Reason of Falling Dollar

It has been observed these days that

  • The value of the American dollar against six other big currencies to 75.24, its lowest point in more than a year.

  • American exporters, whose goods have become more competitive abroad, are happy with their weaker currency.

  • Domestic producers may be cheered that rival, imported goods are more expensive.

  • European tourists, who can buy more for their euros during weekend shopping excursions to America, may cheer too.

  • China and Russia, who hold much of their reserves in dollars, about the need to shift their reserves out of the greenback.

  • Brazil has imposed a 2% levy on portfolio inflows is also a sign that other countries are getting nervous about seeing their currencies rise against the dollar.

  • Sub-prime mortgages and over-leveraged financial institutions plunged the world into its worst recession since the Great Depresssion.

The simplest explanation for the currency’s decline is based on risk aversion. On the days when risky assets fall, the dollar tends to go up. When risky assets rise, the dollar falls. The dollar has fallen fairly steadily since March, a period which has seen stockmarkets enjoy a phenomenal rally. Domestic American investors may be driving the relationship, repatriating funds in 2008 when they were nervous about the state of financial markets and sending the money abroad again this summer because of a perception that the global economy is reviving.

Some cite the American budget deficit, expected to be 13.5% of GDP this year. There is little sign that the Obama administration has a plan to reduce it, and health-care reform may add to it. One reason may be that the Federal Reserve has been buying so much of the year’s debt issuance, as part of its quantitative easing programme. That has helped to keep yields down.

A simple dynamic may be at work: supply and demand.

Last year the market was short of dollars because investors needed the American currency to meet their liquidity needs. This year QE is creating a surplus of dollars (and pounds) and is thus driving both currencies down. Low yields offer little support to the dollar. The Fed seems highly unlikely to raise interest rates from their near-zero levels over the next 12 months or so.

But it is hard, also, to think of a parallel in history. A country heavily in debt to foreigners, with a government deficit it is making little headway at controlling, is creating vast amounts of additional currency. Yet it is allowed to get away with very low interest rates. Eventually such an arrangement must surely break down, bringing a new currency system into being, just as Bretton Woods emerged in the 1940s.

The absence of a credible alternative to the dollar means that, despite its declining value, its status as the world’s reserve currency is not seriously under threat. But the system could change in other ways. A world where currencies traded within bands, or where foreign creditors insist on America issuing some debt in other currencies, are all real possibilities as the world adjusts to a declining dollar.


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