When market participants attempt to predict currency shifts, they must be wary of applying outmoded assumptions. Projecting currency moves has become increasing challenging in globalized markets. A misinterpretation of trends can lead to poor business decisions.

Fading Currency Assumptions

It is also increasingly difficult to predict the impact currency shifts may have. For example, it used to be thought that as the U.S. dollar fell against other currencies, American exports benefited. That’s because U.S. goods became less expensive when prices were translated into foreign currencies. As a result, American manufacturers became more competitive abroad. At the same time, a relatively weaker U.S. dollar was expected to lead to increased prices in imported goods. For a variety of reasons, these assumptions may be outdated.

Today, changes in the value of the U.S. dollar in international markets are having lessened effects on America’s balance of trade. Globalization and increasingly sophisticated international supply chains are empowering manufacturers around the world to take advantage of best-priced components produced in a range of countries.

Role of Pass-through Rates

The value of the U.S. dollar is reflected in the Federal Reserve’s Nominal Major Currencies Dollar Index. Over the past third of a century, the dollar has undergone considerable market gyrations. The all-time high came in March 1985 when the index reached 143.90, while the lowest point came in December 2004 at 80.10.

In roughly a 20-year period, the dollar fluctuated in an almost 100 percent range. As of January 2007, the index stood near its low at 81.9.

Applying conventional thinking, when the dollar falls in value, imports should become more expensive and begin to slow. Except for oil, however, imports in the past several years have not become more expensive, according to international trade studies.

Instead, changes in the value of the dollar have, in economists’ terms, much smaller pass-through rates. That is defined as the extent to which changes in the exchange rate lead to changes in the prices of a country’s imports and exports. Those changes are much smaller than the conventional theory would predict.

Among factors accounting for the low pass-through rates are moderate inflation worldwide and foreign exporters taking smaller margins in favor of building U.S. market share. As a result, it will take a much deeper fall in the value of the dollar to alter import prices to the point where the American appetite for foreign goods will decline.

In one study, economists found that pass-through rates for the United States were much lower than for other industrial countries. A 10 percent change in the dollar, for example, 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.

Changes in trade balances are not necessarily correlated with shifts in currency values. Such other factors as changes in relative incomes and wealth, the availability of domestic and other foreign substitutes, and opportunity costs of finding new suppliers play critical roles.

Dollar Value and Trade Deficits

There have been instances when the U.S. dollar dropped as measured against other currencies, while the country’s trade deficit rose. It was not, however, a lockstep move.

Stated by Daniel Ikenson in Impact Analysis, between 2002 and 2005, the U.S. dollar fell 23 percent against the Canadian dollar and 24 percent against the euro. Concurrently, the U.S. trade deficit with Canada and the 12 European Union members who use the euro rose by 58 and 39 percent, respectively.

Nevertheless, among such major U.S. trading partners as Japan, the United Kingdom, Korea, Taiwan, and Brazil, only Taiwan had a trade surplus that declined over the period. Furthermore, that decline was only 8 percent. Meanwhile, 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.

Brave New Trade World

Capital goods, industrial supplies and materials for production of finished goods account for about 50 percent of all American imports. A decline in the value of the U.S. dollar against other currencies would actually increase — not decrease — the costs of U.S. exports that use imported inputs.

Changes in the value of the U.S. dollar can take a multitude of forms. Generally accepted assumptions from the past concerning the effect of a rising or falling currency may no longer necessarily hold true. A new world order has dawned, characterized by globalization and infinite supply chain strategies. In time, new realities will destroy old assumptions that have been spawned by contemporary trade dynamics.

This article appeared in Impact Analysis, January-February 2007.

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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