An exchange rate is the price at which the world demand for one currency equals the world supply of another currency. Foreign exchange rates are of particular concern to governments because changes in foreign exchange rates affect the value of products and financial instruments. As a result, unexpected or large changes can affect the health of nations’ markets and financial systems. Variations in exchange rates also impact international investment flows, as well as export and import prices. These factors, in turn, can influence inflation and economic growth.
Interest-rate differentials between countries are one of the main factors that influence exchange rates. Money tends to flow into investments in countries with relatively high real (that is, inflation-adjusted) interest rates, increasing the demand for the currencies of these countries and thereby their value in the foreign exchange market. Price of oil, trade and the fiscal position and ratings of each country are also equally important.
The Greenback's tumble early on in the year to a 20-year low of $1.32 against the Euro was no surprise to many observers. In fact, now that the Dollar has continued to fall to its present rate of $1.35 for Є1.00, in retrospective the only real surprise was that it had not slipped sooner. And, furthermore, there are good reasons to expect the slide to continue.
The recent decline was triggered by nasty news about the American economy, paramount among which the fact that the housing markets’ troubles are having a wider impact on the economy as a whole than originally anticipated and, second in line, the global imbalances that the American current account deficit has created. The U. S. current account deficit, which is mirrored by current account surpluses in Asia and in many oil-exporting countries, has grown to the point where the United States needs to attract 70 percent of the world's capital flows to finance its interest payments only - clearly an unsustainable situation. There are also mounting concerns that Central Banks in China and to a lesser extent in India, which have been piling up Dollars assiduously for years, may start selling.
Ben Shalom Bernanke, the Chairman of the Federal Reserve System, continues to sound unperturbed suggesting that the American economy will enjoy a soft landing, a statement which would lead to believe that interest rates are not going to undergo drastic cuts. This notion has underpinned the belief that the Dollar will hold up in the medium run, because foreign investors will remain eager to buy American assets and so finance the country's current account deficit. But if house prices continue to fall, the risk of a recession will grow and the enthusiasm of foreign investors for the Greenback will shrink.
Yet, despite all, the attractiveness of the American Dollar is based more on an illusion than anything else.
The main psychological reason for the strength of the Dollar has been the widespread belief that the American economy vastly outperformed the world other rich-country economies in recent years. This belief is now beginning to change among foreign investors, for a variety of reasons. First and foremost the figures do not support the hype. For instance, it is true that America's GDP growth has been faster than Europe's, but that is mostly because America's population has grown more quickly. In fact, in real terms productivity growth over the past decade has been almost the same in the Euro Zone as it has been in America.
So therefore, contrary to the popular perception, the American economy has not significantly outperformed Europe's in recent year. But to achieve this not much better than parity status, the United States has incurred a huge current account deficits, while household savings have plummeted to a record low. Over the same period, the Euro-area economies saw no fiscal stimulus and household savings barely budged.
America's growth has been driven by consumer spending. That spending, supported by dwindling saving and increased borrowing, is clearly unsustainable and the consequent economic and financial imbalances must be inevitably unwind. As that happens, the country could face a prolonged period of slower growth that could spill across the border and affect America's single biggest trading partner as well: Canada.
In light of the foregoing, then, how should American and Canadian real estate consumers react?
Two countervailing factors tend to support the Dollar. First, emerging economies - especially China and India - hold so many Greenbacks that they fear the capital loss that they would incur if they encouraged the Dollar to drop. Second, emerging economies have all the interest to keep the value of their own currencies down to help their exports. As much as China and India have done giant leapfrogs forward in both manufacturing and finance - and in this respect both countries deserve the praise of the international community - neither has been able to fully create a domestic economic section of consumers that can absorb in whole or even in noticeable part what they produce. Besides, many a firm located overseas are American or branches or sub-branches of American multi-national corporations, and their ultimate goal is to produce output cheaply for export into North America.
Seen in this light, that talk of the weakness of the American Dollar is vastly exaggerated. In fact, the Federal Reserve reports that the real trade-weighted exchange rate of the Greenback against a broad basket of currencies is still close to the 30-year average. In other words, the Dollar needs to fall a lot more to make a dent in America's external deficit.
Moreover a falling Dollar does not necessarily spell doom for American consumers. In fact, all of us in North America could well benefit from a gradual slide in the American currency, as the ultimate result would be to shift production back into America's tradable sector, thus cushioning the domestic economy. A weaker Dollar would tend to hurt exporters in Europe and Asia and benefit those in North America as goods made here would become far more competitive abroad, thus spurring capital in-flow into the continent, as well as both foreign and domestic consumption.
Hence, so long as interest rates remain stable, real estate consumers both in Canada and in the United States need not to be overly concerned with the drop in value of the Greenback.
Luigi Frascati is a Real Estate Agent based in Vancouver, British Columbia. He holds a Bachelor Degree in Economics and maintains a weblog entitled the Real Estate Chronicle where you can find the full collection of his articles on Real Estate Economics and Finance. Luigi is associated with the Sutton Group, the largest real estate organization in Canada, and is based with Sutton-Centre Realty in Burnaby, BC.
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