(WSJ) Despite all of the ink and tears spilled on the dollar’s recent decline, one nagging question still hasn’t been answered: What’s the dollar really worth? Economists and analysts around the world have several yardsticks for measuring a currency’s value, but at the end of the day they all come up short in some way — and they often arrive at different conclusions.
That is partly because the dollar’s worth is based on a hopelessly complex web of shifting and interlocking factors, including trade balances, government spending, interest rates, inflation and economic growth.
Complicating the issue further, the dollar is valued differently against various world currencies. Most measures say it is overvalued against the Chinese yuan, while some find it too cheap relative to the euro, which closed Friday at $1.49, near a 14-month high.
Whatever the dollar’s true value, the trends that have punished it this year are still in place, suggesting it has further to fall. U.S. interest rates remain low, government borrowing is high and the economy is expected to remain weak. The buck is also losing its luster as a safe haven as the thirst for risky assets picks up.
“The burden of proof is on dollar bulls to make their case,” says Alan Ruskin, head of international strategy at RBS. “Valuations are not a catalyst for a turn.”
The IntercontinentalExchange dollar index, which measures the greenback against six major currencies and heavily weighted to the euro, fell to a 14-month low last week of 75.48, not far from its all-time low, set in April 2008, of 71.33.
The index has tumbled 15% since March 9. During that time the Dow Jones Industrial Average has soared 53%, gold is up more than 14%, and the Bank of New York Emerging Market index is up 89%.
Most observers agree that the dollar’s decline so far has been relatively orderly. The recent tumble has only partially reversed a spike during the financial crisis and reflects a healing of the U.S. economy, as investors leave the safety of dollar assets for riskier fare.
U.S. officials have done little to stop the decline, in part because a weaker dollar benefits U.S. exporters and helps the Federal Reserve fight deflation.
In the futures market, speculators betting that the dollar index will fall outnumber those betting that it will rise by nearly two to one, according to the Commodity Futures Trading Commission. But that ratio has shrunk from roughly three-to-one two months ago. And some currency watchers suggest the dollar is due for a rebound, if only temporarily.
“We expect significant downward re-pricing of foreign currencies and the dollar to rally some,” says Jonathan Clark, vice chairman at FX Concepts, an $8 billion New York hedge fund that focuses on foreign exchange. “It’s not a long-term phenomenon, but the rally in other currencies is overdone.”
An oft-used gauge for this purpose is a real effective exchange rate index compiled monthly by the Bank for International Settlements, which acts as the central bankers’ central bank.
According to the BIS measure, which adjusts for price changes and tracks the dollar against a broad basket of global currencies, the value of the dollar was roughly 11% below its 10-year average in September.
Getting more complicated, some analysts derive a working exchange rate from the amount of each currency it takes to buy similar goods around the world.
Here’s one of the simplest examples: If a latte costs $4 in the U.S. and €2 in Paris, then the euro could be said to have the purchasing power of $2. If this exchange rate is higher or lower than what the foreign-exchange market says it is, then market valuations might be out of kilter.
Most banks and economists compose still-more complicated models, using whole baskets of goods, rather than one latte, to find the “purchasing power parity” of currencies.
One such model by the Organization for Economic Cooperation and Development finds the dollar is worth roughly 0.85 euro, compared with its market valuation of 0.67 euro, suggesting that the euro is 21% overvalued. A similar model from the International Monetary Fund suggests China’s yuan is 76% undervalued.
On this basis, the dollar is also undervalued against the Japanese yen, which has rallied lately. Some investors have long used yen to finance the “carry trade,” or borrowing cheaply where interest rates are low to invest in higher-yielding assets. Now many are using the dollar for that purpose.
On the other hand, the dollar seems to be roughly on par, if slightly undervalued, against the British pound, which has suffered its own bruising of late, thanks partly to the easy monetary policy of the Bank of England.
The future of the dollar and other currencies depends largely on what their central banks do to unwind the extraordinary measures they have taken to stabilize their economies. If the Fed acts first, “that would lend credibility to the dollar,” says Lena Komileva, head of G7 market economics at London-based broker Tullett Prebon.
But few expect that shift to occur soon. Meantime, longer-term fundamental factors that affect currency movements lean heavily against the dollar.
For one thing, the U.S. still runs a trade deficit of some $31 billion. It was cut in half by the deep recession but has edged higher lately as imported oil prices have risen and consumers have tiptoed back to stores to buy cheap imported goods.
William Cline and John Williamson, economists at the Peterson Institute for International Economics, have constructed what they call “fundamental equilibrium exchange rates,” designed to account for big trade deficits and the ability of countries to finance them.
Based on their measure, the dollar is overvalued against China’s yuan by about 40%, the result of China keeping its currency tethered to keep its exports competitive. But their model finds the dollar slightly overvalued against the euro — a far different result than the OECD model suggests.
Meantime, Chinese officials have expressed alarm about rising U.S. government budget deficits, a long-term threat to the dollar’s value. Recession fighting and low tax receipts helped foster a U.S. budget deficit of roughly $1.4 trillion in fiscal 2009, the worst since 1945. A weak recovery could keep the red ink flowing for some time.
“A lot will be determined by how credible the fiscal constraints this and future governments put into place,” says David Gilmore of Foreign Exchange Analytics, a Connecticut research firm. “All I can see is more pedal to the metal.”
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