What is hurting US dollar

What is hurting US dollar

Recently, US dollar has been in a free fall against a basket of of other major currencies. This has left many investors wondering what exactly is hurting the dollar.

A number of reasons seem to be leading to a depreciating dollar. The most obvious of the reasons is the perception of a stabilizing global economy. A stronger economy leads investors to return to stocks and other riskier securities. This leads to what is called “carry trade” and erodes US dollar strength as a “safe haven”. In layman's terms it means that investors need to sell their dollar denominated government holdings and convert it into various currencies for investing. This leads to selling of the dollar against other currencies. This leads to a fall in Dollar value and the present scenario appears to be related to this phenomenon. This may be considered a short term cause of a falling dollar and may be viewed as a positive development as the underlying cause is an improvement in the global economic scenario.

However, the medium term reasons seems to be negative. The medium term reason that seem to be dampening the dollar is related to the US fiscal deficit. The damages caused by the economic depression are enormous in the shape of bust banks, bad home mortgages, looming unemployment and closing businesses. To repair these damages the US government has announced a number of bailout packages. The money for these bailout packages can come from two sources. The government can either print more money (currency notes) or borrow money. The first recourse is highly dangerous which will lead to very high inflation. The wiser thing is to borrow money. However, the borrowing money has a cost. A high level of government borrowing leads to a general rise in the interest rates unintended results like crowding out of private investment. In simple terms, when government starts borrowing interest rates rise making it wither difficult or unprofitable for private firms to borrow and invest in new business or in expansion of existing business. It may be noted that this increase in the interest rate is not induced intentionally to fight inflation, but is a result of worsening economic conditions. This presents a negative view of the US economy, which is likely to keep the dollar subdued in medium term.

What is presented above is theoretical discussion of two primary issues leading to a weak Dollar. In actual practice what happens is that investors who see weakness in US dollar start selling it and converting to other currencies. This can be done, for example by selling USD against CHF or buying EUR against USD. On of the biggest worries have been concerns that Chinese investments in US dollar may be liquidated. The reason why China is feeling the heat is because it holds a huge amount of national saving in US government treasuries and a fall in the value of the US dollar means a fall in the value of their national savings. China has become the largest holder of US paper, with investments of nearly $768 billion. The dollar index has weakened nearly 8.6% since February this year, making the Chinese jittery about their savings. This threatens liquidating of Chinese investments and conversion into other currencies.

How things actually unfold remains to be seen. Obama has already made tall promises of curtailing the deficit to 3% of GDP. However, Obama’s plan needs to be analyzed more closely before one can jump to any conclusion. Fiscal deficit is not something which can be wished away overnight. To reduce fiscal deficit ether government expenses need to be reduced by curtailing expenses or government revenues need to be increased by increasing taxes. Reducing government expenses in such economic scenario seems impractical where more chaos is likely if government stops bailouts. Only way to increases government revenue is by increasing taxes. However, an increase in taxes reduces disposable incomes of consumers. Lower disposable incomes can slacken demand and reduce production. This in turn can again slacken growth of GDP, leading to a negative investor sentiment, which can exert further downward pressure on the value of the US dollar.

In conclusion, fundamentals dictate that the US dollar may face some downward pressure in the medium term and its long term performance will depend upon how the US economy recovers during this period. In any case, we can be happy to note that the most of the talk today is about economic recovery and the recession seems to be fading into the past.