Who Gains and Who Loses as the Dollar Falls?

"I love to go to Washington, if only to be nearer my money."

- Bob Hope

There seems to be growing concern about the dollar's recent weakness - some might even call it hysteria. Yes, the dollar has weakened this year, but the losses have been relatively modest in most cases, with the exceptions being the Australian dollar (AUD), Brazilian real (BRL) and a couple of others. The euro (EUR) is at the same level it was at in August 2008, as is the overall dollar index (DXY). So why all the fuss?

So far, most of the chatter has been in the financial press and is an academic discussion about whether this will remain an orderly decline or will turn into a collapse and what the consequences will be. We have only heard occasional murmurs of concern from those that stand the most to lose. I believe they include most countries, with the exception of the U.S. and those countries in Asia that have their currencies pegged to the dollar - obviously, China is the most visible example.

We stand to gain for obvious reasons. A weak dollar is an export boost and a disincentive for our consumers to buy imported goods. It could help us tremendously in reducing our trade deficit, thereby boosting GDP. The main concern we would have under normal circumstances would be heightened inflation risk, as imported goods cost more and dollar weakness is the equivalent of monetary easing. However, that is not a concern today, and while it may be in the future, that is many moons away - almost certainly after the congressional elections next year.

China stands to gain in several ways. They have essentially pegged the renminbi at around 6.83 since last July, and as a result, the currency has depreciated versus most other currencies as the dollar has fallen. That is a huge boost to China's export competitiveness (not that they need it) and even more importantly, a significant reason why their economy has bounced back as rapidly as it has. China's day of reckoning with inflation will approach far faster than it will for us, but for now they have enjoyed the upside without facing any significant consequences. Until they have reduced their holdings of U.S. assets or hedged most of the currency risk, allowing their currency to appreciate versus the dollar would imply large markdowns in the value of those assets - yet another reason why this unofficial peg will last a while longer. Of course, a weaker renminbi implies soaring import costs as commodity and other raw material prices soar, which is why the Chinese have recently entered into several bilateral barter agreements, which immunize them to an extent.

For the rest of the world, the weak dollar is a tax on exports to the U.S., while enhancing our export competitiveness. However, I believe that the European Union in particular is far more concerned with the benefits accruing to China in this regard than they are with us. China's share of European trade (both exports and imports) is growing far faster than their trade with us and China already has a currency that is dramatically undervalued, even without the help of the dollar link. The one benefit they get is that the price of oil, gold or other commodities is more stable in euros than it is in dollars, but overall, the negatives far outweigh the positives. This drag on trade is far more an issue for the slower growing economies of Western Europe that desperately need a boost than it is for commodity producers such as Australia and Canada, or faster growing emerging market countries like Brazil.

As a result, I expect more vocal protests from Europe should the dollar decline continue, and especially, if the pace should intensify. We will respond with the usual statements about following a strong dollar policy and as usual, it will count for absolutely nothing, unless the dollar nosedives. That could destabilize other financial markets and the Fed and Treasury would respond. I consider that highly unlikely.

China will remain silent on the issue and will in all likelihood stick to their agenda. In my opinion, they will keep the renminbi stable until unemployment has fallen, GDP growth is back at a nine to ten percent level, inflation is a more pressing issue and their exposure to the USD is more manageable. That implies no significant change until late 2010 or beyond. Without China's active cooperation, the chances of an accelerated dollar sell-off are remote - there is no imminent catalyst, no other capital market is able to absorb the supply, and fundamentally, the dollar is now under-valued vs. most currencies, the notable exceptions being the CNY and other regional Asian currencies.

However, the world is rapidly being aligned into three major trading blocs: the U.S., Europe and Asia. As Asia's economies grow and their share of global GDP increases - as it surely will - they will want more control over their monetary policy. At present, they effectively get their cues from the Federal Reserve, given the inflexibility of their currencies. When they decide the time is right, Asian currencies will delink from the dollar. This will almost certainly reduce the dollar's reserve currency status, but is not necessarily a bad thing, nor is it likely to play out in a catastrophic fashion. It will almost certainly result in Asian currencies collectively appreciating vs. the dollar and the rest of the world. I believe that will take years, not decades to play out. In the interim, Europe will keep protesting, we will continue our policy of benign neglect and China will reap the gains.