From the June 2010 issue of Treasury & Risk magazine

The Dollar Climbs Back

The U.S. dollar looked weak for considerable stretches of the last decade, but the global financial crisis gave it a boost. And the current sovereign debt crisis in Europe is likely to ensure that the dollar retains its status as the world's dominant currency, despite some down years.

Over the next year or two, experts see the dollar strengthening against most other currencies except the Chinese yuan and the currencies of some emerging countries, like Brazil's real. In the long term, many experts had predicted that the dollar would again begin to weaken, but given the magnitude of problems currently plaguing its chief competitor, the euro, that's no longer an automatic assumption. Observers worry the conditions that led to the recent EU bailout of Greece could spread to other countries in the euro zone, like Portugal, Spain, Ireland and Italy, further damaging the euro's value.

"One or two years ago, everybody said the dollar was doomed," says Barry Eichengreen, a professor of economics and political science at the University of California, Berkeley. "Now people say the same thing about the euro."

With job creation and consumer demand on the rise, the U.S. economy is on the path to recovery, and the Federal Reserve could soon start hiking interest rates. Both are positive signs for a strengthening dollar.

Meanwhile, in Europe, including the U.K., the economic recovery from the global financial crisis has been much slower. Coupled with the current fiscal problems affecting Greece and the possibility that they could spread to other members of the EU, both the euro and the pound are likely to take a hit to the benefit of the dollar, at least in the next couple of years.

"We're on the verge of a multi-year recovery for the dollar," says Michael Woolfolk, senior currency strategist at BNY Mellon. He sees the euro, which ended 2009 at $1.43, weakening to $1.28 by the end of the year and to $1.10 by the end of 2011.

Even if Greece manages to pass austerity measures and contain the crisis, uncertainty will continue to surround the euro zone. At the very least, the debt crisis is revealing flaws in the European system.

Woolfolk calls the development of the euro zone "unfinished business" since European laws lack real enforcement measures. The European Union needs the power to eject countries if they don't respect its requirements, especially those pertaining to budget deficits, he says, and it needs a process in place for countries to return to their own currencies and interest rates if they can't comply with the EU rules. Until such big glitches are addressed in earnest, the euro will likely remain weak against the dollar.

The fact that the Federal Reserve will likely hike interest rates sooner and at a quicker pace than the European Central Bank, creating an interest-rate differential, will add to the dollar's appeal.

A stronger dollar is not necessarily good news for U.S. companies. In fact, it's likely to provide European companies, especially exporters, with a distinct advantage over the next year or two.

"In the near term, U.S. companies may have a bit of a problem against European rivals," says Nariman Behravesh, chief economist at IHS Global Insight, an economic forecasting company. He says that dynamic will be obvious in the aerospace industry, for example, where Boeing will find it harder to compete with Airbus, which is based in France. "But it will be true in any market," Behravesh says. "[A stronger dollar] will be a negative because it erodes competitiveness."

A stronger dollar will help U.S. companies that have set their sights on global expansion, though, according to BNY Mellon's Woolfolk. "U.S. companies should continue to follow through on their plans for expansion globally," he says. "U.S. companies with manufacturing capabilities abroad will be able to expand. Those are positive factors."

In the longer term--the next four to five years--however, the outlook for the dollar is much less clear cut.

U.S. spending has grown in recent months in part as a result of increased consumption of imported goods. That worsens the current account deficit, which is currently hovering around $40 billion, according to the Commerce Department's Bureau of Economic Analysis. Since it remains unclear whether and how the U.S. will address its deficits both internal and external, such uncertainty could increasingly weigh on the dollar going forward.

"Looking further down the road, the big issue will be whether we allow our budget deficit to go untreated," says Eichengreen. "People will grow disenchanted. That won't be good for the dollar."

The dollar's relationship to the Chinese yuan is another a complicating factor. Although dollar weakness against the yuan will lead to a decrease in imports from China, it won't help repatriate manufacturing jobs to the U.S. Instead, it's more likely that manufacturing will shift to other emerging economies, like Vietnam and Mexico. "The U.S. is a service-based economy," Woolfolk notes, adding that it will stay as such even with a stronger yuan.

China's unwillingness to properly value its currency hasn't helped the U.S. external deficit. Chinese leaders have failed to cooperate with demands from the U.S. and other global leaders to halt what they say is the artificial undervaluation of China's currency. By keeping its currency pegged at a fixed rate to the dollar, Beijing has been able to boost exports and drive growth, but its strategy has helped fuel the U.S.'s dependence on imports and accentuated trade imbalances.

Even if rampant Chinese inflation as a result of its own economic growth and increased pressure from the U.S. pushes China to strengthen its currency against the dollar in the near future, it remains to be seen whether the move would be significant enough to correct the trade imbalance between the two nations.

But deficit problems aren't exclusive to the U.S., and to the extent that other countries are overly burdened with debt, that could be a boon for the dollar.

"Many other countries, especially in Europe, are running deficits and are accumulating debt too," says Menzie Chinn, a professor of public affairs and economics at the University of Wisconsin. Although nobody knows which nation's set of problems will prove to be more serious, the long-term outlook for the dollar isn't as dire as some had predicted prior to the European crisis.

"Given the difficulties the euro encountered as of late, I'm not so worried about the dollar as I was a year ago," says Chinn. "I'm not so worried about the value of the dollar collapsing because the problems are the same throughout the world."


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