The dollar has fallen in the last few weeks to record lows against the euro and now fetches less than even the Canadian dollar. Currency experts have predicted that the euro will hit $1.50 by the year's end. The rise and fall of the US dollar traditionally reflects both the strength of the US economy as well as the confidence international investors have in its future.
The seriousness of the impact of the falling dollar depends on how far apart currencies drift and whether things are "under control." This is very important and people would do well to remember that the most significant movements on Wall Street have occurred not because of growth rates of the US economy but because of currency movements. Of course the two are linked to a large extent but not completely.
Causes for decline in the value of the US Dollar
1. The most important reasons for the decline in the US dollar are the consistently increasing budget and trade deficits.The US has been funding a part of these deficits by simply printing more money and a situation has been reached where the demand for the dollar has fallen. This is putting pressure on the dollar.
2. Interest rates: Interest rates have a direct impact on the value of the dollar. If interest rates fall, investors who have bought US treasuries get a lower return. This reduces the demand for these instruments, and therefore the dollar, leading to a decline in the dollar's value.
3.The central banks of countries who have extensive trade relations with the US, and have large dollar holdings such as China, Japan and oil rich Arab states had traditionally been ploughing back their trade surplus into US treasuries. This created a demand for the dollar and prevented the dollar from declining too far.Now things are slightly different.Given the uncertainty surrounding the US economy and increasing investment opportunities around the world the demand for the dollar is simply not what it used to be. In fact there is speculation that these nations may in fact be diversifying from the dollar into other assets. Although there is no sell off of US dollar denominated assets as yet, fresh demand is declining.
Impact of the low Dollar
1.The decline of the dollar is not all bad news though. The fall in the value of the US dollar has a very important trade benefit for US companies. It makes their products cheaper as compared to those of other countries which gives a boost to the US economy.
2. On the flip-side it raises the cost of the goods purchased by the Americans. This can contribute to inflation and may affect the finances of the American consumer. Fortunately this has not hapened as yet because except prices of oil, the manufacturers of other goods have been reluctant to pass on the increase in prices to the US consumer in order to retain market share.
3. The weak US dollar also drives up the prices of commodities which are priced in dollars such as crude oil. Demand for commodities is relatively less elastic and the impact of higher prices almost invariably gets pased on to the consumer.
4. The businesses which are impacted the most are travel and transportation, because of the increase in oil prices. Americans who travel abroad should also be prepared to pay more as the dollar will now buy less than it used to previously.
If the scenario is so bleak then what is preventing a much sharper slide in the value of the dollar? The answer is fairly simple. Those very countries which not only have large dollar holdings but also continue to add to them, cannot afford a sharp fall in the dollar's value as it will cause great losses to the value of their accumulated assets. No wonder then that the US simply dismissed China's warning that it might be forced to liquidate its dollar holdings.
For its part the US Federal Reserve seems to be content to let the dollar slide. They are unlikely to be worried if the dollar fluctuates within a broad band and if the decline is orderly.Once the economy starts growing again and the various crises are behind us the dollar is likely to regain its former strength.