The rising dollar Featured

7:00pm EDT December 26, 2008

The U.S. dollar has surged as investors, wary of the stock market’s extreme volatility, have flocked to the relative safety of U.S. Treasuries. In some respects, a strong dollar adversely impacts the U.S. economy: It increases the trade deficit while weakening exports and eroding the competitiveness of American-made goods.

However, some entities stand to benefit from the strengthening dollar.

“American importers, consumers buying foreign goods, corporations making capital investment in overseas ventures and American vacationers traveling overseas can all benefit from a stronger dollar,” says Gary Loe, vice president, foreign exchange at Comerica Bank.

Smart Business spoke with Loe about the dollar’s rise, its implications on the global economy and his prediction for how the dollar will fare in 2009.

Why has the dollar strengthened against major currencies?

This past summer, beginning with the global credit/financial crisis, we experienced a ‘flight to quality’ effect. As equity markets around the world have been battered, many investors sought the safety of U.S. Treasuries to protect their money. As investors from around the world reevaluate their risk tolerance, they buy dollars in order to purchase U.S. Treasuries, which are very liquid and have low default risk, backed by the power of the U.S. government.

The world started a global economic race to the bottom in 2008. The world economy has been heading toward a global recession with the U.S. in the lead. The first to reach the bottom should be the first to bounce back. Problems are not just contained within the U.S., as evidenced in Germany. Europe’s largest economy is at a 15-year low in consumer confidence, and the spillover in the credit crunch has already reached Asia. Many believe that the U.S. government has helped steer us away from a deep depression. The U.S. can act quicker to get to an eventual recovery as opposed to Europe where many countries are needed to come together for action.

How has the stock market’s recent volatility affected foreign exchange?

The market has experienced extreme volatility with a downside trend. We have had thousand-point swings in a day in the Dow. We have had 10 percent swings in a day in the dollar against hard currencies like the euro, British pound and Australian dollar. It’s not just the U.S. stock markets that are volatile and weak, as seen in the S&P 500, currently down about 45 percent this year. London’s FTSE index and Tokyo’s Nikkei 300 index are down about the same. The biggest effect the volatility has had in foreign exchange is the increased bid/ask spreads and diminished liquidity with tighter credit standards.

Is a strong dollar good for the United States?

Usually, the word ‘strong’ is perceived as a positive feature, but when it comes to a country’s economy, it may not be in its best interest. Some say a strong dollar helps accelerate growth. Growth will attract foreign capital and boost our stock market. This leads to increased production, consumer spending and an expanding economy. However, there are many negative ramifications. It tends to widen the trade deficit as we purchase more imported goods. This increase has its detriments as it erodes overall growth, hurts GDP and weakens the economy. It will also hurt corporate profits of global companies as foreigners will have to pay more for U.S. goods. The dollar should act as a self-correcting mechanism as a stronger dollar leads to a weaker one and vice versa.

How do foreign central banks tend to react when the dollar rises?

Central bankers in export-driven economies, such as Japan, would tend to do nothing as it would allow growth in the export sectors. However, if I am a central banker where my currency is devaluing at a pace that needs defending, I would raise my interest rates to defend it. This should attract flows into my currency, therefore stopping the depreciation. Malaysia’s central bank froze its currency in the 1997 Asian financial crisis when facing steep depreciation by cutting off all market players.

Where do you see the dollar heading over the course of 2009?

Through the beginning, we will still be watching for weak global equity markets and weak commodity prices and bracing for possibly the biggest economic slowdown since World War I. As investors flee from chancier bets and more deleveraging takes place in the credit world, this will give further room for boosts in the U.S. dollar. Take advantage of any further dollar strength at the beginning of 2009. Once our government’s actions in stimulating the economy and getting our credit situation back in check take effect, look for the dollar to start weakening again, which I predict will happen later in 2009. Fundamentals are bound to return. At the forefront will be renewed talk about America’s huge ‘twin deficits,’ budget and trade. In addition, all the printing of money that has, and will, occur to help us out of our current financial and economic crisis will turn inflationary, which will erode the value of the dollar.

GARY LOE is vice president, foreign exchange at Comerica Bank. Reach him at (800) 318-9062 or gloe@comerica.com.