Ten Days in London In January I had the distinct pleasure of leading a UST MBA course in London. The 29 students enrolled in the course, Global Financial Services, were exposed to two salient facts: London is the center for international finance beyond the United States, and the Great Britain Pound (GBP) has become extremely expensive in dollar terms.
The prices for day-to-day living in London in U.S. dollar (USD) terms were fantastic: $8 for a tube ride, $1.70 for the daily newspaper, $5 for a Starbucks medium coffee, and even a $20 admission fee to St. Paul’s Cathedral. The USD is now at an historic low versus most other world currencies. But there will come a day when the dollar will strengthen.
A Brief History The current exchange rate system can be traced back to World War II. Within a few weeks of the end of the war, representatives of the world’s free economies met in New Hampshire to establish international currency exchange standards.
In what has become known as the Bretton Woods Agreement, all major world currencies were “pegged,” or fixed, to the USD, and the U.S. government guaranteed that dollars could be redeemable in gold. Central banks of non-U.S. governments would need to buy or sell USDs on a daily basis.
This currency exchange system worked well for about 25 years, until the inflationary period of the late 1960s. In 1971, the United States relaxed its guarantee of exchange of dollars for gold, moving off the “gold standard,” and the major world currencies moved toward a “floating” exchange rate to the USD. Since then, the USD has moved through a number of bull and bear markets relative to other world currencies. We are presently at an historical low, making foreign goods expensive here, and U.S. goods cheaper outside the United States.
Every day, the “spot rate” is determined for the USD relative to world currencies, which include the GBP, the euro, the Swiss franc and the Japanese yen. These spot rates are driven by currency speculators anticipating that the exchange rates will strengthen or weaken in a relatively short time. This is classic supply-demand economics. If currency speculators think the United States will weaken, the demand for the USD declines, and the dollar declines. The reverse also is true. Emotionality drives the spot rate. Over the past 5 Â½ years, the dollar has been in continual decline, falling 36 percent against a basket of foreign currencies. Why is this the case?
The Twin Deficits In simple terms, non-U.S. investors, including currency speculators, have lost faith in the U.S. economy and U.S. foreign policy. The U.S. economy has been financed almost exclusively by foreign investment in the United States. This sounds counterintuitive, but the reality is that U.S. consumers have borrowed extensively over the recent past to finance their lifestyles, and savings rates in the United States are at an all-time low.
The first deficit, the “current deficit,” represents the amount of exports relative to the amount of imports. We arrive at a negative trade deficit when imports exceed exports. When this occurs, foreign investors purchase USDs in order to finance this trade deficit.
The second deficit, the “federal government deficit,” has increased dramatically over the last eight years, from approximately $5.9 trillion (USD) to $9.3 trillion. The federal government does not raise enough taxes to finance its spending, and needs to finance this difference by issuing government bonds, which have been purchased by non-U.S. investors over this time period. Presently, 52 percent of U.S. treasuries are owned by non-U.S. investors. The governments of Japan, China, Taiwan, and the OPEC countries own approximately 40 percent. Some pundits put it this way: The Iraq war and other government programs are being funded by non-U.S. investors rather than the taxpayers of the United States.
The Cycle Turns
As mentioned, the cost of U.S. goods has become less expensive outside the United States. Thus, the current deficit declined in the second and third quarters of 2007 and is expected to continue to decline. The government budget deficit also has begun to decline.
Over the last few months, the dollar has seemed to stabilize against the basket of world currencies. In addition, the rates of return on U.S. investments have declined, which lead some to believe that non-U.S. investors may decrease their investments in the United States. Or some foreign governments may remove their peg to the USD, which, if done in a rapid and haphazard fashion, could lead to further declines in the USD. So it’s a precarious moment.
There are others who believe, and I am among them, that the non-U.S. economies have so much at stake in USD denominated investment that they cannot afford to allow the dollar to continue to precipitously decline, and would prefer stabilization, if not appreciation, of the USD. Too many people have too much to lose if the dollar continues to decline.
Long-Term vs. Short-Term Exchange Rates Any discussion of currency exchange rates must include the economic principle of purchasing power parity (PPP). This principle holds that long-term equilibrium must be realized to equalize the price of purchasing similar goods in all currencies. This is based on the law of one price.
In an efficient market, identical goods must have one price. As noted above, while spot rates or daily market exchange rates fluctuate based upon currency speculation, long-term exchange rates must eventually return to parity. At any given moment, the USD will be undervalued or overvalued relative to other world currencies, and so they to each other, but in the long-term, rates must equalize on a purchasing parity basis. A brief example: Suppose a Starbucks regular coffee is priced at $2 in U.S. terms, and that the GBP current spot rate exchange is USD2 for GBP1. The price of the Starbucks coffee in London, therefore, should be $4. If it is more than that, then the USD is undervalued, and conversely if it is less than $4 then the USD is overvalued.
Now, suppose that the actual cost in London is GBP2.5, or USD5. This means that, in this example, the GBP is overvalued relative to the USD by 25 percent. The principle of one price holds that ultimately the price of this cup of coffee in London will decline to $4, or GBP2. This means that the USD will strengthen. It’s not a question of if this will happen, but when it will happen.
Presently, the euro is overvalued on a PPP basis by 17.7 percent, the GBP is overvalued by 9.8 percent, and the Swiss franc is overvalued by 4 percent. This indicates to me that the USD, absent any significant changes in economic variables, will strengthen by approximately 10 percent against the other major world currencies.
Conclusion This short opinion column does not allow me to address a number of other factors, such as real relative interest rates, savings rates or national GDPs, which affect currency exchange rates.
The dollar must strengthen to revert to the equilibrium long-term PPP, or inflation/recession will occur at some point in the countries of the other world currencies. The dollar seems to have stabilized recently, but that is no guarantee that it will not weaken again in the short term before it reverts to the long-term equilibrium price.
The outlook is good for the USD. So we can stop dissing the dollar.
Michael Sullivan is an associate professor of finance and chief investment officer at St. Thomas.