Author`s name Alex Naumov

US dollar undervalued and it may become more so

Against the pound, the dollar recently dropped to a 26-year low; against the euro, down to nearly 1.50 from 0.83 seven years ago; down by 25pc over nine years against the yen; by nearly 40pc in seven years against the Swiss franc; and by nearly 40pc in six years against the Canadian dollar. And, against the oldest currency - gold - it has fallen by nearly 70pc in eight years and 40pc in two years.

Yet it is still not so weak overall. Since 2002, against just about all the currencies involved in US trade, it is down by 24pc. The reason is clear - many countries peg their currencies to the dollar, so when it goes down they go down with it; others manage their currencies so their value sticks pretty closely to the dollar.

China is the most striking example. The renminbi is not rigidly fixed against the dollar, but its value is not allowed to diverge greatly. So, over the period when the dollar has fallen by 20pc against the euro, it has fallen by only 10pc against the renminbi. Yet China is the source of 15pc of US goods imports.

Why has the dollar been weak? The fundamental reason is trading performance, as shown in our chart. The US is running a current account deficit of roughly $800bn (£390bn) a year, or 6pc of GDP. In order to finance this, it has to draw in capital from abroad to the same extent. In other words, foreigners have to add $800bn of dollar-denominated assets to their portfolios each year.

It has become fashionable to decry the influence of trade balances when assessing currency prospects. There is no doubt that as a guide to short-term currency performance they are awful. But, in the end, large and persistent deficits have a marked bearing on currency values.

Several factors can overpower their influence in the short run. In particular, strong economic growth offers the prospect of good returns on equities and property and tends to be accompanied by high interest rates. This has been the US position during much of the past 10 years. Equally, the liquidity and security of dollar markets have been a major attraction for some of the world's biggest investors, including those natural dollar holders, the Asian central banks and the Middle Eastern oil producers.

What has caused the dollar to wilt has been the undermining of these two supports. First, it is becoming clear that the weakness of the US housing market will have a decided effect on its economy. This worsens the prospects for real investment, whether it is in equities, residential real estate, or foreign direct investment. Meanwhile, interest rates look likely to fall further. Indeed, if recession does loom, then, on past form, the Federal Reserve is likely to slash interest rates.

Nor can the investor in US assets take comfort from the idea that America will try to prevent the dollar from falling. For all the rhetoric about a strong dollar, in practice they almost always follow a policy of benign neglect.

Second, traditional holders in the Middle East and Asia have recently started to show signs of dollar satiation. The proportion of dollars in their portfolios is already large and, as their current account surpluses continue, they will probably want to allocate a larger share of their additional assets to other currencies.

For us here in the UK, the dollar's weakness is felt acutely. In fact, our economy is rather like a smaller version of America's. We, too, are running a huge current account deficit and our currency needs to be lower for this to be corrected. Yet, perversely, the pound has been carried higher against the dollar, reports.

There are three main reasons why this period of dollar weakness may persist. The first is that there is a rival currency covering an economic zone of comparable size to the US, the euro. Even since the currency was created, the eurozone has grown more slowly than the US. This year it looks like changing, with Europe growing faster. That inevitably creates a demand for the currency, for people want to invest in a place that is doing well.

The second is that the current account deficit of the US is larger relative to GDP than in any previous bout of dollar weakness. It is improving a little but is still about 6 per cent of GDP and that is huge.

Foreigners don't need to take money out of the US to put pressure on the dollar; they don't even need to stop investing; they merely need to stop putting so much money in. That is what has been happening in recent months, particularly since the summer.

And the third is that the relative size of the US economy has been shrinking, while the Asian economies – China of course but also India – have been gaining ground every year. Next year, China will pass Germany to become the world's third largest economy after the US and Japan and, on present trends, will pass Japan within a decade. So while the US will retain the title of the world's largest economy for another generation, it no longer dominates the world in the way it used to.

So what will happen? Currencies generally overshoot their true underlying value. Why that should happen is bound up in the mists of market psychology. The dollar is probably already undervalued but that does not mean that it will not become more so. Its reputation is being chipped away by a series of events, small in themselves but large in total.

They include the story this week that the United Arab Emirates may cut the link with the dollar, as Kuwait already has done. If there were a general loss of confidence then the dollar could fall quite a lot more. Eventually there will be a floor – there always is – but the collapse would be disruptive, not least to the European economy, where exporters are suffering from the surge in the euro.

If things really get out of hand, there may have to be some dollar rescue but that – for the moment at least – seems some way off. The big point is even when the dollar does recover the world will be different. Maybe we will still price oil in dollars but a lot more people around the world will think – and place their assets – in euros, Independent reports.

Sources: agencies