The Dollar vs. the Euro

How low will it go?

When currency exchange rates change, businesses must adapt quickly. Knowing how a weaker American dollar is likely to affect your business may save some critical mistakes.

John Snow, the U.S. Treasury Secretary, made headlines in May 2003 with his response to questions on the decline in the value of the dollar. He commented that a weaker dollar is good for American exports (and the worrisome trade imbalance). Whether or not this was a casual statement or an intention to signal the market of a U.S. policy change, market participants reacted and the value of the dollar dropped even further. The dollar lost 19 percent of its value against the euro during 2003 with one-fourth of this loss occurring in December. [1] The Bush Administration continues to maintain that it supports a strong dollar, but as Secretary Snow reiterated on January 16, 2004, The determination of exchange rates is best left to the markets. [2]

The dollar has shown weakness against other currencies as well, including the British pound, Australian pound and Japanese yen. However, the most dramatic losses have occurred against the euro. From its low of 84 cents in July 2001, the euro has risen steadily in value, stopping just short of $1.29 on January 13, 2004. At that point, Jean Claude Trichet, European Central Bank (ECB) president, signaled mounting concern over the euros rapid rise by saying brutal moves in the dollar and excessive exchange rate volatility were not welcome and not appropriate and that Europes policy makers were concerned. His remarks and those of other European officials triggered a sharp fall in the euro. [3] However, observers note that talk without supporting action usually produces only short-term results, and the dollar continues to trend downward in value.

What does the decline in the value of the dollar against the euro mean to U.S. firms? Is the decline a sign of looming economic problems, or will it increase the competitiveness of U.S. products in Europe and lead to increased corporate profits, new jobs, GDP growth, and decreased government deficits? This article will examine these questions. While the question of the effects of the devaluation of the dollar against other currencies is important, that topic is beyond the scope of this article.

Why the Free Fall?

The exchange rate between the dollar and the euro is set by supply and demand. That is, the exchange rate floats or adjusts to the demand for (and supply of) dollars versus euros. Why has the value of the dollar declined so much, so quickly against the euro? Economic theory states that there are four major factors that determine the exchange rate between two currencies: the comparable interest rates, the relative inflation rates, the comparative level of income, and the macro policies of the respective governments. Two of these factors are most commonly cited as the causes of the loss in value of the dollar against the euro: interest rates and macro policies (both the trade and budget deficits).

Short-Term Interest Rates

Economic theory states that investors should earn the same return for investments of like risk regardless of the country in which the investment is made. If comparable rates differ in two countries, capital (money) would be expected to flow into the country offering the higher return. The greater rate of return would increase the demand for the countrys currency, which would appreciate in value, as reflected in the exchange rate, against the other currency. Short-term rates in the U.S. have been at 45-year lows resulting from the U.S. Federal Reserves (Fed) setting the discount rate and the Fed Funds target rate at 1 percent. Comparable rates in the eurozone are 2 percent. The Fed continues to state that it sees no evidence of the return of inflation and expects to keep rates at this level for a considerable period. The European Central Bank left rates unchanged after its January 2004 meeting. However, market participants anticipate an interest rate cut by the ECB to limit the euros rise. [4]

Trade Deficit

A trade deficit is created when the aggregate imports of a country exceed its aggregate exports. A trade deficit must be financed with government issued securities. The cumulative U.S. trade deficit set an annual record during 2003 with the $489.4 billion deficit surpassing the previous record of $418 billion recorded in 2002. In addition, the deficit grew from 4 percent of GDP in 2002 to 4.5 percent in 2003. [5] To finance the deficit, the government must attract funds domestically and/or globally. Some market participants fear the size of the deficit coupled with the low interest rates discussed above could cause financing problems.

So far, however, Asian central banks continue to be big buyers of U.S. Treasury securities as they increase their dollar debt in an effort to curb the appreciation of their own currencies and protect the competitive prices of their exports to the U.S. Japan spent a record $187 billion to support the yen [6] and protect the stirring of life in its economy. Like many Asian countries that peg their currency against the dollar, China increased its dollar foreign exchange reserves by 41 percent in 2003. [7] However, the Bush Administration has been putting pressure on China to float its currency, thereby increasing the price of its exports to the U.S. and helping to offset the trade deficit. Analysts expect China to show some flexibility and to slightly reduce its demand for dollars. [8]

Government Budget Deficit

If a governments expenditures exceed its receipts, then a deficit is created. As is true with the trade deficit, the budget deficit must also be financed with government borrowing. The federal budget surplus of the Clinton years has turned into the increasing deficit of the Bush years. The deficit has ballooned as taxes were decreased to stimulate the economy and government spending was increased to fight terrorism. However, the U.S. economy seems to have rebounded with a remarkable 8.2 percent growth in GDP in the third quarter of 2003. Consensus forecasts for 2004 predict that the U.S. economy will grow at 4.2 percent, compared with 2 percent for Japan and 1.8 percent for the eurozone. [9] As the U.S. economy rebounds, receipts will increase, and if no additional economic or political shocks occur, the deficit should begin to decrease.

What Are the Implications of a Weak Dollar?

Who benefits from the weaker dollar? European tourists are flocking to U.S. destinations such as New York City. New York stores report a surge in sales, particularly in high-end items. New York hotels report high occupancy rates and restaurants report increased reservations. [10]

However, the major impact is to U.S. firms, who benefited from a weaker dollar that made their products less expensive in overseas markets. Less expensive products translate into increased sales and higher earnings. It is estimated that the weaker dollar added 2 percent to the S&P 500 companies revenues during the first half of 2003. [11] U.S. exports continued to increase in the last half of the year. In November, exports hit their highest level in three years, thereby causing the trade gap to decrease to $38 billion from $41.6 billion in October. Imports also retreated slightly from Octobers record highs. [12]

Large companies are not the only ones to benefit from the weaker dollar. More than 212,000 small businesses – those with fewer than 100 employees – and 18,000 midsize companies – with 100 to 500 employees – exported their goods or services overseas in 2001 (the latest year for which the Commerce Department has data). These small and midsize businesses accounted for $182 billion in trade, or 29 percent of all exports. [13]

The weaker dollar has had a positive impact on GDP. International trade represents a portion of GDP, so one may infer a positive effect of the weakened dollar on GDP growth. The Institute for International Economics in 2002 estimated that a decline of 10 percent in the value of the dollar increased GDP by .5 percent and that a 20 percent decline increased GDP by 1 percent. [14] Given the approximately 15 percent decline in the dollar valuation in 2003, we may infer a .75 percent increase in GDP due to the weakened dollar.

Higher corporate profits helped major stock indices post double digit increases in 2003 after two years of negative returns. The good news continued in early 2004 as indices hit two year highs with the Dow Jones Industrial Average passing the 10,000 mark and the NASDAQ exceeding 2100. However, political events in March overshadowed the positive news. The train bombings in Spain, the acceleration of the Israeli-Palestinian conflict, and the continuing fighting in Iraq and Afghanistan caused the markets to retreat, and the indices lost all of their 2004 gains. Market participants still expect good news when firms announce earnings in April. Given no new security worries, indices are expected to gain back some (if not all) of the March losses.

Who is hurt by the weaker dollar? Domestic consumers are paying substantially more for imported goods and U.S. tourists in Europe are finding their dollars buy much less.

Some U.S. businesses are also hurt by the decrease in the value of the dollar. The Commerce Department does not keep data on the number of small and midsize businesses that import goods from overseas to sell in the U.S. However, evidence suggests that small and midsize importers are scrambling to find ways to survive the weak dollar. Paul W. Vierck, a vice president in the Oakland, California office of Commonwealth Foreign Exchange, reports that he receives calls daily from small firms asking what they can do about the exchange rate. His reply is, Not much. Larry Lazin, a businessman who imports lamps from several European countries, estimates his profits will decrease by 10 percent this year even though he has increased his prices. [15]

A more subtle and difficult-to-measure problem develops for industries that ship raw materials to Europe for manufacture into finished products, which are then shipped back to the U.S. For example, the European market for wood veneers used by the furniture industry from states such as Indiana and Pennsylvania had almost disappeared because of lower cost products from Eastern Europe and Austria. However, the weaker dollar has again made U.S. wood veneer competitive. The problem is that the weaker dollar has also increased the price on European furniture in the U.S. and therefore has had some negative impact on demand. Lower demand for the finished product (the furniture) has decreased the demand for the raw material (the wood veneer). [16]

An additional problem may be developing with the price of oil. Oil producing countries have traditionally denominated transactions in dollars because of the dollars strength and relative stability. Use of dollars has thus allowed such countries to set their dollar target price per barrel and regulate supply to maintain this price. However, the depreciation in the value of the dollar has required the Organization of Petroleum Exporting Countries (OPEC) to increase their price above the targeted range. In addition, a report from the Bank for International Settlements found that OPEC countries are increasingly repatriating money rather than keeping dollars or exchanging dollars for euros. The implications of higher oil prices for the economy and/or the decreased OPEC demand for the dollar have a potential, tremendously negative effect on the value of the dollar. [17]

The eurozones largest economy, Germany, slipped into a recession last year for the first time since 1993. A major cause of the recession was the impact of the strong euro on exports. The domestic German market has been weak for several years. However, until 2003, strong growth in exports offset the weak domestic demand. Francis Mer, the French finance minister, has warned that exchange rate volatility was dangerous and could endanger the eurozones fragile economic recovery. [18] Ferrari, the Italian sportscar maker, reported that it is losing money on each car it sells in the U.S. its largest market, because of the falling value of the dollar. Other European carmakers, including BMW, Volkswagen, and Porsche, have seen their profits plummet as they have tried to absorb some of the loss rather than pass through the price increases to consumers. [19]

Why should the U.S. worry about the financial health of Europe? It is a major trading partner of the U.S. If the countrys expansion is to continue, the U.S. needs a healthy Europe.

Conclusion

Market participants believe that the dollar will continue to fall against the euro. Forecasts that the euro will increase to $1.35 U.S. or more by the end of 2004 are being discussed. However, we can expect to see European policymakers take steps to slow the rise of the euro to effect the development of a more orderly and less volatile market. Who will be helped? U.S. firms that export their products to Europe can look for another banner year. U.S. firms that import from Europe should protect themselves by hedging in foreign exchange markets.

And what are the implications for U.S. citizens? Have you seen the Grand Canyon?

There are many currency converters available on the Internet should you wish to check the current exchange rate of the US dollar against the euro or other world currencies or to check any currency against another. You may cllick here for one such currency converter .

If you would like to check out your understanding of currency exchange rates and some of the other concepts mentioned in this article, try your hand at the Currency Exchange Quiz . It is fun, and there is nothing to lose.

[1] The New York Times, December 30, 2003, p. C8.

[2] The Financial Times, January 17/18, 2004, p. 1.

[3] The Financial Times, January 13, 2004, p. 1.

[4] The Financial Times, January 17/18, 2004, p. 13.

[5] The New York Times, February 14, 2004, p. B3.

[6] The Financial Times, January 5, 2004, p. 13.

[7] The Financial Times, January 13, 2004. page 1

[8] The Financial Times, December 9, 2003, p. 17.

[9] The Financial Times, December 6/7, 2003, p. 6.

[10] The Financial Times, January 9, 2004, p. 1.

[11] The Wall Street Journal. June 6, 2003.

[14] Institute for International Economics conference, 2002.

[15] The New York Times, January 15, 2004, p. C6.

[16] The Financial Times, January 9, 2004, p. 1.

[17] The Financial Times, December 9, 2003, p. 17.

[18] The Financial Times, January 16, 2004, p. 4.

[19] The Financial Times, January 6, 2004, p. 20.

About the Author(s)

Terry Young, PhD. has over 15 years of business experience in Asia and the United States. Thoroughly versed in international economics, Dr. Young has extensive knowledge of the global marketplace, with primary emphasis on Asia. Her consulting expertise includes global sourcing, business start-ups and management in such industries as food distribution, the textile and garment industries, agriculture, electronics, and real estate development. Dr. Young’s 20-year university teaching experience includes assignments at the University of Southern California, at two California State University campuses, and a full-time professorship at Pepperdine University’s Graziadio School of Business and Management where she received the Luckman Distinguished Teaching Award in 1994.