Monday, September 5

Some effects of a devalued Dollar.

During my trip to Finland this last May I met up with a number of my Finnish MBA classmates. During the course of the evening, the topic of the value of the dollar came up. It was almost unanimously agreed (Not including me) that the US dollar is headed for a severe devaluation. It was also agreed that there has been a decent devaluation of the dollar compared to the Euro over the last couple of years. (That is fact)

It seems a strange time to write about the ‘impending’ depreciation of the dollar, especially considering that the value of the dollar has been rising against the Euro, with the recent decline, due mostly to the hurricane. One of my expert friends was explaining that the current rise is partly due to the close of contracts where dollars were borrowed earlier with the expectation that they could be purchased later at a lower rate. Now the dollars need to be bought back and that has increased the demand for dollars with the result of supporting the currency.

The general consensus was that this was a US generated problem but now that I have thought about it, I do not think so. The cause of the problem lies elsewhere. Sure the US Government is a key player, but not the only one. The other key players are the Asian economies that have been buying dollars in order to keep their own currencies devalued. This of course is to support their industries that depend highly on exports to the US, and these exports are highly dependent on their currencies being cheap in relation to the dollar.

There have been a couple of news articles suggesting that Asia just might stop propping up the dollar unless the US institutes reforms. (See links at bottom.) In essence the Asian economies, by keeping the value of their currencies artificially low, have prevented any nature market corrections to take place. China for the longest time has fixed the value of its currency to the dollar. To do so, they buy and sell the two currencies in order to maintain the exchange rate. This has resulted in the buying of large quantities of dollars.

But the ‘fear’ now is that China, Japan, South Korea will stop buying dollars, thereby causing a collapse of the dollar. Alternatively, to prevent the collapse of their foreign reserves, these countries will continue to buy dollars to protect the value of the dollars they already own, stuck in a catch-22, in essence throwing good money after bad. Should we feel sorry for them? I don’t. It was this very activity that enabled growth in each of these countries. Unfortunately, they did not attempt to create a natural balance in the exchange rate, and the growth in their own economies forces them to spend ever more money to maintain the export advantage that they currently enjoy.

But lets pretend that the value of the dollar does collapse. Who might be effected and how?
Here are my thoughts about this:

Firms that have invested heavily in China – At the moment it is extremely cheap to shift manufacturing to China, but what happens if the value of the dollar drops? Technically the value of the factories in China in dollar terms appreciates. However, the factories will lose the market that they were producing products for due to the loss of the cost advantage. Of course they could produce for other markets or even the domestic Chinese market, but I would suspect that there would be a severe manufacturing overcapacity in that case.

Take for instance Play-Doh. In Target a four tub pack of Play-Doh costs under $2. Not bad for a product made in the USA. In Finland the same four tub pack, made in China was selling for €4 (about $4.80.)

There are countless other products that would no longer be imported from China if the dollar depreciates.

The Bond Market – The US has never defaulting on a bond issue and the devaluation of the dollar will not change that. However, as a wise Finnish friend pointed out, that does not matter as the value of the bonds in their own currency will have lost value in direct proportion of the drop in the dollar compared to their home currency.

The guess is that foreign investors will shy away from buying US bonds, especially those that are burned by a devaluation. I agree when it comes to current purchasers who will have seen billions in value of their holdings disappear. Bonds might be a great investment opportunity for new investors, provided that the dollar recovers, which it most likely would over time. Of course current bond investors could ‘average down’ to lower their average cost. But if you’re willing to buy bonds, why not buy stocks instead?

The Stock Market – Can you say CAOS? At least initially the stock market will probably dive at first. The effect will be worsened because the initial drop will hit all those who are playing in the market on margin hard. Many margin players will be forced to sell because they do not have enough money to cover the drop of their portfolios. This will force the market even lower, at first. However, I would think that this would be short lived, at least for better stocks. See the devaluation will create a buying opportunity for foreign investors and those who have money on the sidelines.

Domestic Manufacturing – The demand for products will not disappear with the drop of the dollar. Of course there will be exceptions. As foreign-made products become more expensive it becomes more viable to product ever more products domestically.

American-made products will also become cheaper to foreign markets, creating an export boom.

Inflation - Well this will probably take a good hit especially concerning an increase in energy and raw material prices. The country does have a good record of controlling inflation. Part of this will be tied to the ability to the government to control spending. Not for anything but there is a ton of pork in the Federal Budget. The question will be if they can cut pork, or find a way to spend our way out of this.

Countries that will suffer more than the US – the stories are predicting doom and gloom for the US if the dollar is devalued, but I think the following countries will be much bigger losers if this happens:

China, Japan, South Korea – All are heavy purchasers of US bonds and depend on their currencies being relatively cheap compared to the dollar to power their exports.

Canada – Our Northern neighbor has already been crying foul regarding the recent appreciation of the Canadian dollar against the US dollar. A further drop in the US dollar will surely hurt them. Canada might benefit in one way, the drop of the dollar might stop the steady stream of skilled professionals from Canada to the US.

China – China’s economy is on fire. The drop in the dollar will surely put the fire out.

The EU – As with Canada, some members of the EU, like Germany, have been blaming the decline in the dollar as stifling growth within the Euro countries. On a posting at Finlandforthought.net I had asked what would happen to Europe if these was a collapse of the US economy. One poster replied “Much the same as happened to Finland when the Soviet Union disappeared, taking its trade with it.” (comment here, the topic was hurricane related)

The Housing Boom - A drop in the dollar might actually sustain the housing boom and counteract the signs that it has reached the end of its run. Property in the US would be much cheaper to foreign buyers who would probably take the opportunity to buy up America. This is a good thing to protect home values, unless you have something against selling to a damn foreigner.

Energy and Global Warming – A drop in the dollar might do a world of good in stemming global warming. First by extinguishing many ‘dirty factories’ and second by cutting wasteful use of gasoline in the US. There are already signs that SUV’s are losing popularity. A substantial rise in the price of gas will surely aid in a shift to more economical vehicles as has happened in the past. In an odd twist of fate, the drop in the dollar might lead to an increase in SUV exports. At any rate, a drop in the dollar will make gas more expensive as crude will be more expensive as that is priced in the international market.

This is by no means an all-inclusive list. That is better left to an Economist. However looking at the issue, the rest of the world has more to lose than the US if the value of the dollar declines. So what if French wine and cheese will cost more. We do make these items at home. Perhaps its time to try it before its the only products that you can afford. At the same time you can protect the value of the dollar. What you buy decides where your money goes, including to countries taking American Jobs...

Brand Loyalty – Buy American - Fred Fry
Asian Central Banks Play Chicken With the Dollar - Bloomberg, Caroline Baum
Don’t bank on China - Financial Times, John Dizard

3 comments:

learn e currency exchange program said...
This comment has been removed by a blog administrator.
mr.smooth said...

Thank you for this article. I have been searching for information on the effects of a possible dollar devaluation.

It seems much has happened since you wrote this. Are we close to a dollar devaluation? Many think we are in for a bank holiday soon.

Anonymous said...

Yes, very close .... end of 2010.