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Strong Dollar? Weak Dollar? What Does it Mean to Individual Investors?

Strong Dollar? Weak Dollar? What Does it Mean to Individual Investors?

In recent months we have been confronted day by day with financial news headlines concerning the decline of the US dollar. A typical story line: "The dollar is down against both the Japanese Yen and against the Euro this morning, marking the fifth straight daily loss for the greenback." The dollar is down against the Yen? The dollar is down against the Euro currency? What does this mean, and how does this affect our personal finances?

The dollar is considered the standard unit of currency in commodity markets across the globe (particularly gold and oil). Since these basic commodities are currently priced in dollars, there is a strong interest in the dollar’s value against other currencies. If the dollar declines in value against other currencies, those other currencies will have greater purchasing power in terms of products priced in dollars. At the present time, the U.S. dollar remains the world's foremost reserve currency, primarily held in $100 denominations. This means that throughout the world, next to their own currency, people have more dollars in their possession than any other currency. The majority of U.S. notes are actually held outside the United States. The US Treasury estimates that at the end of 2008 there was approximately $853 billion of US currency in circulation with one half to two thirds held outside the US. It is because of the fact that so many dollars are held in reserve in foreign countries that the daily value of the dollar is headline news whenever its value fluctuates.

A few nations besides the United States use the U.S. dollar as their official currency. Ecuador, El Salvador and East Timor all adopted the currency independently. Additionally, local currencies of several countries such as Bermuda, the Bahamas, Panama and a few other countries can be freely exchanged at a 1:1 ratio for the U.S. dollar. Finally, a number of nations have tied their currencies to the U.S. dollar, including: Lebanon (one dollar = 1500 Lebanese pound), Hong Kong (one U.S. dollar = HK$ 7.8 since 1983), and several more. A significant recent development is the action taken by the People's Republic of China. The Yuan (China’s currency, also called the renminbi) had once been informally and controversially pegged to the US dollar (since the mid-1990s, at 1 U.S. dollar = 8.28 Y); however the peg was removed on July 21, 2005. Instead, the central bank of China manages the exchange rate of the Yuan against a basket of global currencies. This means that the bank buys and sells various foreign currencies in an attempt to influence the value of those currencies relative to the value of their own currency.

One of the many problems which plague our economic health is the imbalance between the value of the goods we import into the US versus the value of the goods we export. We seem to have an insatiable appetite for everything from foreign made cars to the shelves full of merchandise at the dollar stores. Therefore, in a view held by many economists, it is a good thing when the dollar declines in value because foreign buyers of US goods will have greater purchasing power which in turn brings our import/export ratio closer into balance. However, traditionally the stability and strength of a country’s currency has been considered indicative of the country’s overall stability and strength, and that is the primary reason we should have concern over the value of the dollar relative to other currencies.

Dollars and other currencies are similar to commodities in that there is a market for currencies; the foreign exchange market or "forex” market as it is called. As in any market, supply and demand dictate price. China holds more than $2.25 trillion in various foreign currency reserves; there are estimates that 2/3 of that amount is in US dollars. If they choose to reduce their exposure to US dollars by selling dollars and buying Yen or Euros in place of dollars, that would weigh heavily on the value of the dollar and further depress its value relative to other currencies. The supply and demand for dollars would be affected by their actions. Again, this would be good for US exporters whose goods would be more attractive to foreign buyers. However, to the extent that the strength of a currency is indicative of overall economic strength, the decline of the dollar would signal weakness. For example, dollar weakness makes it more difficult to sell US debt (government bonds) to foreign investors who have in recent years facilitated our huge financial bailouts and deficit spending, because those investors will have less appetite for assets that are dollar denominated. Regarding our personal finances, dollar weakness could adversely affect the price of various investments we hold such as shares of stock or government bonds.

The chart below tracks the value of the dollar against the Euro currency since the Euro currency was first adopted in 1999.You can see that the Euro was actually worth less than the dollar for the first several years of its existence. However, as more and more countries in the European Union adopted the common currency and strengthened their trading position, the Euro's value has increased against the dollar. Today the European Union is the world's largest trading block, accounting for over 20% of global imports and exports. This strength in trade has directly affected the relative value of their currency.

While those of us fortunate enough to be able to travel to Europe or to Asia may experience first-hand a negative aspect of a weaker dollar, there are far more serious implications to the dollar’s decline than more expensive hotel and restaurant bills.

In my opinion we need to be concerned for the longer term. We need to remain competitive in an ever-changing economic climate. To that end, the creation of jobs through new industry and the increase in our productivity in existing industries will go a long way toward improving our position as a global trading partner and strengthening the dollar. Our failure to answer the call in the automotive industry opened the door for vastly successful foreign competition and the near collapse of our domestic auto producers. The same occurred in our domestic steel industry. There remains opportunity to excel in the areas of agriculture, technology, and energy; all of which could create new jobs, improve our position as a trading partner, and in turn strengthen value of the dollar.

Historically, a nation’s military strength and resultant ability to protect its borders and its infrastructure have played a role in the strength or weakness of its currency. As we have become more involved militarily in the Middle East over recent years, we have seen more weakness in the dollar. Not only have our peace keeping efforts drawn heavily on our military readiness, but also the additional costs incurred have steeply increased the issuance of government bonds to pay for all of the activity. Again the forces of supply and demand come to play. The more bonds we issue the greater the supply, and the greater the supply the lower the price. As our bonds are denominated in US dollars there is pressure on the dollar whenever there are large scale sales of US bonds, whether the sales are new issues from the Treasury, or bonds currently held by investors or foreign central banks.

In summary, there are many forces at play in determining the daily value of the dollar against the values of all other major currencies. To the extent that our personal investments are denominated in dollars, our financial well being is impacted when a weaker dollar diminishes the demand for the investments we hold. Each day it becomes more and more evident that we are part of a "global" economy, and that our actions as a nation regarding both our political and economic health have a measurable impact on our personal financial health.

©Patrick J. Catania 2009
The views and opinions expressed herein are solely those of the author and do not necessarily reflect those of Baxter Credit Union, its Board of Directors, or its employees. The author is responsible for the content. Readers should consult with, and seek professional advice from their own attorneys, accountants, and financial advisors with respect to their individual financial needs and circumstances.

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