Will the Dollar Rise Again?

Reasons to sell the greenback are many, and reasons to buy are few. Expect the dollar's decline to continue for a long while.

By Andrew C. Schneider, Associate Editor, The Kiplinger Letter

May 23, 2007

A rebound for the dollar is nowhere in sight. Odds are that the gradual decline of the buck -- particularly against the euro, but also versus the British pound, the Canadian dollar and a few other major currencies -- will continue well into next year and perhaps even longer.

A number of fundamental factors aren't favoring the greenback, with the first being interest rates. They're headed higher in Europe, but the next rate move by the Federal Reserve is likely to be a cut. So euros will attract investors seeking better short-term yields. Then there are macroeconomic trends. For the first time in 17 years, economic growth in both the euro zone and Japan could top that of the U.S. this year, taking some of the shine off the dollar. Finally, there is the greenback's own trading history. Despite its five-year slide so far, the buck remains comfortably above lows hit in the mid-1990s. Foreign exchange traders view this as a signal that they can continue to sell the dollar without encountering much resistance.

A weaker dollar will be mostly positive for U.S. businesses and for the U.S. economy. It'll pump up exports and thereby partially offset the economic drags from the housing slump and the sluggish pace of domestic business investment. Exporters -- notably companies selling medical equipment, information technology, motor vehicles, pharmaceuticals and chemicals abroad -- are clearly benefiting from the dollar's swoon. Note that the trade deficit is on a downward path for the first time since 2001.

The chief negative: higher energy costs, as oil exporters try to keep the price of their dollar-denominated crude exports as high as they can to make up for the loss of dollar purchasing power they're seeing. Oil costs, as well as rising prices for other imports, will push up the rate of inflation, though not by very much -- perhaps a couple of tenths of a percentage point per year through next year. Foreign firms that sell to the U.S. are becoming less willing to absorb the impact of the lower dollar on their profits to preserve U.S. market share. Instead, they're raising prices to maximize income before the dollar falls even further.

Dollar weakness, if it is in fact a chronic condition in the years to come, poses a bigger long-term risk. At some point, U.S. interest rates will probably have to start rising as foreign investors demand higher returns to counterbalance their growing exchange rate losses on dollar-denominated investments. The problem is that higher rates tend to slow down economic growth.

A sudden crash of the dollar isn't likely. There are no signs that foreigners are about to dump U.S. assets because of the greenback's weakness. Holders of Treasuries and other American assets, especially in Asia, have an interest in preserving the value of these large holdings, so they won't simply sell them en masse. For China and other Asian countries, there's also a risk that they could send their currencies shooting up against the dollar as a result, crippling their exports to the lucrative American market.

What would it take to reverse the dollar's fading fortunes? A shift in global economic trends in favor of the U.S. wouldn't do it all. In fact, the buck lost value in recent years even when the U.S. economy was flourishing.

Ironically, the dollar has to drop faster against Asian currencies to set the stage for its future strength. The irony is that China and other Asian nations are preventing the U.S. currency from losing value at an accelerated pace so that they can preserve their competitive currency advantage in the U.S. and other dollar markets. Letting their currencies rise faster against the dollar would lead to a swifter decline in the U.S. trade deficit and hence bolster the attractiveness of and confidence in the dollar over the long term.

But we don't see this happening, at least not anytime soon. Most important, China is likely to stick to its slow appreciation of the yuan against the dollar -- maybe 5% or so a year -- out of fear that a faster clip would roil its fragile financial system and undercut the domestic economy's brisk rate of growth. China needs its economy to remain robust to provide jobs for the millions of people migrating from impoverished rural areas to the cities.

Congress is also easing its currency pressure on Beijing. Threats of high punitive tariffs on Chinese imports have given way to a more subtle approach to the yuan issue. U.S. lawmakers are realizing that Chinese leaders don't respond well when a sword is dangled above their heads.

For weekly updates on topics to improve your business decisionmaking, click here.