Download INBU 4200 Spring 2004

INBU 4200
Spring 2004
Addendum to Lecture 4, Part 1
A Review of Exchange Rates, Interest
Rates and U.S. Trade with China
February 2004 Information
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Fundamentals of the Dollar's Fall
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The rise of the yen and euro against the
U.S. dollar
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Source: WSJ
THE DOWNWARD DOLLAR
INVESTORS WORLD-WIDE are watching
the value of the U.S. dollar fall, and no
U.S. intervention has taken place to
counteract its steady depreciation.
Plagued by the swelling budget and trade
deficits, low interest rates and waning
foreign investment flows, the dollar has
lost 26% of its value against the world's
major currencies since early 2002. It has
fallen 14% against an index of all U.S.
trading partners' currencies, including
Asian countries.
The euro continues to steam ahead,
reaching a record intraday high of
$1.2930 in February. The European
Central Bank recently expressed concern
about excessive exchange-rate moves
and said the common currency has
climbed too high. The yen, meanwhile, is
trading at about 105 to the dollar. The
dollar has lost about 11% against the yen
since year-end 2002. The decline may
have been steeper hadn't Japan stepped
in, spending nearly $200 billion in 2003 to
restrain the yen's rise.
A MAIN CONTRIBUTOR to downward pressure on the
dollar is the current-account deficit -- the shortfall
in goods, services and the flow of investments
between the U.S. and the world. The deficit hovers
at half a trillion dollars annually. As the widest
measure of U.S. international trade, it's running at
about 5% of U.S. gross domestic product, a high
and historically unsustainable level.
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The trade deficit is the largest component of the
U.S. current-account deficit. The trade deficit
grows when a country imports more goods and
services than it exports. Currently, the U.S. is now
importing at greater than 1.5 times the rate of its
exports, meaning the U.S. has been buying about
$500 billion a year more from foreign countries
than those countries buy from the U.S. Analysts
expect imports to keep increasing as companies
replenish inventories and U.S. manufacturing
operations move overseas. By country, the
shortfall with China is the largest at a record
$123.96 billion for 2003.
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The U.S., in large part, finances its trade deficit by
selling assets, including Treasury bonds, Treasury
bills, corporate bonds, stocks, real estate and
companies to foreign investors, much as you
might take out a home-equity loan or sell some of
your mutual funds if your wages weren't enough to
cover your spending habits. Traditionally,
foreigners have financed the debt by buying U.S.
securities, but because U.S. interest rates are so
low, the returns on their investments have become
less attractive. While that reduces many private
investors' appetites for U.S. investments, foreign
governments, especially China and Japan, remain
aggressive buyers.
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Chart: U.S. Current Account as a % of GDP
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Key interest rates in the U.S. and the EU
DIFFERENCES IN the level of interest rates from
country to country have a powerful influence
on the relative value of currencies. Money
tends to flow to countries where interest rates
are higher as investors seek out higher
returns. Investors' purchases lift the value of
the currency in which the investments are
denominated.
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The low level of rates in the U.S. relative to
those in Europe has helped to depress the
value of the dollar. Amid recession and a
sluggish recovery, U.S. interest rates fell
steadily from 2001 through last year, leaving
the key federal-funds target rate at a 45-year
low of 1%. European interest rates have been
higher on average; the European Central Bank
has held the 12-nation euro zone steady at a
2% minimum bid rate since its last cut in June.
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There are signs that the disparity between
rates in the U.S. and Europe may change in the
coming months. In the U.S., economic growth
has accelerated. Continued strength could
convince the Federal Reserve to lift interest
rates to head off inflation. Although inflation
has remained subdued for some time, a rise in
the price of imported goods -- including crude
oil -- could put upward pressure on prices.
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At the same time, the ECB feels pressure to
reduce rates. The surging euro tends to
increase the cost of goods exported from
Europe, which reduces demand.
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European companies are being pinched. Many
are reluctant to see the cost of their goods rise
in America and elsewhere, fearful that they will
lose market share to competitors.
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U.S. trade balance with China
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WHILE GROWTH is picking up across Asia, almost all
of it comes from exports, mainly to the U.S. and China.
China's economy grew at a ferocious pace last year,
with GDP up 9.1% compared with 8% in 2002.
Ordinarily, this lopsided U.S. demand for Chinese
goods should force China's currency, the yuan, higher
against the dollar. As China's exports to the U.S.
increase more than China's imports from the U.S., for
example, the demand for yuan rises because China's
exporters either want to be paid in yuan or have to be
paid in yuan due to government regulation. If more
dollars flow to China, and the supply of the dollar in
China became greater than the demand for the dollar,
the yuan would appreciate and the dollar depreciate.
However, China fixes the exchange value of its yuan
against the dollar, fearing that should the yuan rise,
Chinese exports would fall, costing jobs. China's
currency has been pegged at about 8.28 yuan to the
dollar since 1993. U.S. officials are concerned that the
yuan is undervalued, keeping Chinese imports into the
U.S. cheap and creating an unfair trade advantage.
There are signs, however, that China may no longer be
able to hold the yuan down. Chinese monetary
authorities must continually issue new yuan in
exchange for the dollars earned from exports, the
quantity of yuan in circulation is climbing faster than
the economy's ability to produce goods and services,
fueling inflation. A higher yuan would likely raise the
price of many Chinese-made goods in the U.S. and
eventually reduce the U.S. trade deficit with China,
which U.S. manufacturing industries believe has cost
the U.S. jobs.
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Chart: U.S. Trade Balance with China