What has caused the U.S. Dollar to fall?

Numerous factors affect the value of a currency. Although financial pundits within the media give a reason(s) for every move, it is usually not possible to pinpoint exactly why a currency has moved. What we can do, however, is to look at the big picture: we can analyze large forces weighing on the markets.

In explaining the fall of the U.S. dollar, we focus on the current account deficit as the biggest single factor. The current account deficit is the difference between what Americans earn from other countries (exports, services, investments abroad) and what we pay out to other countries (imports, services, loans). This shortfall in trade and investment income between the U.S. and the rest of the world amounted $738.6 billion in 2007.* As a share of gross domestic product (GDP), the deficit amounted for 5.3% in 2007. Foreigners must absorb this shortfall by buying about $2 billion worth of U.S. dollar denominated assets every single day, just to keep the U.S. dollar from falling.

We often hear about the trade deficit, which is simply exports minus imports. Let us visualize what the trade deficit means: if we import $600 billion+ more than we export, we are passing many U.S. dollar bills to other countries. They can hold the cash (e.g. purchase U.S. bonds), re-invest in the U.S., or exchange it into their local currency. Unless other countries purchase U.S. dollars at a rate of about $2 billion a day, there will be downward pressure on the U.S. dollar.

Visualize the U.S. buying Chinese goods and paying for them with U.S. dollars. The Chinese must decide what to do with the U.S. dollars they receive: as they do not find enough American goods and services to consume, they can decide to purchase U.S. dollar denominated assets, such as U.S. Treasuries; or they could convert them to their own currency, which would cause the U.S. dollar to fall.

(Source: Bureau of Economic Analysis news release March 17, 2008.)

Another big weight on the dollar is the large U.S. budget deficit. More worrying than the absolute level of government debt is the trend at which it has been increasing in recent years. And there is the prospect of future large increases should tax revenues not continue to increase as forecast, should military spending continue to increase, and should Congress not find a solution to the exploding cost of Social Security, Medicare and Medicaid. None of these are imminent threats, but are concerns to economists as the baby-boomer generation starts retiring and our population ages. It is one thing for a government to run a deficit—it can (with some limitations) simply issue bonds; however, when American households have an anemic savings rate, we have to borrow from abroad to finance our deficit.

Our international trading partners have been reinvesting our U.S. dollars back into the U.S. economy. China, one of the main buyers of U.S. debt, has been increasing its foreign currency reserves at a rate of about $500 billion a year; by the end of 2007, China's currency reserves surpassed $1.5 trillion, compared to $1 trillion in 2006.** Since 2005, there has been a gradual diversification from buying U.S. Treasuries to acquiring real assets, especially those that help China secure its vast appetite for natural resources. The highest profile attempt to acquire U.S. assets was by the Chinese state controlled oil conglomerate CNOOC, as it tried to acquire the American oil company Unocal. The Chinese wanted to use their U.S. dollar reserves to buy something of value to them, but were rebuffed by the resulting political firestorm. Since then, the Chinese have looked beyond U.S. borders to make acquisitions — amongst them Canada, Latin America, Africa, and Australia.

The questions are: Why do Asian central banks purchase so many U.S. dollars, is it sustainable, and what happens if these purchases were to slow down? Asia buys U.S. dollars because their governments deem it to be in their interest. Asia’s interest is to sell goods to the American consumer, so that they can build up their local economy and create jobs for an enormous flood of the rural population into cities. China has to generate more than 15 million jobs a year. As the Chinese leadership has social stability as a top priority, they are likely to continue to favor to subsidize their exports through U.S. dollar purchases, which allows them to keep their currency competitive.

However, China and Asia, and indeed the U.S., may not be able to afford to continue this policy forever. We have all heard about soaring commodity prices, a side product of global overproduction. Given that the U.S. economy is about 8 times larger than the Chinese economy, you may be able to imagine that any small impact we may feel in the U.S. economy has a huge impact in some other way on the Chinese economy.

Next: Will the U.S. Dollar continue to fall?

* Source: Bureau of Economic Analysis news release March 17, 2008.

** Not all of China's reserves are denominated in U.S. dollar.