Value of U.S. Dollar

¶ … Down? The Value of the Dollar

International Currency Exchanges

Current Trends and Initiatives

Impact of the Euro on Dollar Valuation

Analysis of Current Trends and Initiatives on Dollar Valuation in the Future

Up or Down? The Value of the Dollar: A Historical Analysis of the Valuation of the U.S. Dollar

According to Michael Artis, Elizabeth Hennessy, and Axel Weber (2000), capital losses can be caused by differential changes in the value of assets and liabilities, primarily exchange rate changes; these changes affect the value of a central bank's foreign exchange reserves. To date, exchange rate changes have only been a major problem for national central banks with very large foreign exchange reserves (i.e., Portugal); however, it might also become a problem for the European Central Bank in the future, whose balance sheet on the asset side will be dominated by the approximately 40 billion euro in foreign exchange reserves it has called up from the national central banks as of the end of 1999 (Artis et al. 208). The strength of the euro compared to the U.S. dollar has been growing in recent months, and economists are of mixed opinions about the impact on the valuation of the dollar as the European Union continues to gain economic momentum as it streamlines it trading practices.

Purpose of Study

The purpose of this study will be to examine the historical basis for the valuation of the U.S. dollar, the impact of recent trends and initiatives including but not limited to the euro, and an analysis of how these factors will serve to affect the dollar's valuation in the future.

Importance of Study

A country's nominal exchange rate is defined as the actual foreign exchange quotation in contrast to the real exchange rate, which has been adjusted for changes in purchasing power (Harvey 2004). Artis et al. (2000) suggest that it is reasonable to assume that the nominal exchange rate will be a key element in determining the level of competitiveness of a country, which in turn will be an increasingly important factor in stock market valuations in the future.

Scope of Study

This study will examine a wide range of international currencies, with an emphasis on the world's leading economies besides the U.S. And EU such as China, Japan, Korea, and others, with a particular emphasis on how these currencies have tended to interact with the U.S. dollar over the years. Current theories concerning currency valuation techniques will be provided, and statistical analyses will be carried out where appropriate.

Overview of the Study

According to Mike Luck, Rob Pocock, and Mike Tricker (2000), "In its crudest form, exploratory research produces endless series of descriptive statistics, correlation analyses and multi-way cross-tabulations that encompass every conceivable permutation and combination of variables in the hope of finding something significant" (153). Therefore, this study will use an exploratory approach to review the relevant and peer-reviewed literature to develop fresh insights and theories concerning what can be expected as these increasingly powerful international valuation forces come to bear on the U.S. dollar in the future.

Chapter 2: Review of Related Literature

Background and Overview: International Currency Exchanges. While it may not be hard to believe that people are making money in the international currency exchange market, it is difficult to understand how they are doing it. After all, if there was a magic formula whereby accurate predictions could be consistently made concerning an individual currency's likely behavior against another currency, that formula would eventually become known and it would be boom times for everyone. Alas, such a magic formula does not exist but that has not stopped analysts from trying for the past 400 years. In fact, much of the existing mechanisms of transnational trade were introduced during the last four centuries; international currency exchanges, the joint stock company, marine insurance, international arbitration, bills of lading, and the stock market all fueled international trade and therefore interest in international currency exchanges (Arthurs 1996:132).

More recently, the increasing globalization of the world's economy has compelled analysts to redouble their efforts at understanding how market forces and world events all affect the rise and fall of a nation's currency. In fact, the same pressures that served to hasten the development of international trade over the past 400 years are the same ones taking place today: "At the core of it all, globalization - then as now - was about wealth and dreams of wealth" (Arthurs 133). In this regard, foreign exchange represents both an opportunity and a potential liability if handled inappropriately. According to Laux, Pantzalis and Simkins (2001), "Investors are concerned with the impact of unexpected changes in the exchange rate on their portfolio values, while managers who typically are over-invested in their own firms are primarily concerned with the exposure of their firms. Risk aversion provides an incentive to manage foreign exchange risk" (793). The authors define foreign exchange exposure as the effect of unexpected changes in the real exchange rate on firms, and distinguish between two types of economic exposure:

1) Transaction exposure (this is the effect of unexpected changes in the nominal exchange rate on cash flows associated with monetary assets and liabilities such as contractually fixed cash flows); and

2) Transaction exposure (this is usually a short-term exposure that can be easily hedged using currency derivatives) (Laux et al. 794).

By contrast, operating exposure is the effect of unexpected changes in the exchange rate on the cash flows that are associated with a company's non-monetary (real) assets and liabilities. According to these authors, "Operating exposure results from unexpected changes in the exchange rate on the firm's input costs (e.g., raw materials, labor costs, etc.) and output prices (e.g., product prices)" (794). Further, because the correlation of prices with exchange rates is determined by the extent of segmentation within their respective markets, operating exposure will depend on whether input costs and output prices are influenced on a local or global level (Laux et al. 795). Taken together, these risks and opportunities are all based on how the U.S. dollar has been historically valued; these issues are discussed further below.

Current Trends and Initiatives. According to Richard N. Cooper, the U.S. current account deficit reached $450 billion in 2001, or 4.4% of the nation's GDP; this was a 3.6% from 1999. In fact, current account balance was last achieved in 1991 (actually, in 1981 if the First Persian Gulf War-related expenses are excluded for 1991). "One has to go back to the two decades before 1914," Cooper says, "a period of mass immigration and extensive infrastructure construction, to find deficits even approximately as large, relative to GDP, as those of recent years" (217). By global standards, the U.S. is regarded to be relatively rich in capital; the questions emerge then, as to why the U.S. has been importing more capital than ever before?

There are two clear trends in thinking evident in the growing body of literature on the impact of foreign debt on the U.S. dollar in this regard. In their essay, "The Looming U.S. External Debt. How Serious is It?," Susan Charrette and Juann Hung (1997) report that, "When the United States first became a net debtor in the mid-1980s, some analysts worried that the prospect of an escalating U.S. foreign debt would cause foreigners to become unwilling to hold dollar assets, precipitating a sudden depreciation of the dollar. Such a scenario was thought to be plausible since a continued rise in the U.S. external deficit would lead to rapid accumulation of external debt" (32). Having receded for a number of years, though, this lingering doubt about the U.S. external debt has reemerged in the public forum. According to Charrette and Hung, as a result of the United States becoming the world's largest net international debtor, some observers have blamed the net international debt for depressing the dollar: "They argue that the weak dollar should signal policymakers to act now in order to redress the continuing buildup of U.S. international debt" (32). By contrast, other financial analysts suggest that this concern about external deficits and debt accumulation is unwarranted; provided that a significant share of the net borrowing from abroad is directed toward investment, the accumulation of external debt should not be a reason for worry. "As long as foreign debt is incurred for productive investment and its cost is lower than the rate of return on its investment," the authors point out, "the United States should profit from foreign borrowing" (Charrette & Hung 33). Beyond these two schools of thought, though, there is a new major player in the international currency exchange marketplace that is having profound effects on the valuation of the U.S. dollar in some unpredictable ways; these issues are discussed further below.

Impact of the Euro on Dollar Valuation. According to Cooper (2001), the increasing purchase of euros places some amount of downward pressure on the dollar, thereby reducing some of the exchange rate pressures on U.S. producers; these pressures are taking place during a period when some export stimulus would be a stimulus to the U.S. economy. Further, the purchases would serve to provide the Federal Reserve with background in undertaking open market operations in financial arenas besides Treasuries, something Cooper suggests will have to been sooner or later if the marketable federal debt is paid off; however, the administration and Congress do not appear to be acknowledging that course of action is an eventuality, and continue to press for proposed tax reductions that will simply drive the need for Federal Reserve adaptation further into the future (Cooper 217). The processes are being further exacerbated by the oil-producing countries of the Middle East which now possess vast quantities of U.S. Treasury Bonds. According to Vesely (2004), "Since oil is priced in dollars, the flow of U.S. currency into their coffers is accelerating as oil prices rise. Economists fear Saudi Arabia and the adjacent oil producers of the Middle East will grow concerned that their portfolios are too swollen with dollar-dominated assets, and begin to sell off a portion to bring back a sensible balance" (36). Should that eventuality take place, these Middle Eastern countries could potentially transfer some of their future hedging into euro treasuries; with the euro up approximately 40% since the U.S. dollar's peak in 2003, this trend is already causing concern in some quarters. For example, from 2003-2004, the euro gained 20% against the U.S. dollar; some economists are pointing to this rise as an indication that long-term movement is already taking place. Many international institutions and renowned scholars have recently pointed out that the possibility of a U.S. dollar slump is increasing which may lead to a new U.S. dollar crisis in the near future (Vesely 37).

Analysis of Current Trends and Initiatives on Dollar Valuation in the Future. According to Charrette and Hung (1997), the results to date suggest that the overall interest rate paid on external debt has been much smaller than that on external assets in the U.S. In fact, the favorable differential between the yield on external assets and that on external liabilities ensured that the net international investment income remained positive until 1994 even though the United States became a net debtor in 1987; however, the favorable yield differential has been on a downward trend since 1990 and continued to decline further in the closing years of the 20th century (Charrette & Hung 33). The 2005 Forex Currency Forecast reported that 2004 was been an important year in the currency markets. "Dollar weakness was the predominant theme as the world's premiere reserve currency slid to a fresh all-time low against the euro, a nine-year low against the Swiss franc and a 12-year low against the British pound" (2). Further, 2004 also represented the beginning of the global tightening cycle, with a number of central banks increased their rates for the first time since reducing them to extremely accommodative levels. "The U.S. current account deficit became a primary point of focus, along with increasing pressure on China to revalue the Renminbi. We expect these themes to resonate into 2005, especially the earlier half. However, growth should also become a primary focus as the world monitors the strength of the U.S. economic recovery" (Currency Forecast 2).

Chapter 3: Methodology

Description of the Study Approach

As noted above, this study employed an exploratory methodology; this methodology was comprised of a qualitative review of the relevant literature followed by a quantitative analysis of key statistical data to develop new insights into how international currency exchanges operate and what forces come into play in the valuation of the U.S. dollar. Wood and Ellis (2003) identified the following as important outcomes of a well conducted literature review:

It helps describe a topic of interest and refine either research questions or directions in which to look;

It presents a clear description and evaluation of the theories and concepts that have informed research into the topic of interest;

It clarifies the relationship to previous research and highlights where new research may contribute by identifying research possibilities which have been overlooked so far in the literature;

It provides insights into the topic of interest that are both methodological and substantive;

It demonstrates powers of critical analysis by, for instance, exposing taken for granted assumptions underpinning previous research and identifying the possibilities of replacing them with alternative assumptions;

It justifies any new research through a coherent critique of what has gone before and demonstrates why new research is both timely and important.

Data-Gathering Method and Database of Study

The literature review was conducted using a variety of online sources, including the World Bank, the CIA's World Factbook, premium services including Questia and Britannica.com, as well as governmental and nongovernmental Web sites dedicated to international currency exchange and its related issues.

Chapter 4: Data Analysis

Euro vs. Dollar. While the euro reached record highs against the dollar in 2005, the currency was not driven by positive European economic news; rather, the increase in the unit was driven mostly by "massive bearish sentiment towards the dollar" (EUR/USD Forecast 2005:2). The euro also enjoyed an enormous advantage from its de facto status as the world's "anti-dollar"; the euro is the underlying currency for the world's second largest economy in the form of the European Union, with its state-of-the-art financial markets. More recently, a number of central banks (including the Bank of Russia as well as the central banks of various Middle Eastern governments) have diversified their reserve assets from dollars to euros lending further status to the euro as an alternative reserve currency (EUR/USD Forecast 3).

Currency Forecast

Index*

1-month

3 months

1-year

EUR/USD

1.3146

1.3236

1.3527

Dollar vs. Yen. According to the economists at Forex, Japan may be headed for a recession. Following a brief upturn following months of negative growth, the Japanese economy recorded worse than expected results for Household Spending, Leading Economic Indicators and the TANKAN survey. The currency forecast for Japan is based on the latest household spending data which showed a decline of -2.0% versus -0.5% expected as Japanese consumer demand contracted for the 2nd consecutive month in a row while the index of Leading Economic Indicators dropped to only 20% out of possible 100% (USD/JPY Outlook 2005:2). Forex points out that this represented the second month below the critical 50% expansion/contraction line and it bodes badly for the future growth of the Japanese economy; at the same time, the latest TANKAN survey of business sentiment registered its first decline in 7 quarters. "Clearly," they say, "the strong yen is damaging the economic performance of the most export sensitive of the G-3 nations and Japanese authorities are becoming increasingly uncomfortable with the yen rally. The problem is exacerbated by the global slowdown in demand for key Japanese goods such as electronics" (USD/JPY Outlook 2005:3).

Chinese Yuen. According to U.S. government analysts, in 2004, China was the second-largest economy in the world after the U.S. measured on a purchasing power parity (PPP) basis; however, in per capita terms the country remained poor (China 2005:3). China is also second only to the U.S. In terms of Internet use, with 94 million users at the end of 2004; in addition, foreign investment continues to represent a strong element in China's remarkable economic growth. Shortages of electric power and raw materials, though, may adversely affect industrial output in 2005 but mre power generating capacity is scheduled to come online in 2006 (China 4). The Chinese yuan per U.S. dollar rate is shown in the figure below.

(Source: Forex 2005)