trade balance will compel the U.S. dollar devaluation.

The Bottom Line

As a global economic trend, the U.S. dollar devaluation is a balancing mechanism that tries to offset negative fundamental factors. The U.S. dollar is reflecting the negative consequences of low interest rates relative to the potential for inflation, serious government spending deficits and a large trade deficit. Each on their own put downward pressure on the dollar. All three together will encourage the dollar devaluation. The fundamentals of the dollar will force it to fall further despite what the politicians say.

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