Shifts in the value of the U.S. dollar can be felt in a variety of ways. Old assumptions regarding the impact of a rising or falling currency may not necessary hold true. In this era of globalization and infinite supply chain strategies, new realities are increasingly painting a different picture.

Currency Assumptions Fade

A weakening dollar traditionally has been assumed to result in less expensive American exports, making them more competitive abroad. A weakened dollar also is expected to cause the price of U.S. imports to rise. Increasingly, however, both U.S. and foreign manufacturers rely on imported components and materials, making the impact of exchange rate fluctuations more nuanced.

Consequently, previous assumptions that reducing the value of the dollar will improve the U.S. trade balance may no longer be valid. At play are new factors that have turned a previous black-and-white scenario grey.

Smaller Pass-Through Rates

In March 1973, the Federal Reserve’s Nominal Major Currencies Dollar Index was set at 100. Since then, the dollar's value has risen and dipped considerably. For example, the dollar reached 143.90 in March 1985 and fell to an all-time low of 80.10 in December 2004. As of October 2006, it was at 82.69.

As the value of the dollar declines, imports should become more expensive and, in turn, slow. With the exception of oil, imports have not become more expensive, according to Catherine Mann of the Institute for International Economics. Studies indicate that a change in the value of the dollar has a much smaller pass-through rate — that is, the extent to which changes in the exchange rate induce changes in a country’s import and export prices — than previous believed.

Mann cites several factors that explain a low pass-through rate, including low global inflation and the willingness of foreign exporters to accept smaller margins to retain U.S. marketshare. As a result, she says, a bigger drop in the dollar will be necessary to change import prices enough to slow the American appetite for foreign goods.

Economists Linda Goldberg of the Federal Reserve Bank of New York and Jose Manuel Campa of the University of Navarra in Madrid, Spain, found that pass-through rates for the United States were significantly lower than for other industrial countries. They indicate a 10-percent change in the dollar generally yielded only a 2.5-percent change in American import prices within one quarter, and only a 4-percent price change after several quarters.

"Currency values have had little to do with changes in the trade balance in recent years," according to Daniel Ikenson, a Cato Institute policy analyst. Changes in relative incomes and wealth, the availability of domestic and other foreign substitutes, and opportunity costs of finding new suppliers play a more significant role, he says.

Dollar Falls While the Trade Deficit Rises

Between 2002 and 2005, the U.S. dollar depreciated 23 percent against the Canadian dollar and 24 percent against the euro. During this period, the U.S. trade deficit with Canada and the 12 European Union members utilizing the euro rose by 58 and 39 percent, respectively, Ikenson says.

"Of all the other major U.S. trading partners whose currencies appreciated against the dollar — Japan, the United Kingdom, Korea, Taiwan, and Brazil — only Taiwan had a trade surplus with the United States that declined over the period," Ikenson continues. "And that decline was a relatively modest 8 percent. In contrast, the U.S. deficit increased by 18 percent with Japan, 22 percent with Korea, 71 percent with the United Kingdom, and 181 percent with Brazil."

Yuan Assumptions Risky

Assumptions about the Chinese yuan could be problematic. In response to a substantially undervalued currency, many believe China should float the yuan, assuming its value would rise. In that case, some economists predict the yuan would become volatile due to China’s fragile financial sector and fall, possibly leading to a financial crisis.

It also is widely believed that a stronger yuan would result in a vastly improved U.S. trade deficit. However, many economists, including former Federal Reserve Chairman Alan Greenspan, say if the yuan were to significantly rise, Americans would continue to seek low-cost imports from other countries. That would not improve the deficit.

Additionally, yuan appreciation would reduce Chinese costs of imported materials, enabling Chinese producers to lower their selling prices without denting profits, Ikenson says. In turn, increased Chinese purchasing power could inspire greater demand for commodities, such as copper, iron ore, and oil, driving up U.S. commodity import costs beyond levels associated with a depreciating dollar.

New Realties Require New Thinking

Today, approximately half of all American imports are capital goods, industrial supplies, and materials used in the production of finished goods. Consequently, the declining value of the dollar relative to other currencies can increase — not decrease — the price of U.S. exports that use imported inputs.

While attempting to predict currency shifts has become even riskier, applying outdated assumptions about their impact can lead to poor business decisions.

This article appeared in October 2006. (CM)

John Manzella
About The Author John Manzella [Full Bio]
John Manzella, founder of the Manzella Report, is a world-recognized speaker, author of several books, and an international columnist on global business, trade policy, labor, and the latest economic trends. His valuable insight, analysis and strategic direction have been vital to many of the world's largest corporations, associations and universities preparing for the business, economic and political challenges ahead.

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