The Falling Dollar

An index of the value of the American dollar against has decreased by 15% in the past half year, from 89.11 on March 5th to 75.24 on October 20th. Because the American dollar has been described as a “safe haven” in the investment market for a long time, the simplest explanation of the currency’s decline is based on the increasing value of risky assets, lowering the demand for the dollar to hedge. But this hardly constitutes an outright collapse, nor is it necessarily cause for concern.

Worries about the dollar are hardly new. The current-account deficit of America has increased since the 1980s, implying the pressure on depreciation. Some may argue that the U.S. dollar’s dominance is due to America’s position as a superpower, which is, however, now seriously challenged by the emerging countries. Moreover, these emerging countries, like China and Russia, who hold a large portion of their reserves in dollars, have recently called for the need to shift the world’s currency reserves out of the greenback. All of these factors cause the weakness of the dollar.

The weakness of the dollar has also revived fears of a currency crash. However, this kind of concern is going too far. Depreciation, if it continues in the future, will be a gradual move instead of a sharp crash. That is because its liquidity ensures the dollar’s irreplaceable position as the settlement currency of international trading and the main currency reserve for most central banks. It is clear that no other currency can compete with the dollar in terms of the amount in circulation, maintaining demand for the greenback. In fact, the financial crisis actually caused a flight to dollars as a safe-haven, proving that the dollar is still considered a safe asset, and the recent weakness merely reverses the previous risk aversion.

Responses of countries with floating exchange rates to the dollar’s slide vary. To ease appreciation of the Brazilian real, Brazil’s government directly reintroduced a tax on foreign purchases of equities and bonds this week, causing the real to fall by 2% and Brazil’s stock market to drop by 3%. Instead of similar direct measures, the Canadian government has resorted to “talking their currency down,” saying that the strength of the Canadian dollar would offset the good news in the past three months. The foreign-exchange market responded to the statement immediately, leading Canada’s currency to fall by 2% against the American dollar. In general, since the recovery is uneven between different regions, countries with stronger trading relationships with Asia, such as Australia and Japan, are relatively sanguine about a weak greenback.

The lesson we have learned for the past year is that the dollar is that during the financial meltdown the dollar was still a currency to flee to, not from, showing that a dangerous collapse in the greenback is unlikely. But since the American budget deficit is expected to last for years and the world’s trading imbalance cannot not be solved in the short term, all governments may have to prepare to face a weak dollar for a long time.