By Richard Lee, Currency Analyst Published: February 22, 2007
Dollar Good or Bad For the US
Is a strong US dollar good or bad for the US economy? Typically the word strong is perceived as a positive reference but when it comes to a country’s economy, a strong currency may not be in their best interest. In fact, many countries like China and Japan take an active effort to weaken their currency because their countries are export dependent. Being the most actively traded currency in the world, it is very important to understand whether a strong dollar actually helps or hurts the US economy, especially given the currency’s recent movements. Over the past 2 months, the dollar has advanced almost 4 percent or 500 points against the Euro. Against the Japanese yen, the greenback has mounted an advance of 750 points or 7 percent in two months. Is this appreciation good for America? Some people claim that it helps to accelerate the pace of growth while others hail the drawbacks of a stronger dollar, saying that it will have detrimental effects over the longer term. With arguments on both sides, it is important to examine the specific pros and cons of a stronger dollar.
Benefits of a Stronger Dollar
When growth is strong, we typically see an increase in the value of the US dollar because at that time, the stock market is most likely performing well and attracting foreign investment. As the stock market rallies and the economy continues to boom, the Federal Reserve becomes worried that this euphoria may get out of hand by boosting inflationary pressures and creating a speculative bubble. Therefore towards the middle boom, they begin to consider raising interest rates to tame growth and to prevent a damaging crash that may occur later on.
Reflective of US Economic Growth
A stronger dollar is good for the US because it tends to reflect accelerating growth in the economy. When investors and speculators buy or sell a specific currency, they do so because they expect the value of the currency to go higher relative to another currency. Since the US dollar is the most actively traded currency in the world, its valuation tends to be reflective of the direct outlook for the US economy and its monetary policy. Higher amounts of exports, increased production and advancements in goods manufacturing all contribute to a growing economy and increase the demand for the US dollar. Consumer spending also helps. With higher employment, consumers will not only become more optimistic, but they will tend to spend more as well. This increase contributes a good portion to the economic expansion as consumer spending equates to almost 60 percent of overall growth. Ultimately, all factors considered, the positive sentiment supports a stronger currency as foreign investors seek stable assets.
US Purchasing Power Increases Abroad
The benefit of a stronger dollar is that it also increases the purchasing power of US consumers abroad. A luxury handbag or a car that once was too expensive to own, may be purchased for a cheaper price thanks to a higher exchange rate. Vacations and trips to foreign countries also become bargains as travelers are able to see the world at adjusted package prices. Here, not only has the cost of travel (buying a ticket, booking a hotel room) become cheaper, voyagers can also stretch their budgets to include more activities that would have otherwise been foregone. This tends to boost consumer confidence as the shift in exchange rates make US citizens feel wealthier.
Cross Border Transactions Accelerate
Consumers are not the only ones to benefit from a stronger dollar; companies on an acquisition binge do so as well. Much in the same light as a consumer, a company’s purchasing power also increases when converting dollars into euros, pounds or yen. With a stronger dollar, foreign companies become cheaper in valuation compared to US based or domestic companies. The bargain notion could spark a wave of cross border transactions as American companies look to either add to their own overall business or eliminate a competitor by acquiring them.
Risks Brought on By a Stronger Dollar
Yet there are as many negative ramifications of a stronger dollar as there are positive ones.
Widens the Trade Deficit
Although the appreciation in the dollar does give consumers more purchasing power, odds are that most of the increased spending will take place outside of the US. The demand by Americans who known for their penchant for foreign luxury goods, will increase the import balance and the US trade deficit. This increase has its detriments as it erodes overall growth, hurts GDP and weakens the economic expansion. There is essentially a self-correcting mechanism in the foreign exchange market. A stronger dollar basically leads to a weaker dollar while a weaker dollar eventually leads to a stronger one through the implications of growth.
Cuts Into Corporate Profitability
Along the same lines, a stronger dollar reduces the competitiveness of US goods that are sold outside of the US. When the US dollar strengthens, foreign trade partners will have to pay more euros and pounds in order to make up for the appreciated dollar when they import from the US. Subsequently, the increase will lead to a decline in demand as American made goods become less attractive to buy at the consumer level. This slump in demand will ultimately translate into thinner profit margins of manufacturers and producers in the US, depleting expansion potential in the country. The result in the longer term will be slower growth even as US consumers up their near term standard of living.
Could Force the Fed to Raise Rates to Tame Growth
A stronger economy could force Federal Reserve policy makers to consider raising benchmark interest rates. Initially this will help to fuel even further gains in the US dollar as foreigners send money into the US to capitalize on the higher yield. However the rate hikes essentially raise the cost of money, making it costlier for consumers to spend. Ultimately, the decisions would hinder growth as they promote consumer hesitance rather than spending.
What’s Going On Now?
A more macro look at the performance of the US dollar over the past 12 months reveals that it has fallen 10% against the Euro, 12% against the British pound and has risen 2.5% against the Japanese Yen. The fact that dollar strength is not unanimous indicates that the currency’s value is not a major concern for economy watchers at the moment. Instead, the dollar’s strength against the Asian currencies such as the Chinese Yuan and Japanese Yen are a mere annoyance, albeit a big one. The depreciated yen and low value of the Yuan are making Asian goods cheaper than American goods both domestically and internationally. This has fueled a record trade deficit with China and spurred protectionist sentiment. Manufacturers have been screaming since the strong dollar, and weak Asian currencies are cutting into corporate profitability.
A stronger currency has its backers and opponents like anything else in the market. A stronger dollar is good in the sense that it helps consumer spending and reduces inflation. It effectively allows the American consumer and corporation to stretch their dollar further, either abroad or on imported goods. But, an appreciated greenback conversely increases the trade deficit while weakening the export sector, removing the competitiveness of American made goods. Ultimately currency valuations are cyclical. A stronger dollar tends to lead to a weaker one which eventually helps to encourage economic growth and provide the backdrop for a stronger currency. Either way, currency fluctuations are becoming an increasingly larger consideration expanding from the small town shopper to the manufacturing giant and onto even bigger US policy makers. As the dollar continues to strengthen, or weaken, everyone in some part will need to take a side.