Friday, July 3, 2009

Is Strong Dollar Good And A Weak Dollar Bad?

“The Euro has risen to record levels against the dollar”. “The pound sterling has risen to record levels against the dollar”. These are the common quotes that we usually bump into in any economic and financial headlines. What do these headlines mean? Do they matter to us?

Yes, of course. But it has different incentives onto different economic agents which we shall explore shortly. Basically weakening or falling of dollar against other currencies means the same. We need greater quantity of dollar to buy per unit of foreign currencies or a unit of dollar acquires lesser foreign currencies

Very often people are caught up with the idea that strengthening dollar is good and weakening dollar is bad. It is similar with the misperception that people usually have on current account. If deficit is bad but if it’s in surplus, then is good. To be honest there are both advantages and disadvantages to a strong or weak dollar with economic dangers lurking at either extreme

Here I’ll consider only the case of a strong dollar since the argument for weak dollar is just the mirror image
Advantages from a strong dollar:

(1) Lower price of foreign goods and services. With strong dollar, foreign luxury goods such as LCD televisions, handbags, shoes and sport cars from Western European countries which were once perceived expensive now seem to be more affordable. Even household goods such as food item, clothing and other necessities with inelastic demand can be bought in greater quantity. These two lead to rise in standard of living and is a great boost to welfare

(2) Cheaper to import capital goods. Rise of dollar is a good news for companies in secondary sectors. It will provide them an incentive to upgrade or replenish those old capital equipments with falling productivity. From medium to long term perspective, it should be able to increase the productive capacity of US economy. Aggregate supply (AS) will shift rightward. This is important to maintain its productivity ahead of major rivals like Germany, France, UK and Japan. Rise in productivity will lead to many things such as falling price level, increase in national output thus economic growth and lowering unemployment. Second engine of growth is necessary since US depends too much on private consumption to steer its economy forward

(3) Easier to borrow. When the greenback is strong, it is a sign that the US economy is ‘vibrant’. Yes, some may argue that the American economy is in a pathetic state like now, but it is worthy to note that other major economies suffer too. So, generally when all economies are sinking, capital and funds will flock to US which is perceived as safest haven

Sustaining the might of dollar is inevitable. Only by doing so, investors will be keen to continuously hold dollar assets. Dollar run will be minimised. US government will also find it easier to finance their ballooning fiscal deficit by issuing bonds. China and Japan, the two biggest ‘banks’ for US will be very glad to snap up those securities. There are two reasons for this. First both have large dollar reserves and secondly, they are heavily depending on American consumers to buy their goods

(4) Cheaper to travel overseas. Since the dollar is now appreciating against RM we would expect more Americans to visit Malaysia during this summer holiday. More local goods can be bought thus contributing to an increase in economic welfare. Voyagers can also stretch their budgets to include other activities that would have otherwise been foregone. Also more part time jobs will be created in tourism related industries such as airline, hotel, food and beverages and craft industries. It will have multiplier effect although the effectiveness may somehow be slightly muted with recession in US. So, it’s a win-win situation

(5) More affordable foreign stocks. It is not only the consumers that benefit from rising dollar as companies on an acquisition binge do so as well. With stronger buying power, foreign stocks or companies become cheaper in valuation compared to US based firms. This will likely spark a wave of increase in cross border transactions such as vertical, horizontal or even conglomerate integrations. American companies can look forward to expand the scale of their operations or eliminate competitors by buying them out

(6) Reduce inflation. Stronger greenback will reduce the risk of imported inflation. Raw materials and many other intermediate goods will appear cheaper, thus reducing overall production costs. Some of the cost saving may be passed on to end consumers in the form of lower price. Consumer surplus will increase then
Problems:

(1) Uncompetitive exports. This is a bad news for US manufacturing sectors. Stronger dollar against other foreign currencies will mean that importers now need more of their home currencies in order to exchange for the same US $1. American goods therefore become more expensive even when there is no changes in the actual price quoted in dollar. Demand for exports will fall in relative to imports. Current account deficit will worsen. Higher exchange rates will have different impacts onto different parts of the world. Japanese and Chinese government would most probably intervene to devalue their currency if there is an upward movement of yen and yuan against dollar. Meanwhile, for world’s largest manufacturer like German, there is nothing much it can do since the power to manipulate currency and interest rates is at the hand of ECB

(2) Outsourcing. US firms soon find it difficult to compete with local market in overseas due to uncompetitive reasons such as ridiculously high wages and high exchange rate. They will begin to outsource their production, mainly in emerging economies like China, Malaysia, Indonesia or Vietnam since labour costs are far lower and yet the productivity is high. If this happens, average Americans will lose their jobs when factories are shut. It may also lead to severe problems like regional unemployment, hysteresis and negative multiplier effect onto local supply chain

(3) Gloomy tourism sector. On average, US attracts more than 50 million tourists every year and the large influx is during summer. Popular destinations include New York, LA, Miami, San Francisco, Florida and many more. Most of these tourists are from European countries and Latin America. If dollar strengthens, most likely we will witness a fall in tourist arrival during this summer. American stores also expect to see their sales dip further compared to previous years

According to Commerce Department, about 90% of travellers make shopping their first priority and they generally spend more than local visitors. As such, it is not difficult to understand why their presence is important since it may contribute to increase in consumer and business confidence. Probably the US officials are banking on this when they announced that we will likely see a recovery by the 3rd quarter of 2009

(4) Lower overall profits for firms. Weakening home currency against the dollar means that any increase in sales revenue or profits will lead to nothing when repatriate to parent company in US

1 comment:

kening_lee said...

thank you, information is useful.