dollar falling

How the dollar's value is threatening your shares
By Nick Louth, MSN Money special correspondent
Last updated March 4 2005

The dollar is falling, and is unlikely to stop for quite a while. Whatever your investments, this is going to affect you. Here are some quick answers to seven key questions on this issue

Travelling across the Pacific Ocean, enormous freighters arrive in US ports, stuffed with Chinese clothing, and electrical goods, South Korean flat-screen TVs and Japanese electronics. Many of these vessels return home empty to pick up another load and bring it back.

The US economy is living beyond its means, with both government and consumers spending like there is no tomorrow, and running up bills with those economies that supply it. In 2004 alone that trade deficit was $672 billion, a 30% rise from 2003. When those exporting nations decide to cash in their dollars, the greenback will inevitably fall.

Why does the dollar have to fall when it represents the world’s strongest economy?

Though the US economy has been growing strongly, at more than 5.5% a year, about twice the rate of the UK, that growth has been led by domestic consumption. That in turn has been partly fuelled by US budget deficits, with the government spending far more than it receives in taxes.

Though President George W. Bush has recently proposed a tighter than usual budget for 2006, it will be too late to stop spending exceeds taxes by a record $427 billion in 2005. Although that may seem modest at 3.9% of annual GDP of $10.9 trillion (ie. $10,900 billion), it is the stack of debt being built year after year up that is frightening.

Who owns all these debts?

US debt owed to foreigners has trebled to $3.5 trillion in the past 20 years. Japan is owed $715 billion, China $191 billion, Britain $152 billion and South Korea $70 billion.

Britain’s high placing on the creditor list owes much to the fact that British banks hold a vast amount of US debt on behalf of investors from other countries. That same reason explains Caribbean banking centres huge $76 billion holding.

When will the dollar plunge?

That is the hardest part to predict. Currency re-alignments are like the tectonic plates of economics. They can strain for years, building up pressure without much happening, driven by the pressure of economic imbalances. The bigger the imbalances, and the weaker the corrective action taken, the greater the chance of a devastating dollar collapse which could throw the world into a slump.

Already this month, South Korea has said that it will spread its future foreign exchange holdings away from the dollar which account for a third of its $200 billion reserves. The announcement was enough to set the dollar on a temporary slide.

How far will it fall?

A falling currency should be a self-correcting mechanism for trade imbalances by encouraging exports and making imports more expensive. However, Asian countries such as China and Hong Kong, where the US trade deficit is particularly large, have pegged their own currencies to the US unit, rather than letting them float as the pound does. The dollar doesn’t fall against them, but drags down their currencies too against floating currencies like the pound, euro and Japanese yen.

So although the dollar fall does nothing to help US deficits with dollar-linked economies, it helps those same economies become more competitive against the rest of the world. The effect is to slow correction in trade flows, and make a sharp dollar fall, or even a crisis more likely.

How long will it last?

That is an even harder question. Once the dollar starts sliding again, it could fall for months or even years before stopping. It may well move beyond the point at which it is ‘correctly’ priced for future balance. This is not unusual. Like a supertanker, the billions of dollars of selling cannot be easily turned around.

Can anything be done to stop it?

The Federal Reserve, the US central bank, has been gradually raising interest rates since June 2004, but they are still extremely low by historic standards. US bonds yield around 4.5%, and the official Fed Funds rate is only 2.5%.

For Alan Greenspan, chairman of the Fed, this is a delicate balancing act. He needs to keep rates rising so that US bonds are attractive to foreign investors, but each rise devalues trillions of dollars worth of existing bonds which pay lower rates. Moreover, increasing rates raises the government’s own bill for debt interest charges, and if pursued with too much vigour may slow down the economy on whose strength all attempts at debt repayment hinge.

Cutting the budget deficit directly is the main way of addressing the problem, as the Fed chairman himself said earlier this month. Though he acknowledged that it wouldn’t be easy, he added: "But that does not mean that we shouldn't begin focusing on the goal of getting the deficit down, especially, as quickly as we can, before we begin to run into the really serious problems in maybe 2012, 2014. We don't have a lot of time to do it."

I only own my house and a few BT shares. Why should I care about the dollar?

The falling dollar tends to drag the pound down a little against other currencies, particularly the euro. While that will make exports more competitive (except to the US), it pushes up the price of imports. An open economy such as Britain’s is hard to insulate against rising interest rates across the Atlantic because of the competition for international interest-bearing deposits.

In short, if US rates go higher, our rates will tend to rise too. That could affect your mortgage interest rate, and to some degree could lessen the attractiveness of high dividend shares like BT.

What can I do about it?

* Don’t buy US assets such as real estate.
* Steer clear of US shares unless they are in export-based industries and can be expected to become more competitive.
* Consider borrowing in dollars. As the currency falls, these debts will become smaller. The interest charges are already lower than you would pay in the UK
* Holiday and shop in the US and take advantage of falling prices in sterling terms. Be sure to pay for your items by credit card. By the time the bill comes through you may have saved a few cents in every dollar.
* Don’t buy shares in big dollar earning UK stocks, such as pharmaceuticals.
* Expect UK interest rates to rise, so keep your overall indebtedness low.
* Expect the price of dollar-denominated commodities such as oil to keep rising.