Wednesday, December 16, 2009

Scanning for more US$ knowledge

Merk Funds specializes in global bonds and currency investing. They offer an example of what might cause downward pressure on the dollar in light of today's environment. Their web site provides much more depth for inquiring minds.

Numerous factors affect the value of a currency. Although financial pundits within the media give a reason(s) for every move, it is usually not possible to pinpoint exactly why a currency has moved. What we can do, however, is to look at the big picture: we can analyze large forces weighing on the markets.

In explaining the fall of the U.S. dollar, one factor we focus on is the current account deficit. The current account deficit is the difference between what Americans earn from other countries (exports, services, investments abroad) and what we pay out to other countries (imports, services, loans). This shortfall in trade and investment income between the U.S. and the rest of the world amounted $673.3 billion in 2008. As a share of gross domestic product (GDP), the deficit amounted for 4.7% in 2008. Foreigners must absorb this shortfall by buying about $2 billion worth of U.S. dollar denominated assets every single day, just to keep the U.S. dollar from falling.

We often hear about the trade deficit, which is simply exports minus imports. Let us visualize what the trade deficit means: if we import $600 billion+ more than we export, we are passing many U.S. dollar bills to other countries. They can hold the cash (e.g. purchase U.S. bonds), re-invest in the U.S., or exchange it into their local currency. Unless other countries purchase U.S. dollars at a rate of about $2 billion a day, there will be downward pressure on the U.S. dollar.

Visualize the U.S. buying Chinese goods and paying for them with U.S. dollars. The Chinese must decide what to do with the U.S. dollars they receive: as they do not find enough American goods and services to consume, they can decide to purchase U.S. dollar denominated assets, such as U.S. Treasuries; or they could convert them to their own currency, which would cause the U.S. dollar to fall.