Gonzalo Garland. Professor. IE Business School
7 January 2010
The dollar is at an all time low, and everything points to it continuing to show signs of weakness over the next few months. Is this the beginning of the end of its reign?
In the last few weeks we have seen how the euro continued to appreciate against the dollar to reach 1.5 dollars per euro, settling at around 1.47-1.48. Though this level is still far from the high of 1.6 in July 2008, it has generated worries about European exports during the current economic lull. Moreover, although the official stance maintains the importance of a strong dollar, in reality this exchange rate boosts US exports which is positive for the recovery of the world’s largest economy. A weak dollar is also convenient for China: With the Yuan semi-pegged to the American currency, the weak dollar in turn lowers the prices of Chinese exports. Although there are many other drivers underlying the growth of the Asian giant, we shouldn’t forget this effect.
Furthermore, the US trade deficit remains substantial, constituting one of the main reasons for the dollar’s weakness. Additionally, the US policy of keeping interest rates close to zero attracts little capital to the country, further contributing to a depreciated dollar. Therefore, and despite the enormous appetite for US assets by countries like China, there aren’t many reasons to expect a serious strengthening of the dollar in the short term. In the medium term, however, the situation may change. The latest figures for GDP growth corresponding to the third quarter in the US was positive. But it’s still early for excessive optimism, since the recovery is fragile and plenty of uncertainty remains. The exit strategy for expansion poicies will be complicated, and adjustments will have to be made subtly. Experience from the recent past tells us that when the US decides to change the direction of its monetary policy and starts raising interest rates, it does so very rapidly in a series of raises that take them above the interest rates of the Euro zone, which in turn boosts the dollar. This is why analysts are forecasting a euro-dollar exchange rate of 1.2-1.3 dollars per euro for the next year or so. This could change, however, if inflation rises in Europe and the European Central Bank with its anti-inflationist attitude raises interest rates in the Euro zone.
And in the long term? In the long term and as long as the US current account deficit is not significantly reduced, it is reasonable to assume that the dollar won’t be as strong as in the past. This is even more likely if China opts slowly but surely to diversify its reserves and investments among other currencies and geographical areas, even though that particular move doesn’t seem imminent. We still live in a world in which the main currency is the dollar, with competition rising. If there is movement, it will be slow. Despite the fact that we have been hearing more lately about the dollar crisis, we shouldn’t expect a collapse of the dollar in the short or medium term.